Chapter 12
PRICE AND OUTPUT
DETERMINATION UNDER
OLIGOPOLY
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Economic Principles
The concentration ratio and the
Herfindahl-Hirschman Index (HHI)
Balanced and unbalanced
oligopoly
Horizontal, vertical and
conglomerate mergers
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Economic Principles
Cartels
Game theory
Price leadership
Kinked demand
Brand multiplication
Price discrimination
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Concentration Ratios
For a vast number of US manufacturing
industries, the competition among
firms in the industry is essentially
competition among the few—oligopoly.
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Concentration Ratios
An industry may consist of many firms,
but if only a few of the many dominate
the industry, then the industry is
oligopolistic.
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Concentration Ratios
Concentration ratio
• A measure of market power. It is the ratio of
total sales of the leading firms in an industry
(usually four) to the industry’s total sales.
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Concentration Ratios
A criterion for determining whether an
industry is an oligopoly:
• If the leading four firms in an industry
account for 40 percent or more of total
industry sales, then an industry is likely to
be an oligopoly.
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Concentration Ratios
Herfindahl-Hirschman index
• A measure of industry concentration,
calculated as the sum of the squares of the
market shares held by each of the firms in
the industry.
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EXHIBIT 1
CONCENTRATION RATIOS—PERCENTAGE
OF TOTAL INDUSTRY SALES PRODUCED BY
THE LEADING FOUR FIRMS, AND HHI
Source: U.S. Bureau of the Census, 2002; Concentration Ratios in Manufacturing, 2004.
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Exhibit 1: Concentration Ratios—
Percentage of Total Industry Sales
Produced by the Leading Four
Firms, and HHI
How many industries in Exhibit 1 have
market shares greater than 50 percent at
the four-firm level?
• 13 of the 15 industries
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EXHIBIT 2
DISTRIBUTION OF MANUFACTURING
INDUSTRIES BY FOUR-FIRM SALES
CONCENTRATION
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin
Company, Adapted with permission.
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Exhibit 2: Distribution of
Manufacturing Industries by
Four-Firm Sales Concentration
How many industries had four-firms
controlling 40-59 percent of the
industry sales in 1982?
• 120 out of 448 total industries had four firms
controlling 40-59 percent of the total industry
sales.
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Oligopoly and Concentration Ratios
Contrary to many people’s intuition,
there is no convincing evidence that
the share of industry sales controlled
by the four leading firms in the US
manufacturing economy is growing.
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EXHIBIT 3
PERCENTAGE OF TOTAL INDUSTRIAL
SALES PRODUCED BY INDUSTRIES WITH
FOUR-FIRM SALES CONCENTRATION RATIOS
OF 50 PERCENT OR MORE: 1895–1982
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright
© 1990 by Houghton Mifflin Company, Adapted with permission.
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Exhibit 3: Percentage of Total Industrial
Sales Produced by Industries with FourFirm Sales Concentration Ratios of 50
Percent or More: 1895–1982
What is the trend in the percentage of
industrial sales produced by the largest
four firms since 1963?
• There is a downward trend in the percentage
of industrial sales by the largest four firms
from 1963 to 1982.
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Oligopoly and Concentration Ratios
Market power
• A firm’s ability to select and control market
price and output.
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Oligopoly and Concentration Ratios
Unbalanced oligopoly
• An oligopoly in which the sales of the leading
firms are distributed unevenly among them.
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Oligopoly and Concentration Ratios
Balanced oligopoly
• An oligopoly in which the sales of the leading
firms are distributed fairly evenly among them.
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EXHIBIT 4
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BALANCED AND UNBALANCED OLIGOPOLY
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Exhibit 4: Balanced and
Unbalanced Oligopoly
1. What percentage of their industry’s
total sales do the leading four firms
in Industry A and B control?
• The leading four firms in both industry A and
B control 80 percent of their industry’s sales.
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Exhibit 4: Balanced and
Unbalanced Oligopoly
2. Why is industry B considered an
unbalanced oligopoly?
• The largest firm in industry B controls 50
percent of the industry’s sales. It’s market
share is greater than the other three leading
industries combined and more than four times
greater than the next largest firm’s
sales share.
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Oligopoly and Concentration Ratios
• The dominance of oligopolies in
industry is not unique to the U.S.
• The concentration ratios for U.S.
industries are similar to other
modern industrialized economies.
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EXHIBIT 5
PRODUCTION CONCENTRATION RATIOS IN
JAPANESE MANUFACTURING INDUSTRIES BY
LEADING AND FIVE LEADING FIRMS
Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano
Memorial Society, p. 162.
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Exhibit 5: Production Concentration Ratios
in Japanese Manufacturing Industries by
Leading and Five Leading Firms
In how many Japanese industries do the
five leading firms have greater than a 90
percent production concentration ratio?
• Four industries—beer, nylon, glass, and tires and
tubes—are controlled by the five leading firms at a
concentration of 90 percent or greater.
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Concentrating the Concentration
An oligopoly can build market power
in two ways:
• Reinvesting its profit and painstakingly
expanding its production capacity.
• Merging with and/or acquiring other firms.
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Concentrating the Concentration
There are three reasons why firms
merge:
1. To exercise greater market control.
2. To increase control over the supplies of
their inputs or the buyers of their goods.
3. To expand and diversify their asset
holdings.
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Concentrating the Concentration
There are three types of mergers:
1. Horizontal merger
2. Vertical merger
3. Conglomerate merger
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Concentrating the Concentration
Horizontal merger
• A merger between firms producing the same
good in the same industry.
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Concentrating the Concentration
A number of high-profile horizontal
mergers occurred in the 1990s.
• Boeing and McDonnell Douglas in the aircraft
industry.
• Staples and Office Depot in the office supply industry.
• Union Pacific and Southern Pacific Rail in the railroad
industry.
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Concentrating the Concentration
Vertical merger
• A merger between firms that have a supplierpurchaser relationship.
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Concentrating the Concentration
An example of vertical merging is
that of Anheuser-Busch.
The firm has acquired malt plants,
yeast plants, a corn-processing
plant, beer can factories, and a
railway that ships freight by rail and
truck.
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Concentrating the Concentration
Conglomerate merger
• A merger between firms in unrelated industries.
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Concentrating the Concentration
The conglomerate merger is the
most common type of merger.
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Concentrating the Concentration
• One reason for conglomerate mergers is the
desire to diversify operations.
• While horizontal and vertical mergers
strengthen the firm’s position within the
industry, the fate of the firm rests on the
health of the industry.
• Acquiring unrelated firms insures the
conglomerate against catastrophe if one
industry faces severe problems.
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Concentrating the Concentration
Cartel
• A group of firms that collude to limit
competition in a market by negotiating and
accepting agreed-upon price and market
shares.
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Concentrating the Concentration
Collusion
• The practice of firms to negotiate price and
market share decision that limit competition
in a market.
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Concentrating the Concentration
Cartels are an example of a merger in
which firms don’t have to actually
buy each other’s assets, yet they
enjoy the benefits of having market
power.
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Concentrating the Concentration
• While cartels are illegal in the United States,
it is difficult to prove collusion.
• Some governments encourage cartels to
form in their countries. OPEC is one
example.
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Concentrating the Concentration
Many studies support the contention
that price and concentration ratios
move in the same direction – an
increase in one is associated with an
increase in the other.
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Mergers without Merging
Firms don’t have to merge or acquire
each other to gain the advantages of
merging. They can remain
independent by creating a joint
venture or joining a cartel.
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Mergers without Merging
Joint venture
• A business arrangement in which two or more
firms undertake a specific economic activity
together.
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Mergers without Merging
Cartel
• A group of firms that collude to limit
competition in a market by negotiating and
accepting agreed upon price and market
shares.
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Mergers without Merging
Collusion
• The practice of firms to negotiate price and
market share decisions that limit competition
in a market.
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Cartel Pricing
• A cartel determines price by acting as
if it is a monopoly.
• Price and quantity are determined
using the MR = MC rule.
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EXHIBIT 6
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CARTEL PRICING AND OUTPUT ALLOCATIONS
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Exhibit 6: Cartel Pricing and
Output Allocations
Why is there an incentive for cartels to
“cheat” and produce greater quantities
than they are assigned?
• The price and output decisions made by the
cartel are determined by the MR = MC rule.
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Exhibit 6: Cartel Pricing and
Output Allocations
Why is there an incentive for cartels to
“cheat” and produce greater quantities
than they are assigned?
• The price and quantity assigned to individual
firms within the cartel may not coincide with
where the firm would maximize profit using
its own MR and MC curves.
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Exhibit 6: Cartel Pricing and
Output Allocations
Why is there an incentive for cartels
to “cheat” and produce greater
quantities than they are assigned?
• There is an incentive for the firm to try to
secretly increase quantity and thereby
increase its own profit.
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EXHIBIT 7
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RELATIONSHIP BETWEEN THE
CONCENTRATION RATIO AND PRICE
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Exhibit 7: Relationship Between the
Concentration Ratio and Price
Where on the curve in Exhibit 7 does
the concentration ratio have the
strongest effect on price?
• The effect is the strongest in the middle of
the S-shaped curve.
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Theories of Oligopoly Pricing
In monopoly, monopolistic
competition and perfect competition,
firms react only to the demand and
cost structures they face. Prices
tend toward equilibrium.
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Theories of Oligopoly Pricing
In oligopoly, firms are continually
second guessing how the competition
will respond to price decision they
make. Prices are subject to fits of
change.
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Theories of Oligopoly Pricing
Game theory
• A theory of strategy ascribed to the firms’
behavior in oligopoly. The firms’ behavior is
mutually interdependent.
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Theories of Oligopoly Pricing
Nash equilibrium
• A set of pricing strategies adopted by firms
in which none can improve its payoff
outcome, given the price strategies of the
other firm or firms.
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Theories of Oligopoly Pricing
Payoff matrix
• A table that matches the sets of gains (or
losses) for competing firms when they choose,
independently, various pricing options.
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EXHIBIT 8
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FIRM PROFIT, GENERATED BY HIGH AND
LOW PRICING
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EXHIBIT 9
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PAYOFF MATRIX
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Exhibits 8 & 9: Firm Profit Generated
by High and Low Pricing
How does total profit change as Dell
and Compaq change their prices?
• When both firms price high, total profit is 20.
When one firm prices high and the other
prices low, total profit is 18. When both firms
price low, total profit is 12.
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Theories of Oligopoly Pricing
Price leadership
• A firm whose price decisions are tacitly
accepted and followed by other firms in the
industry. The theory explains pricing in
unbalanced oligopolies.
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Theories of Oligopoly Pricing
Tit-for-tat
• A pricing strategy in game theory in which a
firm chooses a price and will change its price
to match whatever price the competing firm
chooses.
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EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF
GODFATHER OLIGOPOLY
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Exhibit 10: Price and Output Under
Conditions of Godfather Oligopoly
How is the price of chocolate
determined in Exhibit 10?
• Hershey is the “godfather” in the chocolate
business. Hershey produces where its MR =
MC. That is, 5 tons of chocolate at $5 per
pound. The other firms in the chocolate
industry accept the $5 per pound price.
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EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND
CURVE
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Exhibit 11: Constructing an
Oligopolist’s Demand Curve
1. If Lipton were to raise its price
above $0.80 per box, what would its
competitors do, according to the
curve in panel b?
• Lipton’s competitors would not follow suit.
Lipton’s demand curve above $0.80 (NK) is
relatively elastic.
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Exhibit 11: Constructing an
Oligopolist’s Demand Curve
2. If Lipton were to lower its price
below $0.80 per box, then what would
its competitors do?
• Lipton’s competitors would feel compelled to
follow suit. Lipton’s demand curve below
$0.80 (YK) is relatively inelastic.
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Theories of Oligopoly Pricing
Kinked demand curve
• The demand curve facing a firm in oligopoly;
the curve is more elastic when the firm
raises price than when it lowers price.
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EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH
KINKED DEMAND CURVES
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Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
The marginal revenue curve
associated with a kinked demand
curve is:
i. Continuous
ii. Discontinuous
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Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
The marginal revenue curve
associated with a kinked demand
curve is:
i. Continuous
ii. Discontinuous
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Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
As long as the MC curve crosses the
gap created by the discontinuity in the
MR curve, price will remain
unchanged, as shown in panel b.
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Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
If the MC curve cuts the MR curve
above the gap, output will decrease
and price will increase. This scenario
is depicted in panel c.
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Brand Multiplication
Brand multiplication
• Variations on essentially one good that a
firm produces in order to increase its
market share.
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Brand Multiplication
• A firm’s market share =
(Number of brands) × (Brand market share).
• As the number of brands in the
industry increases, market share per
brand diminishes.
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Price Discrimination
Price discrimination
• The practice of offering a specific good or
service at different prices to different segments
of the market.
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Price Discrimination
• Oligopolists sometimes segment the
market in order to charge consumers
what they are willing to pay for a
good or service.
• Differences in airline ticket prices
are a good example.
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EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED
AIRLINES ROUND-TRIP FLIGHT BETWEEN
LOS ANGELES AND NEW YORK
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Exhibit 13: Demand Schedule
for a United Airlines Round-Trip
Flight Between LA and NY
If United chose not to segment its
market in Exhibit 13, what would be its
total revenue?
• The maximum total revenue for United
would be achieved at a ticket price of $318
each, for a total of $119,250.
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EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A
UNITED AIRLINES ROUND-TRIP FLIGHT
BETWEEN LOS ANGELES AND NEW YORK
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Exhibit 14: Demand by Market
Segment for a United Airlines RoundTrip Flight Between LA and NY
What is United’s total revenue when
it segments its market into a
multiple-fare system?
• United’s total revenue is $210,635. This
is an increase of $91,385 over the
unsegmented market.
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Price Discrimination
• Price discrimination exists in
virtually every market.
• Some differences in price are not
clear cases of price discrimination,
however.
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Why Oligopolists Sometimes
Discriminate
• For example, many would argue that
upper balcony seats are not the
same as front row seats at a
concert. If the goods are different,
then it is not necessarily price
discrimination to charge more for
the front row seats.
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