OLIGOPOLY
Chapter 27
What determines how much market
power a firm has?
How do firms in an oligopoly set
prices and output?
What problems does an oligopoly
have in maintaining price and profit?
What does market power really mean?



Market power is the key to control.
Monopoly is a type of power that all firms
dream of, yet pure monopoly is not
permitted in our economy.
The next best thing is to PUSH the power
base to the very edge of government
acceptance. Gaining market share is a
common term we hear from businesses
and Wall Street.
MARKET POWER

Tom Thumb wants to gain
market share from
Albertsons.

Wal-Mart wants market
share from Kmart… boy
did they get it!

Central Market wants
market share from Whole
Foods
“Defending the Lead”
World-wide PC vender market share
for third quarter. DMN- 10/16/08
Company
HP
Dell
Acer
Lenova
Toshiba
Others
Market Share
18.4%
13.6%
12.5
7.3%
4.6
43.7
Sales Chg from year ago
15.1%
11.6
47.3
8.1
25.8
9.4
Who is sharing?



What about the auto industry now. Government
motors (adv./Ford) Yet Ford 8/2010 sees first
monthly increase in sales in 2 years. 10/2010Ford up 39%. Is auto industry still oligopoly?
Oligopoly is no exception… Outstanding feature
of Oligopoly is “fewness”
OLI (derivation actually means few.. (do you
remember your Oligarchy in government?)

Oligopoly has few sellers- so few that at least one firm is
large enough to INFLUENCE PRICE

The vast amount of GDP is accounted for by
firms in oligopolistic industries.
AT&T and Verizon



October 19, 2012
Communiqué from AT&T management that
they would “continue to provide retirement
benefits, including pensions, to employees
and retirees.”
Where many other Fortune 500 companies
are not doing this. AT&T wanted to make a
statement --- because of market share
position, VZ will no doubt follow.

Most firms are part of oligopoly or
monopolistic competition, with few
monopolies or perfect competition.


These two market structures are called imperfect
competition.
In these structures, you can find both intense
competition and some evidence of monopoly.
25-8
Oligopoly (cont'd)

Oligopoly

A market situation in which there are very few
sellers.

Each seller knows that the other sellers will react
to its changes in prices and quantities.
Oligopolist


The oligopolist is a price searcher.
It produces the quantity of output at which
MR = MC.
Characteristics of Oligopoly
1.
2.
3.
4.
5.
Few firms control the market
High barriers to entry
Produce either differentiated or
homogeneous products
Lack of available substitutes
Name some examples!
Oligopoly (cont'd)

Why oligopoly occurs

Economies of scale

Barriers to entry

Mergers

Vertical mergers

Horizontal mergers
Price and Output Under 3 Oligopoly
Theories



Cartel Theory - oligopolistic firms act as if there were
only one firm in the industry.
Kinked Demand Curve Theory - assumes that if a
single firm in the industry cuts prices, other firms will
do likewise, but if it raises price, other firms will not
follow suit. The theory predicts price stickiness or
rigidity.
Price Leadership Theory - the dominant firm in the
industry determines price, and all other firms take
their price as given.
Characteristics of Market Structures
Market Structure
Characteristics
Perfect
Competition
Monopolistic
Competition
Oligopoly
Number of firms
Very large
number
Many
Few
Barriers to entry
None
Low
High
Market power
(control over price
None
Some
Substantial
Type of product
Standardized Differentiated Standardized
or
differentiated
More Examples
Market Structure
Characteristics
Perfect
Competition
Duopoly
Monopoly
Number of firms
Very large
number
Two
One
Barriers to entry
None
High
High
Market power
(control over price
None
Substantial
Substantial
Type of product
Standardized Standardized Unique
or
differentiated
Why are certain industries composed of
only a few firms?


Because cost economies and other barriers to entry
keep the numbers small (plus mergers keep out the
smaller guys) (enter the political key on who decides
if mergers are not eliminating competition)
Where economies of scale are substantial,
reasonably efficient production will be possible only
with a small number of producers… efficiency
requires that the productive capacity of each firm be
large relative to the total market.
Continued


Technological progress has made more
and more economies of scale attainable
over time.
Other barriers such as the development or
persistence of some oligopolies through
patents, control of strategic raw materials,
in some cases prodigious advertising
(Budweiser) outlays which add a financial
barrier to entry for other firms.
The following = nonprice
competition

http://www.youtube.com/watch?v=xD6ghskN
Ka8
Advertising - Convince the consumer that firm A’s
product is a better buy than those of its rivals.
–
Product differentiation.
• Firm A could modify its products to make them
appealingly different in order to sell more.
Examples of Oligopolies










Aluminum
Automobile
Film
Television
Cell phone
Gas
Beer
Petroleum
Tire
Airline
soft drinks, batteries,
cigarettes, computer
printers, Internet
browsers, baby food,
cereal, and credit cards.
What do we see in the 21St Century?
Many big corporations seeking more market
share have been following a simple rule.
“Don’t build what you can buy.”
Reason - to fill some of the empty
production space created in the building
boon of late 90’s
This will allow for movement to capacity
production which is more efficient.
Oligopoly (cont'd)

Vertical Merger


The joining of a firm with another to which it sells
an output or from which it buys an input
Horizontal Merger

The joining of firms that are producing or selling a
similar product
Measuring Market Power
•
Concentration ratio: the proportion of total
industry output produced by the largest firms.
–
If the industry produces 1 million products and the
four biggest firms produce 700,000 of them, the
concentration ratio is 70%.
25-22
Ways to measure degree of
Oligopolization
Concentration Ratio:
Sometimes the market share of one company in
the oligopoly is so great that it nearly resembles
a monopoly.
Table 27-1 Computing the FourFirm Concentration Ratio
Add up top 4 or perhaps 6- divide by total sales in industry.
Note: This is calculated by Annual $ sales.
E-Commerce Example: Market
Concentration in the Personal Computer
Industry

The computer printer industry generated
$201.1 billion in revenues in a recent year,
and several firms had a high market share.

Of the four: Hewlett-Packard earned $35.0
billion, Dell $27.9 billion, Lenovo $14.1 billion
and Acer $13.7 billion.

These four firms had a concentration ratio for
the computer printer industry of 45.1%
Are their other ways to get market
power?
Sure… several smaller firms
can act in unison in the
amount they supply and
price they charge..
Even in small towns firms can
have market power… (ACE
Hardware, Krispy Kreme, or
the Dunkin’Donut store in
Eastjapip, NJ)
Key Point
Concentration ratio is a quantitative measure of
oligopoly
The total percentage share of industry SALES of
the four leading firms is the industry
concentration ratio. (who has higher % of sales
Ford, GM, or Chrysler?) (the increased foreign
trade has minimized the impact of the HHI ratio.)
Obviously, the total aggregate sales are compiled.
Then the sales for each firm is calculated. Come
up with 35% of market share… Then continue on
HHI calculation.
Herfindahl-Hirschman Index HHI
This is the sum of the square of the market
shares of each firm in the industry.
Example.. Monopolist – one company controls
entire industry = 100% market share. HHI would
be 100 (squared) 100x100 = 10,000 (All
monopolies have 10,000 HHI)
If firm A has 25% and firms B,C,D also have 25 %
Take 25 x 25= 625 Add them up
(625+625+625+625 =2,500 or the total number of
squares for industry power is 2,500
Each firm has 625 squares.
HHI again
The Herfindahl-Hirshman Index of market
equals the sum of the squares of the
market shares of each firm in an industry.
n
share
of


HHI =   firm i 


i=1
2
2
2
share
of
share
of
share
of





HHI =   firm 1  +  firm 2  +     firm n 

 



2
Market Power
Market Power
30
25
20
2005
2006
15
10
5
0
Walmart
Kroger
Kroger
Albertson’s
Tom
Albertsons Minyards
Thumb
Oligopoly (cont'd)

The more U.S. firms face competition from
the rest of the world, the less any current
oligopoly will be able to exercise market
power.
So, where does government enter in this
equation?
The Anti-trust division of the Justice
Department and the applicable IRC has to
decide if a gain of X% of the market share is
destroying competition or not when a merger is
suggested.
HP/Compaq (will this destroy the competitive edge
for Dell?)
1.
2.
In 1992 the Justice Dept decided to use other parameters in
determining anti-trust and destructive competition---barrier to entry. If low, then highly concentrated industry
might be compelled to behave more competitively. (hence,
contestability and structure were now added to the
merger equation.)
Oligopoly Behavior

Firm A could lower its price and undercut its
rivals.


At the lower price, sales would increase and firm
A would increase its market share.
However, others in the oligopoly would
immediately notice this ploy. Since they do not
want to lose market share to firm A, they would
retaliate by lowering their prices also.
25-34
What is the objective here?
Then what happens???


Retaliation
Oligopolists respond to aggressive marketing by
competitors.
Step up marketing efforts.
 Cut prices on their product(s).
Rather than cut prices which causes a general “off the cliff
for all concept.” (hence kinked demand curve)
Oligopolists will engage in “non-price competition.”
Hint:
their products are differentiated for the most part.American Airlines- more leg room… LOL! 

The Kinked Demand Curve
Confronting an Oligopolist
PRICE (per computer)
PRICE (per computer)
Demand curve facing
oligopolist if rivals match
price changes
$1100
1000 900
1000
B
M
A
D
C
Demand curve facing
oligopolist if rivals
match price cuts but
not price hikes
Demand curve
facing oligopolist if
rivals don't match
price changes
8000
0
0
QUANTITY
DEMANDED
(computers
per month)
QUANTITY
DEMANDED
(computers
per month)
How does Gateway respond if Dell cuts
prices?
Rivals’ Response to Price Reductions
 The degree to which sales increase when the price
is reduced depends on the response of rival
oligopolists.
 We expect oligopolists to match any price reductions
by rival oligopolists.
Rivals’ Response to Price Increases
 Rival oligopolists may not match price increases in
order to gain market share.
The Kinked Demand Curve
Confronting an Oligopolist


The shape of the demand curve facing an
oligopolist depends on the responses of its
rivals to a change in the price of its own
output.
The demand curve will be kinked if rival
oligopolists match price reductions but not
price increases.
Game Theory

A mathematical technique used to analyze the
behavior of decision makers who try to reach an
optimal position for themselves through game
playing or the use of strategic behavior, are fully
aware of the interactive nature of the process at
hand, and anticipate the moves of other decision
makers.
Game Theory



Each oligopolist has to consider the potential
responses of rivals when formulating price or
output strategies.
The payoff to an oligopolist’s price cut depends
on how its rivals respond.
Game theory is the study of decision making in
situations where strategic interaction (moves and
countermoves) between rivals occurs.
Moves in the economy
Pepsi meets to decide how to gain market
share
If they reduce Pepsi in Plano, and have
increased promotion, what will Coke respond
with? Are they looking over their shoulder?
Will any of that strategy be applied throughout
the U.S. or is it effective only regionally.
Dr. Pepper… what would strategy be in NE?
Price and Output – Cartel
Theory

To maximize industry profit, the firms in an
oligopoly must agree on a monopoly price and
agree to maintain it by limiting production and
allocating market shares.===Illegal in U.S. – OPEC
is example of how this works (Cartel)

Drug Cartel in Mexico
.
Allocation of Market Shares
One way to distribute output is a cartel
agreement.
 A cartel is a group of firms with an explicit
agreement to fix prices and output shares
in a particular market.
Cartels are illegal in the United States…
OPEC (Organization of Petroleum Exporting
Countries) is the most famous now.(11
countries)
http://www.opec.org/

Let’s Look at Cartels
Each producer is assigned a % they may
produce in the market. These are explicit
production-sharing agreements. (most cheat
due to high oil prices in market)
Saudi Arabia has increasingly violated the % they
were assigned by OPEC several times to:
increase their market share and to help out the
U.S.
They may be less willing to do this in the future
(continued war/Iraq)(new terrorism problems)
(other countries join to ostracize any Arab nation
that cooperates with U.S.) (supply/demand) (U.S.
reduces dependency on oil… OPEC won’t want
to stray too far.
The Benefits of Cheating on the Cartel Agreement I




The situation for a
representative firm of a cartel:
in long-run competitive
equilibrium, it produces q1 and
charges P1, earning zero
economic profits.
As a consequence of the cartel
agreement, it reduces output to
qC and charges PC.
Its profits are the area CPCAB.
If it cheats on the cartel
agreement and others do not,
the firm will increase output to
qCC and reap profits of FPCDE.
PRICE FIXING IS ILLEGAL
 The examples are plentiful. The Ivy League
schools in 2001 were caught by Justice Dept
for fixing prices in biding for students who
qualified for financial aid… which they had
been doing for over 30 years.
Price Fixing Examples


Electric Generators In 1961, General
Electric and
Westinghouse were
convicted of fixing
prices on electrical
generators.
They were charged
again in 1972 for
continued price fixing.

School Milk – Between
1988 and 1991, the
U.S. Justice
Department filed
charges against 50
companies for fixing the
price of milk sold to
public schools in 16
states.
So, you think they don’t fix prices?



Gasoline – Mobil, Chevron and Shell paid $77
million in 1993 to settle charges that they conspired
to fix gasoline prices.
Music CDs – In 2001, the FTC charged AOL-Time
Warner and Universal Music with fixing prices on the
“Three Tenors” CD.
The airline industry is being investigated as of
3/8/06 to see if they fixed prices on jet fuel
purchases.
WSJ- November 13, 2008
“LCD Makers Plead Guilty to Price Fixing”
 Sharp, LG Display, Chunghwa Fined $585
million for schemes affecting TV sets, other
products.
 Criminal charge
 Consumers paid higher prices for TVs,
cellphones, and other products using liquidcrystal displays.
Whirlpool, rivals face price fixing probe
 Michigan business news in brief: Whirlpool, rivals
face price fixing probe
February 19, 2009, Detroit Free Press

Wired PR News – Microsoft Corp. has been fined
for alleged price-fixing. As reported by the
Associated Press (AP), the company’s German
subsidiary was fined 9 million euros, which is the
equivalent of $11.8 million, for purportedly
illegally influencing the retail prices for their
Microsoft Office 2007 software programs.
April 13, 2009
TX Doctors agree to settle
price-fixing (2006)

The FTC’s complaint alleges that Health Care Alliance of
Laredo, LC (HAL), a multi-specialty IPA with about 80
physician members, restrained competition among the
members in violation of Section 5 of the FTC Act. HAL
claimed it employed a “messenger model” process to
negotiate contracts. If properly orchestrated, a
messenger model process does not restrain competition.
HAL engaged in collective bargaining, however, and did
nothing that might justify its challenged conduct.
2009

FTC Settles Price-Fixing Charges Against
San Francisco Bay Area Doctors’ Group
Auto parts investigation the largest of any
investigations in the Antitrust Division.




The following corporate fines have been
obtained in the auto parts investigation since
the beginning of fiscal year 2011:
Furukawa Electric Company Ltd., $200
million
Yazaki Corporation, $470 million—the
second largest criminal fine ever for an
antitrust violation
DENSO Corporation, $78 million
How do we know?
Price Leadership or Fixing?
Leadership is acceptable.. Fixing is not.
Sometimes they send up smoke signals to
alert their rivals about a price increase in
hopes the rivals will follow.
Whenever oligopolist successfully raises
prices, unit sales will decline.
What happens if AA lowers airline fares?
Graph for a price-fixing oligopolist
The graph for a price-fixing oligopolist will
look exactly like the monopolist.
There is no kink in the demand curve.
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
Industry
marginal
cost
Profitmaximizing
price
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
Predatory Pricing
A company decides to lower its prices for a
short period of time to force a competitor
out of business. After the competitor
leaves, the company then raises price
again.
(BroadBand Cable/Internet)
Utah Pie company (forced out by Mrs.
Smith’s pies)

http://www.youtube.com/watch?v=nGx4E8w5
VHg&NR=1
QUESTIONS?