Econ 201
Market Failure:
Oligopolies
Week 9
1
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)
2
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
4
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
5
Cooperative Oligopolies
•
Cartels (highly cooperative)
– Firms act as single-firm monopolist
•
Stackelberg Price Leader (passive
cooperation)
-
leader firm moves first and then the follower
firms move sequentially
– Stackelberg leader is sometimes referred to
as the Market Leader.
6
Non-cooperative Oligopolies
• Competitive/psuedo-competitive behavior (noncooperative)
– Perfect Competition (almost): firms undercut each
other’s prices
• competition between sellers is fierce, with relatively low
prices and high production
– Outcome may be similar to PC or Monopolistic Competition
– Nash equilibrium with a Kinked Demand Curve
• Firms avoid “ruinous” price competition by keeping prices
stable and avoiding price competition (undercutting each
others prices)
• May lead to product proliferation
7
Where We’re Going
• How do we tell if a market is an oligopoly?
– Market Concentration
• CR4: market share for the 4 largest firms
• Herfindahl Index (HHI): computed from the
squares of the market shares
• Strategic behavior (how do they behave in
the market place)
– Collusive: act together
– Non-collusive: act separately and/or
strategicially
8
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
9
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.
10
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.
11
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
12
Figure 12.11 Four-Firm Concentration
Ratio (CR4) for Selected Industries in
1997
13
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
14
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
15
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
16
Non-competitive Oligopolies
• Non-competitive/collusive behavior (cooperative
oligopolies)
– Cartels: firms may collude to raise prices and restrict production
in the same way as a monopoly. Where there is a formal
agreement for such collusion, this is known as a cartel.
– Dominant Firm/Price Leader:
• collude in an attempt to stabilize unstable markets, so as to reduce
the risks inherent in these markets for investment and product
development.
• does not require formal agreement
– although for the act to be illegal there must be a real communication
between companies
– for example, in some industries, there may be an acknowledged market
leader which informally sets prices to which other producers respond,
known as price leadership.
– Stackleberg price-leader model
17
Cartel Pricing Tactic
• Reduce Qs to monopoly levels in order to:
– a) obtain a higher price
– b) earn monopoly rents
18
Competition Versus Cartel
(a) Firm
(b) Market
Price, p,
$ per unit
Price, p,
$ per unit
MC
S
pm
pm
AC
pc
pc
MC m
MCm
em
ec
Market demand
MR
q m q c q*
Quantity, q, Units
per year
Qm
Qc
Source: Jeffrey M. Perloff, Microeconomics, 3rd Ed., 2004, p. 435
Quantity, Q, Units
per year
19
Figure 12.4 Duopoly Equilibrium in
a Centralized Cartel
20
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
21
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
22
An Example of a Cartel
• Organization of the Petroleum Exporting Countries (OPEC) is an
international cartel made up of Algeria, Angola, Ecuador, Indonesia,
Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United
Arab Emirates, and Venezuela.
• Principal aim of the organization, according to its Statute, is the
determination of the best means for safeguarding their interests,
individually and collectively; devising ways and means of ensuring
the stabilization of prices in international oil markets with a view to
eliminating harmful and unnecessary fluctuations
• OPEC triggered high inflation across both the developing and
developed world using oil embargoes in the 1973 oil crisis.
• OPEC's ability to control the price of oil has diminished due to the
subsequent discovery/development of large oil reserves in the Gulf
of Mexico and the North Sea, the opening up of Russia, and market
modernization.
• OPEC nations still account for two-thirds of the world's oil reserves,
and, in 2005, 41.7% of the world's oil production,
23
Game Theory Models
of Oligoploy
• Stackelberg's duopoly. In this model the firms move
sequentially (see Stackelberg competition).
• Cournot's duopoly. In this model the firms
simultaneously choose quantities (see Cournot
competition).
• Bertrand's oligopoly. In this model the firms
simultaneously choose prices (see Bertrand
competition).
• Monopolistic competition. A market structure in which
several or many sellers each produce similar, but slightly
differentiated products. Each producer can set its price
and quantity without affecting the marketplace as a
whole.
24
Why cartels can raise profits
• if a firm is maximizing its profit, why should
joining a cartel increase its profit?
– a firm is already choosing output (or price) to
maximize its profit
– however, it ignores effect that changing its
output level has on other firms’ profits
• cartel takes into account how changes in
one firm's output affect cartel profits
25
Firms “cheat”
• luckily for consumers, cartels often fail
because each firm in a cartel has an
incentive to cheat on the cartel agreement
• cheating firm
– produces extra output or lowers its price
– ignores the negative effect of its extra output
on other firms’ profits
26
Cartel can greatly raise price
• only incur cost of organizing a cartel and
enduring risk of prosecution if cartel can
raise price substantial
• demand facing cartel cannot be very
elastic, which is more likely if the cartel
controls the market
27
Cartel controls market
• if the cartel does not have a large share of
the market, it cannot raise price much
• to control the market
– few noncartel firms
– no recycling
– limited entry
28
Entry and cartel success
• barriers to entry limit competition
• cartels with large number of firms rare
(except professional associations)
29
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
30
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
31
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”
32
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
33
Price-leadership
• Stackelberg price leadership model
– Not explicitly collusive
– Requires a dominant firm (large market share and
some market power)
– Firms are allowed to change prices within a certain
range
• If firm(s) lower price(s) below the “allowed” range, then
dominant firm retaliates with lower price and takes away
market share
– Example: AT&T in the LD market after “Divestiture”
34
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
35
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
36
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
37
Nash Equilibrium
• As a consequence
– Best strategy is to neither raise or lower
prices; but to maintain “stable” prices
• Nash equilibrium in an oligopolist market
will be characterized by long-term stable
prices or “sticky” prices
– Non-price competition
• Advertising to create brand name
awareness/loyalty
• Product proliferation
38