Oligopoly

OligopolyOligopoly
 Oligopoly is an important form of imperfectOligopoly is an important form of imperfect
competition.competition.
 Oligopoly markets are characterized by marketsOligopoly markets are characterized by markets
dominated by a small number of large firms.dominated by a small number of large firms.
 Oligopoly is also often referred to as “Oligopoly is also often referred to as “CompetitionCompetition
among the Fewamong the Few”.”.
 The simple case of oligopoly isThe simple case of oligopoly is duopolyduopoly whichwhich
prevails when there are only two producers orprevails when there are only two producers or
sellers of a product.sellers of a product.

OligopolyOligopoly
 When products of few sellers are homogeneous ,When products of few sellers are homogeneous ,
we talk about Pwe talk about Pure Oligopolyure Oligopoly..
 On the other hand, when products of the fewOn the other hand, when products of the few
sellers are differentiated but close substitutes ofsellers are differentiated but close substitutes of
each other,each other, Differentiated OligopolyDifferentiated Oligopoly is said tois said to
prevail.prevail.

Why do we Study OligopoliesWhy do we Study Oligopolies
 Oligopoly and Monopolistic Competition areOligopoly and Monopolistic Competition are
the two market structures that best describe thethe two market structures that best describe the
real world.real world.

Market ModelsMarket Models
Perfect Competition Mono Com Oligopoly Monopoly
No Firms Very Many Many Few One
Product Standard Different Std/Diff Unique
Sector Entry Easy Relatively Easy Sig. Obstacles Blocked

Characteristics of OligopolyCharacteristics of Oligopoly
 Small number of sellersSmall number of sellers
 InterdependenceInterdependence
 Barriers to entryBarriers to entry
 Indeterminateness of demand curve facing anIndeterminateness of demand curve facing an
oligopolistoligopolist
 Importance of advertising and selling costImportance of advertising and selling cost

Measures of Industry ConcentrationMeasures of Industry Concentration
 How do we tell whether a Market isHow do we tell whether a Market is
OligopolisticOligopolistic
 We use 2 measures of Industry ConcentrationWe use 2 measures of Industry Concentration
 1)1) Concentration RatiosConcentration Ratios::
The degree to which an industry is dominated by aThe degree to which an industry is dominated by a
few large firms is measured by concentration ratios.few large firms is measured by concentration ratios.
These give the percentage of total industry sales ofThese give the percentage of total industry sales of
the 4, 8, 12 largest firms in the industry.the 4, 8, 12 largest firms in the industry.
 Four Firm Concentration RatioFour Firm Concentration Ratio
 % of Total Sales accounted for by largest 4 firms% of Total Sales accounted for by largest 4 firms
 40% or more: Mkt considered Oligopolistic40% or more: Mkt considered Oligopolistic
Maker Sales
Ford 10000
Nissan 20000
Volkswagen 30000
Fiat 5000
Toyota 15000
Total 80000
Top 4 75000
Four Firm CR 93.75%

Measures of Industry ConcentrationMeasures of Industry Concentration
22)) Herfindahl IndexHerfindahl Index
Another method of estimatingAnother method of estimating
concentration in an industry isconcentration in an industry is
Herfindahl Index. This is given byHerfindahl Index. This is given by
the squared values of the marketthe squared values of the market
shares of all the firms in theshares of all the firms in the
industry.industry.
 (%S(%S11))22
+ (%S+ (%S22))22
+ ... + (%S+ ... + (%Snn))22
 %S%Sii is the %age mkt share of iis the %age mkt share of i
 squaring penalizes large firmssquaring penalizes large firms
 greater HI = greater mkt power.greater HI = greater mkt power.
Maker Sales % of Total
Ford 10000 12.5
Nissan 20000 25
Volksw agen 30000 37.5
Fiat 5000 6.25
Toyota 15000 18.75
Total 80000
Herfindahl 2578.13

Models of Oligopoly MarketsModels of Oligopoly Markets
 Remember the key points of oligopoly behavior:Remember the key points of oligopoly behavior:
 Mutual interdependence and strategic behaviourMutual interdependence and strategic behaviour
 Diversity of oligopoly behaviour requires diverseDiversity of oligopoly behaviour requires diverse
modelsmodels
 Three distinct pricing models of oligopoly:Three distinct pricing models of oligopoly:
 Kinked Demand CurveKinked Demand Curve (non-collusive)(non-collusive)
 CartelsCartels (collusive)(collusive)
 Price LeadershipPrice Leadership

I. Kinked Demand Curve ModelI. Kinked Demand Curve Model
 Introduced by by Paul Sweezy in 1939.Introduced by by Paul Sweezy in 1939.
 Behavioral Assumption: A competitor will follow a priceBehavioral Assumption: A competitor will follow a price
decrease but will not follow a price increase.decrease but will not follow a price increase.

I. Kinked demand CurveI. Kinked demand Curve
D1
MR1
7
Q1=100
Rivals IGNORE price changes
Price
Q
P0=10
Q0=20
What if rivals react?

P0=10
D1
MR1
Q0=20
Price
Q
7
D2
MR2
Rivals MATCH price changes
Rivals IGNORE price changesA
B
C
Q1=100Q2
•Original price and quantity at point A.

10
D
MR20
Price
Q
COMBINED STRATEGY:
(1) Rivals IGNORE price increases
(2) Rivals MATCH price decreases
Resulting in Kinked Demand Curve
A
B
CMC1
MC2

10
D
MR20
Price
Q
A
B
CMC1
MC2
•This leads the firm to charge the
same price even if costs change.
The MR curve for the kinked demand curve
is discontinuous at the kink.
In order to maximize profits, use the MR=MC rule.

 Price inflexibility in non-collusive oligopolyPrice inflexibility in non-collusive oligopoly
 Demand Side: the kinked demand curve gives eachDemand Side: the kinked demand curve gives each
oligopolist reason to believe that any change in priceoligopolist reason to believe that any change in price
will be for the worsewill be for the worse
 Cost Side: the broken MR curve suggests that even ifCost Side: the broken MR curve suggests that even if
an oligopolist’s costs change substantially, the firman oligopolist’s costs change substantially, the firm
may have no reason to change its pricemay have no reason to change its price
 CriticismCriticism
 explains price inflexibility but not (the going) priceexplains price inflexibility but not (the going) price
itselfitself

II. CartelsII. Cartels
 A Cartel is formed when firmsA Cartel is formed when firms colludecollude with each other. It iswith each other. It is
an association of business firms formed by an agreementan association of business firms formed by an agreement
between them.between them.
 There are two types of cartelsThere are two types of cartels
 Overt (Explicit)Overt (Explicit)
 Covert (Secret)Covert (Secret)
 There are two types of cartels: the centralized cartel and theThere are two types of cartels: the centralized cartel and the
market sharing cartel.market sharing cartel.

17Oligopoly
CartelsCartels
 TheThe market sharing cartelmarket sharing cartel gives each member thegives each member the
exclusive right to operate in a particular geographicalexclusive right to operate in a particular geographical
area.area.
 TheThe centralized cartelcentralized cartel is a formal agreement amongis a formal agreement among
the oligopolistic members of a product to set thethe oligopolistic members of a product to set the
monopoly price, allocate output among its members,monopoly price, allocate output among its members,
and determine how profits are to be shared.and determine how profits are to be shared.
 For society, the result will be the same as monopolyFor society, the result will be the same as monopoly
with many plantswith many plants

II. Cartels and other CollusionII. Cartels and other Collusion
 Obstacles to collusion:Obstacles to collusion:
 Demand and cost differencesDemand and cost differences
 Large number of firmsLarge number of firms
 Cheating possibilitiesCheating possibilities
 Potential entry lured by profitsPotential entry lured by profits
 Legal obstacles: antitrust lawsLegal obstacles: antitrust laws

III. Price Leadership ModelIII. Price Leadership Model
 Under price leadership, one firm sets the price (priceUnder price leadership, one firm sets the price (price
changes) others follow it.changes) others follow it.
 Not outright collusion but implicit understandingNot outright collusion but implicit understanding
 The price leader assumes that firms will follow a priceThe price leader assumes that firms will follow a price
increase. It assumes that firms may follow a reductionincrease. It assumes that firms may follow a reduction
in price, but will not go lower in order not to trigger ain price, but will not go lower in order not to trigger a
price warprice war

20Oligopoly
Price LeadershipPrice Leadership
 Three Types of Price Leadership:Three Types of Price Leadership:
 (i)(i) Price leadership by a low cost firmPrice leadership by a low cost firm..
 (ii) Price leadership by the dominant firm(ii) Price leadership by the dominant firm
 (iii) Barometric price leadership(iii) Barometric price leadership ((by old, experienced,by old, experienced,
largest or most respected firm assumes the role of a custodianlargest or most respected firm assumes the role of a custodian
who protects the interest of all)who protects the interest of all)

Game Theory – OverviewGame Theory – Overview
 Game theory can be used to explain and predict behaviorGame theory can be used to explain and predict behavior
when there is mutual interdependence.when there is mutual interdependence.
 Game theory was pioneered by the mathematician John vonGame theory was pioneered by the mathematician John von
Neumann and the economist Oskar Morgenstern in 1944.Neumann and the economist Oskar Morgenstern in 1944.
 Game theory is concerned with “how individuals makeGame theory is concerned with “how individuals make
decisions when they are aware that their actions affect eachdecisions when they are aware that their actions affect each
other and when each individual takes this into account.”other and when each individual takes this into account.”
(Bierman and Fernandez, 1998).(Bierman and Fernandez, 1998).

22Oligopoly
Game Theory – OverviewGame Theory – Overview
 Every game theory model includes players, strategies,Every game theory model includes players, strategies,
and payoffs.and payoffs.
 TheThe playersplayers are decision makers (here the managers ofare decision makers (here the managers of
oligopolist firms) whose behavior we are trying tooligopolist firms) whose behavior we are trying to
explain and predict .explain and predict .
 TheThe strategiesstrategies are the choices to change price, developare the choices to change price, develop
new products, undertake a new advertising campaign,new products, undertake a new advertising campaign,
build new capacity, and all other such actions that affectbuild new capacity, and all other such actions that affect
the sales and profitability of the firm and its rivals.the sales and profitability of the firm and its rivals.
 TheThe payoffpayoff is the outcome or consequence of eachis the outcome or consequence of each
combination of strategies by two firms.combination of strategies by two firms.

23Oligopoly
Game TheoryGame Theory
 Zero-sum gameZero-sum game
 One player’s gain is the other player’s lossOne player’s gain is the other player’s loss
 Gains and losses sum to zero.Gains and losses sum to zero.
 Non-zero-sum gameNon-zero-sum game
 Both player’s may gain or lose.Both player’s may gain or lose.
 Gains and losses do not sum to zero.Gains and losses do not sum to zero.

24Oligopoly
 Non-cooperative gameNon-cooperative game
 Players do not share information with each other.Players do not share information with each other.
 Cooperative gameCooperative game
 Players may share information and coordinatePlayers may share information and coordinate
actions.actions.
 Dominant StrategyDominant Strategy
 There is one set of actions (strategy) that is best for aThere is one set of actions (strategy) that is best for a
player, no matter what the other player does.player, no matter what the other player does.

25Oligopoly
Game TheoryGame Theory - Prisoner’s Dilemma- Prisoner’s Dilemma
 Two individuals commit a serious crime togetherTwo individuals commit a serious crime together
and are apprehended by policeand are apprehended by police
 They know there is insufficient evidence to convictThey know there is insufficient evidence to convict
them of the serious crime.them of the serious crime.
 There is enough evidence to convict them ofThere is enough evidence to convict them of
loitering which carries a lesser prison sentence.loitering which carries a lesser prison sentence.
 Each prisoner is interrogated separately with noEach prisoner is interrogated separately with no
communication between them.communication between them.

26Oligopoly
Prisoner’s dilemma, continued:Prisoner’s dilemma, continued:
 Police tell them that if one of them confesses he willPolice tell them that if one of them confesses he will
receive a suspended sentence while the other willreceive a suspended sentence while the other will
receive the maximum sentence.receive the maximum sentence.
 If both talk then they will each receive a moderateIf both talk then they will each receive a moderate
sentence.sentence.
 What will each suspect do?What will each suspect do?

27Oligopoly
Prisoner’s dilemma, continued:Prisoner’s dilemma, continued:
•Payoff Matrix

28Oligopoly
Prisoner’s dilemmaPrisoner’s dilemma
 Confessing is a dominantConfessing is a dominant
strategy for each player.strategy for each player.
 This is the best strategyThis is the best strategy
no matter what the otherno matter what the other
player choosesplayer chooses
 EquilibriumEquilibrium
 Each player have noEach player have no
incentive to unilaterallyincentive to unilaterally
change their strategy.change their strategy.

29Oligopoly
Consider the game between two firms, A
and B, described below.
What is the equilibrium?

30Oligopoly
 Low/Low) is a stable
equilibrium. No
incentive for either firm
to deviate.
 Better off at
(High/High) but it is not
stable. Each firm has an
incentive to deviate.

31Oligopoly
 Efficiency implies that
there is no other strategy
pair that would make one
player better off and no
player worse off.
 (Low/Low) is not
efficient.
 (High/High) is efficient.
 (High/High) would be an
equilibrium if the firms
were allowed to cooperate.

Game Theory - LessonsGame Theory - Lessons
 oligopolies are mutually interdependent inoligopolies are mutually interdependent in
pricing policiespricing policies
 collusion enhances oligopoly profitscollusion enhances oligopoly profits
 temptation to cheat on a collusive agreementtemptation to cheat on a collusive agreement
existsexists

Oligopoly

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