ECON 152 – PRINCIPLES OF MICROECONOMICS
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 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
2

 Characteristics of oligopoly
 Small number of firms
 Interdependence
 Strategic dependence
A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry
3

 Why oligopoly occurs
 Economies of scale
 Barriers to entry
 Mergers
 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
4

 Determining the Existence of an Oligopoly
 Concentration Ratio
 The percentage of all sales contributed by the leading four or leading eight firms in an industry
 It is difficult to specify an arbitrary absolute number to demonstrate the existence of an oligopoly, but it is a good indicator.
 Verification is usually based on the observed strategies and behavior of the firms of the industry.
5

Computing the Four-Firm
Concentration Ratio
Annual Sales
Firm ($ Millions)
1
2
3
4
5 through 25
Total
150
100
80
70
50
450
Total number of firms in
Industry = 25
Four-firm concentration ratio =
400
450
=
88.9%
Table 27-1
6

E-Commerce Example:
Concentration in the Search-Engine Industry
 Internet search-engines collect revenue through advertisements posted on their websites.
 To measure the concentration ratio in this industry, economists count the number of searches conducted on each site.
7

E-Commerce Example:
Concentration in the Search-Engine Industry
 The four most frequently used searchengines are Google, Yahoo, AOL Time
Warner, and MSN.
 The four-firm concentration ratio in this industry is 91 percent, indicating that it qualifies as an oligopoly.
8

Oligopoly, Inefficiency, and
Resource Allocation
 Oligopolistic firms have some degree of market power, which means each one can affect the market price.
 This creates some inefficiency in resource allocation.
 But to the extent that U.S. oligopolies must compete with firms from other countries, their market power is limited.
9

Strategic Behavior and Game Theory
 Explaining the pricing and output behavior of oligopoly markets
 Reaction Function
 The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry
10

Strategic Behavior and Game Theory
 Game Theory
 A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly
11

Strategic Behavior and Game Theory
 Cooperative Game
 A game in which the players explicitly cooperate to make themselves better off
 Noncooperative Game
 A game in which the players neither negotiate nor cooperate in any way
12

Strategic Behavior and Game Theory
 Zero-Sum Game
 A game in which any gains within the group are exactly offset by equal losses by the end of the game
 Negative-Sum Game
 A game in which players as a group lose at the end of the game
 Positive-Sum Game
 A game in which players as a group are better off at the end of the game
13

Strategic Behavior and Game Theory
 Strategies in noncooperative games
 Strategy
 Any rule that is used to make a choice
 Any potential choice that can be made by players in a game
 Dominant Strategies
 Strategies that always yield the highest benefit
14

Example: The Prisoner’s Dilemma
 You and your partner rob a bank and get caught.
15

 You are separated and given these options:
 Both confess and get five years in jail
 Neither confess and get two years
 One confess and the other does not
 Confessor goes free
 One who does not confess gets ten years
 Assume you are Sam reacting to the possible actions of Carol.
16

The Prisoners’ Dilemma Payoff Matrix
Figure 27-1
17

The Prisoners’ Dilemma Payoff Matrix
Confessing is better than not confessing.
Figure 27-1
18

The Prisoners’ Dilemma Payoff Matrix
Figure 27-1
Confessing is better than not confessing.
Confessing is better than not confessing.
19

Strategic Behavior and Game Theory
 Applying game theory to pricing strategies
 Would you choose a high price or a low price?
 Remember
 No collusion
20

 The firms are separated and given these options:
 Both charge high price and each gets $6 million
 Both charge low price and each gets $4 million
 One charges low price and the other high
 Lower priced firm gets $8 million
 Higher priced firm gets $2 million
 Assume you are Firm #2 reacting to the possible actions of Firm #1
21

Strategic Behavior and Game Theory
Figure 27-2
22

Strategic Behavior and Game Theory
Low is better than high.
Figure 27-2
23

Strategic Behavior and Game Theory
Low is better than high.
Low is better than high.
Figure 27-2
24

Strategic Behavior and Game Theory
 Opportunistic Behavior
 Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains
 An example might be writing a check that you know will bounce
 Not realistic
 Consequences tend to be more obvious
 We make repeat transactions
25

Strategic Behavior and Game Theory
 Tit-for-Tat Strategic Behavior
 In game theory, cooperation that continues so long as the other players continue to cooperate
26

Price Rigidity and the
Kinked Demand Curve
Panel (a)
P
0 d
1
A d
1
Figure 27-3, Panel (a) q
0
Quantity per Time Period
27

Price Rigidity and the
Kinked Demand Curve
Panel (a) d
2 d
1
A
P
0 d
1 is relatively elastic
• if one firm raises its price the others will not and it will lose market share
Figure 27-3, Panel (a) q
0
Quantity per Time Period d
2 d
1 d
2 is relatively inelastic
• if one firm lowers its price the others lower their price so gain in sales is small
28

Price Rigidity and the
Kinked Demand Curve
Panel (a) d
2 d
1
A
P
0 d
1 is relatively elastic
• if one firm raises its price the others will not and it will lose market share
Figure 27-3, Panel (a)
MR
1 q
0
Quantity per Time Period d
2 d
1 d
2 is relatively inelastic
• if one firm lowers its price the others lower their price so gain in sales is small
29

Price Rigidity and the
Kinked Demand Curve
Panel (a) d
2 d
1
A
P
0 d
1 is relatively elastic
• if one firm raises its price the others will not and it will lose market share
Figure 27-3, Panel (a)
MR
1
MR
2 q
0
Quantity per Time Period d
2 d
1 d
2 is relatively inelastic
• if one firm lowers its price the others lower their price so gain in sales is small
30

Price Rigidity and the
Kinked Demand Curve
Panel (b)
P
0
MR
1 d
1
A
The kinked demand curve indicates the possibility of price rigidity
Figure 27-3, Panel (b) d
2
MR
2 q
0
Quantity per Time Period
31

Price Rigidity and the
Kinked Demand Curve d
1
P
0
MR
1
MC '
MC
MC" d
2
Changes in cost do not impact output and prices as long as
MC remains in the vertical portion of MR
MR
2 q
0
Quantity per Time Period
Figure 27-4
32

Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Price Leadership
 A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices
 Price leadership behavior is apparent in the overnight package delivery industry
33

Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Price War
 A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices
34

Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Markets where price wars are common
 Cigarettes
 Long-distance telephone companies
 Airlines
 Diapers
 Frozen foods
 PC hardware and software
35

Deterring Entry Into an Industry
 Entry Deterrence Strategy - Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm
 Increasing entry cost
 Threat of price wars
 Government regulations
 Limit-Pricing Strategies – A group of colluding sellers will set the highest common price without new firms seeking to enter the industry
 Raising switching costs for customers
 Non-compatible software
 Non-transferability of college courses
36

Network Effects and Industry
Concentration
 A network effect is a situation in which a consumer’s inclination to use an item depends on how many others use it.
 In an industry selling products subject to network effects, a small number of firms may be able to secure the bulk of the payoffs resulting from positive market feedback.
 Oligopoly is likely to emerge as the prevailing market structure.
37

Market
Structure
Long-Run
Number Unrestricted Ability Economic of
Sellers
Entry and
Exit to Set
Price
Profits Product Nonprice
Possible Differentiation Competition Examples
Numerous Yes None No None Perfect competition
Monopolistic competition
Many Yes Some No Considerable
None Agriculture, roofing nails
Yes Toothpaste toilet paper, soap, retail trade
Oligopoly
Pure monopoly
Few
One
Partial Some
Not Considerfor entry able
Yes
Yes
Frequent
None
(product is unique)
Yes
Yes
Recorded music, college textbooks
Some electric companies, some local telephone companies
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Table 27-3

ECON 152 – PRINCIPLES OF MICROECONOMICS
Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.