Oligopoly
Chapter 12
• Oligopolistic Market Structures
» Few Firms
• Consequently, each firm must consider the reaction of
rivals to price, production, or product decisions
• These reactions are interrelated
» Heterogeneous or Homogeneous Products
• Example -- athletic shoe market
» Nike has 47% of market
» Reebok has 16%
» and Adidas has 7%
2005 South-Western Publishing
Slide 1
Nokia’s Challenge
in Cell Phones
• The market shares of oligopolists change. In 1998, the market
leader in cell phones was Motorola with 25% market share
and Nokia second with 20%
• In 2002, leadership reversed: Nokia held 37% of the market
and Motorola 17%
• However, technology in phones is changing, bringing wireless
web, photos, and other high-speed G3 technologies
• Entry of other firms and new products, such as Dell, Palm,
NEC and Panasonic pose threats to Nokia’s profit margins
• Nokia must decide whether or not to invest heavily in the 3G
technology for the future.
• Being a leader in a oligopoly does not mean that you remain
the leader for long.
Slide 2
Ignoring Interdependencies:
The Cournot Oligopoly
• Models vary depending on assumptions
of actions of rivals to pricing and
output decisions.
• Augustin Cournot (1838) created a
model that is the basis of Anti-trust
Policy in the US.
Cournot
» Relatively simple assumption: ignore the
interdependency with rivals
» This makes the math easy
Slide 3
A Numerical Example:
Competition, Monopoly, and Cournot Oligopoly
Let: P = 950 - Q and MC =50
• IN COMPETITION
» P = MC, so 950 - Q = 50
» PC = $50 and QM = 900
$500
PM
Pcournot
• IN MONOPOLY
$350
$50
PC
D
QM QCournot QC
450
600
900
» MR = MC, so 950 -2Q = 50
» QM = 450 so
» PM = 950 - 450 = $500
• IN DUOPOLY
» Let Q = q1 + q2
Slide 4
Cournot Solution:
Case of 2 Firms (Duopoly)
• Assume each firm maximizes profit
• Assume each firm believes the other
will NOT change output as they
change output.
» The so-called: Cournot Assumption
• Find where each firm sets MR = MC
Slide 5
Let Q = q1 + q2
P
= 950 - Q = 950 - q1- q2
and MC = 50
TR1 = Pq1= (950- q1-q2)q1 =950q1 - q12 - q1q2
and
 TR2 = Pq2= (950- q1-q2)q2 =950q2 - q2q1 - q22


Set MR1= MC
&
950 -2q1 - q2 = 50
950 - q1 - 2q2 = 50
MR2= MC
2 equations &
2 unknowns
Slide 6
With 2 Equations & 2 Unknowns:
Solve for Output
950 -2q1 - q2 = 950 - q1 - 2q2
So, q2 = q1 Then plug this into the demand
equation we find:
950 - 2q1 - q1 = 950 - 3q1 = 50.
Therefore
q1 = 300
The price is:
600
P = 950 - 600 = $350
Competition
Cournot
Monopoly
and Q =
P
Q
50
350
500
900
600
450
Cournot’s
answer is
between the
other two.
Slide 7
N-Firm Cournot Model
• For 3 firms with linear demand and
cost functions:
QC
»Q = q 1 + q 2+ q 3
» In linear demand and cost
models, the solution is higher
output and lower price
QCournot = { N / (N+1) }QCompetition
THEREFORE, Increasing the
Number of Firms increases
competition. This is the historical
basis for Anti-trust Policies
N
PC
N
Slide 8
Example: Cournot as N Increases
N=3
• If N = 3 Triopoly
• P = 950 - Q &
MC=50
• Then, Q = (3/4)(900)
• Q = 675
• P =$275
N=5
• If N = 5
• P = 950 - Q and MC
= 50
• Then Q = (5/6)(900)
• Q = 750
• P = $200
Slide 9
Collusion versus Competition?
• Sometimes collusion succeeds
• Sometimes forces of competition
win out over collective action
• When will collusion tend to
succeed?
» There are six factors that influence
successful collusion as follows:
Slide 10
Factors Affecting Likelihood of Successful Collusion
1. Number and Size Distribution of Sellers.
Collusion is
more successful with few firms or if there exists a dominant firm.
2. Product Heterogeneity. Collusion is more successful with
products that are standardized or homogeneous
3. Cost Structures. Collusion is more successful when the
4.
costs are similar for all of the firms in the oligopoly.
Size and Frequency of Orders. Collusion is more
successful with small, frequent orders.
5. Secrecy and Retaliation. Collusion is more successful
when it is difficult to give secret price concessions.
6. Percentage of External Orders. Collusion is more
successful when percentage of orders outside of the cartel is
small.
Slide 11
Oligopolies & Incentives to Collude
When there are
just a few firms,
profits are
enhanced if all
P
reduce output
But each firm has
incentives to
“cheat” by selling
more
MC
MC
D
incentive
to cut
price
q
Representative firm
QM
MR
Industry
Slide 12
Examples of Cartels
• Ocean Shipping -- maritime exemption from US
Antitrust Laws
• DeBeers -- diamonds
• 1950’s Electrical Pricing Conspiracy -- GE,
Westinghouse, and Allis Chalmers
• OPEC - oil cartel, with Saudi Arabia making up
33% of the group’s exports
• Siemens and Thompson-CSF -- airport radar
systems
• NCAA - intercollegiate sports, also Major League
Baseball
Slide 13
PRICE LEADERSHIP
B arom etric P ric e L ead er
• Barometric:
D om in an t F irm P ric e L ead er
One (or a few firms) sets the price
• One firm is unusually aware of changes in cost or
demand conditions
• The barometer firm senses changes first, or is the first
to ANNOUNCE changes in its price list
• Find barometric price leader when the conditions
unsuitable to collusion & firm has good forecasting
abilities or good management
Slide 14
Barometric Price Leader Example:
Citibank & Prime Rate Announcements
• Banking: 6,000 banks and
falling, but there are still many
banks.
• New York, center of Open
Market activities of the Fed
Reserve
• Citibank’s announcement
represents changes in interest
rate conditions to other banks
tolerably well.
Slide 15
Dominant Firm Price Leadership
• Dominant Firm: 40%
share of market or more.
• No price or quantity
collusion
• Dominant Firm (L) expects
the other firms (F) to
follow its price and
produce where
MC F = PL
Net Demand Curve: DL
MC F
DT
DL
leader’s
demand
= DT - MCF
Slide 16
Graphical Approach to
Dominant Firm Price Leadership
• Find leader’s
demand curve,
DL = (DT -  MC F)
• Find where
MRL = MCL
MC F
DL
MRL
DT
Slide 17
Graphical Approach to
Dominant Firm Price Leadership
MC F
PL
DL
MRL
• At QL, find the
MCL leader’s price, PL
• Followers will
supply the
remainder of
Demand:
D (QT - QL) = QF
QL
Slide 18
Graphical Approach to
Dominant Firm Price Leadership
MC F
MCL
PL
DL
MRL
QL
QT
D
• Followers will
supply the
remainder of
Demand:
(QT - QL) = QF
Slide 19
Implications of
Dominant Firm Price Leadership
• Market Share of the Dominant Firm Declines
Over Time
» Entry expands MC F, and Shrinks DL and MRL
• Profitability of the Dominant Firm Declines
Over Time
profits
TIME
• Market Share of the Dominant Firm is
PROCYCLICAL
» rises in booms, declines in recessions
Slide 20
Numerical Example of
Dominant Firm Price Leadership
Aerotek is the leader, with 6 other firms, given the following:
1. P = 10,000 – 10 QT is the market demand
2. QT = QL + QF is the sum of leader & followers
3. MCL = 100 + 3 QL and MCF = 50 + 2 QF
What is Aerotek’s price and quantity?
»
»
From 2 above, QL = QT – QF and From 1, QT = 1,000 - .1P
Since followers sell at P=MC, From 3, P = 50 + 2 QF, which rearranged
to be QF = .5P - 25
So, QL = (1,000 - .1P) – (.5P - 25) = 1,025 -.6 P, which can be
rearranged to be P = 1,708.3 – 1.67 QL
MRL = 1,708.3 – 3.34 QL
And MRL = MCL where: 1,708.3 – 3.34 QL = 100 + 3 QL
»
The optimal quantity for Aerotek, the leader is QL  254
»
P = 1,708.3 – 1.67 QL = 1,708.3 – 1.67(254)  $1,284.
»
»
»
Slide 21
Historical Example:
U.S. Steel (USX)
• In early 1901 negotiations
among J. P. Morgan,
Elbert Gary, Andrew
Carnegie, and Charles M.
Schwab created United
States Steel.
» 66% market share in
1901
» 46% market share by
1920
» 42% share by 1925
normal
profits
profits in a
profits
dominant firm when
model
using a
lower price
Time
Coke
ovens
in. 1912
in
Gary, IN
Slide 22
Kinked Oligopoly Demand Curve
• Belief in price rigidity
founded on experience of
the great depression
• Price cuts lead to
everyone following
P
» highly inelastic
• Price increases, no one
follows
» highly elastic
no one follows
a price increase
everyone
follows
price cuts
a kink at the price
Slide 23
P
A Kink Leads to Breaks in the MR Curve
• Although MC rises, the
optimal price remains
constant
D
MC2
• Expect to find price
MC1 rigidity in markets with
kinked demand
• QUESTION:
D
MR
» Where would we more
likely find KINKS and
where NOT?
Slide 24
Which industries are likely to have kinks
and which have no kinks?
• The more
• The GREATER the number of firms,
HOMOGENEOUS, likely
likely more kinked
more kinked
• Prices Likely More Rigid
• Prices More Rigid
N=2
N = 10
heterogeneous
homogeneous
Slide 25
Empirical Evidence
vs.
Predictions of the Model
• Oligopolies with few
firms were more rigid
in FACT
2
FACT
prediction
N
• Oligopolies with
homogeneous products
were MORE rigid in
FACT
2
FACT
prediction
heterogeneous homogeneous
Slide 26
Are these Empirical Findings Surprising?
• A kink is a barrier to profitability
• Firms are in business to make profits and
avoid “barriers.”
• Simple Alternative Explanations Exist:
» More firms are more competitive
» More homogenous products act more
competitively
• Collusion leads firms to fix prices. The rigid
prices seen in oligopolies are signs of collusion.
Slide 27
Price Rigidities and
Employment Impacts
• Price rigidity will make business downturns
worse
• Employment will be more volatile over the
business cycle if there are price rigidities
if price changes
with shifts in demand
A rigid price
D BOOMS
D BUSTS
Q3
Q2
Q1
OUTPUT
Slide 28
Oligopolistic Rivalry & Game Theory
• John Von Neuman & Oskar Morgenstern-» Game Theory used to describe situations where individuals
or organizations have conflicting objectives
» Examples: Pricing of a few firms, Strategic Arms Race,
Advertising plans for a few firms, Output decisions of an
oligopoly
• Strategy--is a course of action
» The PAYOFF is the outcome of the strategy.
» Listing of PAYOFFS appear in a payoff matrix.
• A Strategy Game – involves decisions with
consciously interdependent behavior of two or more
participants.
Slide 29
Two Person Game
ASSUMPTIONS
Table 12. 4 page 537
Randle
• Each player knows his and
opponent’s alternatives
Guard
Maraude
• Preferences of all players are known
• Single period game
st Worst, 4th
Better,
1
• Each player can invade the territory
Guard
of the other (Maraude) or Guard his
own territory
Kahn
• Kahn’s payoff is given first,
Maraude Worse, 2nd Best, 3rd
Randle’s payoff is second.
• Randle ranks Guard above Maraude.
• Randle has a Dominant Strategy: a
decision that maximizes welfare
independent of the other player’s
strategy choice
We will get to {Guard, Guard}
• Knowing what Randle will do, Kahn
which is an Equilibrium
decides to Guard as well.
• An Equilibrium--none of the
participants can improve their
payoff
Slide 30
Six or Seven Territories?
Table 12.5 on page 538
6 territories
Sharp
6 territories 7 territories
$40
$70
$35
$55
$30
$60
$45
$45
7 territories
Xerox
• Sharp and Xerox
compete in copiers.
Payoffs for Xerox are in
the lower triangle
• The payoffs depend on
the number of territories
in which they compete
• Sharp has a dominant
strategy of 6 territories.
• What should Xerox do?
• We see we get to {6, 6}
as the iterated dominate
strategy.
Slide 31
Other Strategic Games
• These are viewed as single period, but businesses
tend to be on-going, or multi-period games
• These are two-person games, but oligopolies often
represent N-person games, where N is greater than 2
• Some games are zero-sum games in that what one
player wins, the other player loses, like a game of
poker
• Other games are non-zero sum games where the
whole payoffs depend on strategy choices by all
players.
Slide 32
The Prisoner’s Dilemma
• Often the payoffs vary
depending on the
strategy choices
• The Prisoner’s
Dilemma
• Noncooperative Solution
» both confess: {C, C}
• Cooperative Solution
» both do not confess {NC,NC}
• Off-diagonal represent a Double
Cross
» Two suspects are
caught & held
suspect 2
separately
NC
C
• Their strategies are
1 yr
0 yrs
either to Confess (C) or
NC
1 yr
15 yrs
Not Confess (NC)
6 yrs
» a one period game suspect 1 15 yrs
0 yrs
6 yrs
C
» Suspect 1 in lower
triangle (Bold Red)
Slide 33
Paradox?
• The Prisoner’s Dilemma highlights the
situation where both parties would be best off
it the cooperated
• But the logic of their situation ends up with a
non-cooperative solution
• The solution to cooperation appears to be
transforming a one-period game into a multiperiod game.
• The actions you take now will then have
consequences in future periods.
Slide 34