Econ 100
Lecture 6-3
Market Failure:
Oligopolies
2-11-09
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What is an Oligopoly?
• market in which the industry is dominated by a
small number of sellers
– Derived from the Greek for few sellers.
– Since there are few participants, each oligopolist
(firm) is aware of the actions of the others
– decisions of one firm influence, and are influenced by
the decisions of other firms
• i.e., firms’ behave strategically taking into account the likely
responses of the other market participants (game theory)
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Oligopoly
• Oligopoly markets are more concentrated than
monopolistically competitive markets,
but less concentrated than monopolies.
Perfect
Competition
Monopolistic
Competition
Monopoly
Oligopoly
3
Strategic Behavior
• Perfect Competition
– Only strategy is to reduce costs
• Price-taker => output decisions do not affect market price
– cross-price elasticity = -1 (perfect substitutes)
– Own-price = -∞
• Monopoly
– Price-Searcher: output decision determines price
• Cross-price = 0 (no substitutes)
• Own-price: >= |1|
• Oligopoly
– Cross-price elasticity near -1
– Own-price elasticity > |1|
– Will have to take into account actions of other similar firms when making
output/pricing decisions
– Much more strategy
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Oligopoly Behavior
• Cooperative Oligopoly
– Cartels
• Agree to collude; act/price like a single firm monoploist
– Price leadership (Stackleberg leader)
• Dominant firm establishes the price; other firms react to
“leader”
• Non-cooperative Oligopolies
– Sticky prices (kinked demand curve)
• Sticky upward
– Nash equilibrium
• Characterized by stable prices
– Perfect competition
• Completely rivalarous
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How do we tell?
• Market concentration refers to the size
and distribution of firm market shares and
the number of firms in the market.
• Economists use two measures of industry
concentration:
– Four-firm Concentration Ratio
– The Herfindahl-Hirschman Index
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Attempts to Measure
Market Concentration
• four-firm concentration ratio is often utilized to
characterize/determine whether a market is an
oligopoly.
– market share of the four largest firms in an industry
• Herfindahl index,
– also known as Herfindahl-Hirschman Index or HHI,
– widely applied in competition law and antitrust.
– sum of the squares of the market shares of each
individual firm.
– Decreases in the Herfindahl index generally indicate a
loss of pricing power and an increase in competition,
whereas increases imply the opposite.
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Four-Firm Concentration Ratio
• The four-firm concentration ratio (CR4)
measures market concentration by adding
the market shares of the four largest firms
in an industry.
– If CR4 > 60, then the market is likely to
be oligopolistic.
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Example
Firm
Nike
Market Share
62%
New Balance
15.5%
Asics
10%
Adidas
4.3%
CR 4 = 62 15.5 10  4.3  91.8
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Figure 12.11 Four-Firm Concentration
Ratio (CR4) for Selected Industries in
1997
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The Herfindahl-Hirschman
Index
• The Herfindahl-Hirschman index (HHI) is
found by summing the squares of the
market shares of all firms in an industry.
– Advantages over the CR4 measure:
• Captures changes in market shares
• Uses data on all firms
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Example
Firm
Market Share
Nike
62%
New Balance
15.5%
Asics
10%
Adidas
4.3%
HHI  62 15.5 10  4.3  4,202.74
2
2
2
2
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Example (cont’d)
What happens if market shares are evenly distributed?
Firm
Market Share
Nike
22.95%
New Balance
22.95%
Asics
22.95%
Adidas
22.95%
HHI  22.95 2  22.95 2  22.95 2  22.95 2  2,106.81
CR 4  91.8
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Cartel Pricing Tactic
• Reduce Qs to monopoly levels in order to:
– a) obtain a higher price
– b) earn monopoly rents
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Figure 12.4 Duopoly Equilibrium in
a Centralized Cartel
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How do Cartels Operate?
• Firms in the cartel need to agree on:
– 1) Market price
– 2) Quantity supplied by the Industry
– 3) Each firm’s “quota”
– 4) “Not to cheat” on either price or quantity
supplied
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Conditions for cartel success
• the cartel can significantly raise price
• cartel controls market
• low organizational costs
– few firms (or a few large ones)
– industry association
• many small buyers: no monopsony power
• cartel can be maintained
– cheating can be detected and prevented
– low expectation of severe government punishment
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Cartels
•
A cartel is a formal (explicit) agreement among firms.
–
–
•
Cartel members may agree on such matters
–
–
–
–
–
•
•
as price fixing,
total industry output,
market shares,
allocation of customers,
allocation of territories
aim of such collusion is to increase individual member's profits by reducing
competition.
–
•
usually occur in an oligopolistic industry, where there are a small number of sellers
usually involve homogeneous products.
Competition laws forbid cartels.
Several economic studies and legal decisions of antitrust authorities have found that
the median price increase achieved by cartels in the last 200 years is around 25%.
Private international cartels (those with participants from two or more nations) had an
average price increase of 28%, whereas domestic cartels averaged 18%. Less than
10% of all cartels in the sample failed to raise market prices
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How do Cartels Operate?
• Firms in the cartel need to agree on:
– 1) Market price
– 2) Quantity supplied by the Industry
– 3) Each firm’s “quota”
– 4) “Not to cheat” on either price or quantity
supplied
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Factors that work against a Cartel
- in the long run
• Each firm has an incentive to cheat
– Price that firm receives is still above MC of
production
• Could earn additional profits by slightly expanding
output
• However, when all firms do this
– -> back at competitive market outcome
• Qs up to point where MV=MC
• See “prisoners dilemma”
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What market conditions make
Cartels more likely?
• Market demand is inelastic
– higher prices lead to increase revenues for the cartel
• Homogenous goods
– easier to initially set/enforce cartel price
• Small number of firms/high concentration of
market share (easier to monitor, collude)
– Fringe players could defeat cartel
– More equal shares -> increase incentive to cheat
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Non-Cooperative Cartels
• Some degree of price competition
– Firms engage in highly competitive pricing
• Similar outcome as perfect competition
– Firms have some market power
• Resembles monopolistic competition
• Stable prices prevail
– Non-collusive
– Firms choose not to compete because of
kinked demand curve
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Kinked-Demand Curve
• Above the kink, demand is relatively elastic because all other firm’s
prices remain unchanged. Below the kink, demand is relatively
inelastic because all other firms will introduce a similar price cut,
eventually leading to a price war. Therefore, the best option for the
oligopolist is to produce at point E which is the equilibrium point
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Nash Equilibrium
• If firm facing kinked demand curve tries to
raise price:
– Other firms do not
– As demand is highly elastic and other firms
are “close” substitutes
– Loses market share and revenues
• If firm lowers price
– Competitors match price decreases
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Nash Equilibrium
• As a consequence
– Best strategy is to neither raise or lower
prices; but to maintain “stable” prices
• Nash equilibrium in an oligopolistic market
will be characterized by long-term stable
prices or “sticky” prices
– Non-price competition
• Advertising to create brand name
awareness/loyalty
• Product proliferation
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