Principles of Economics
EC 201
California State Polytechnic University, Pomona
Dr. Bresnock
Fall, 2002
Lecture 16
Oligopoly: Price and Output Determination
Characteristics:
(1)
(2)
(3)
(4)
(5)
Few Firms -- 3 – 4 differentiated oligopoly; 15 – 20 standardized oligopoly
Standardized Product (i.e. industrial machinery, steel, aluminum) or Differentiated
Product (i.e. autos, breakfast cereal, cigarettes)
Pricing Interdependence -- firms watch the pricing behavior of other firms and tend to
follow price increases but not decreases -- hence the expression “sticky downward prices”
has been used to describe one aspect of their pricing behavior
Difficult Entry Barriers -- high capital costs to enter the market, often difficult to obtain
necessary raw materials if incumbent firms have some control over the supply of such
materials
Advertising and Quality Competition -use non-price competition, product
development, and quality competition extensively and often more so than price competition
Oligopoly Development
A.
Internal growth of a dominant firm, i.e. breakfast cereal, candy bars, fosters development of
the oligopoly.
B.
External
growth via mergers, i.e. steel, airlines, banking, entertainment, fosters
development of the oligopoly.
Advantages of such development either via dominance or mergers includes the firms’ ability to
attain discounts on inputs, shipping, and borrowing $.
Industry Concentration Measures
A.
Concentration Ratio – the % of industry’s total sales obtained by the largest firms, i.e. 4
largest firms. If this % is > 40%, then the industry is deemed to be oligopolistic. About half
of U.S. manufacturing industries would thus be oligopolies.
3 Shortcomings
(1)
Concentration ratios are calculated for the national market. The industry may not
seem to be oligopolistic at that level, but it may be at the local level, i.e.. ready mix
concrete – 6% national, very high at local level.
EC 201
Fall, 2002
Lecture 16
A. Bresnock
(2)
Concentration ratios do not capture interindustry competition, i.e. steel and aluminum
are in competition with each other for auto components.
World trade may not be factored into the calculation. U.S. concentration ratios don’t
account for import competition.
(3)
B.
Herfindahl Index (HI)-- This index places greater weight on the larger, more powerful
firms than the smaller ones. It does this by squaring the % market shares of all firms in the
market…
HI = (%S1)2 + (%S2)2 + (%S3)2 +  + (%Sn)2
where S1  Sn represent the market shares of the 1 to n firms.
Thus larger firms will receive much greater weight by this method than with the 4-firm
concentration ratio. As the HI s there is more concentration in the industry and visa versa.
Take a look at 25-1 and 25-2 in your text (p. 238 and p. 244) to see some examples of low
and high concentration industries. Examples of low concentration include: jewelry, leather
goods, wood furniture. Examples of high concentration include: cigarettes, beer, electric
light bulbs, breakfast cereals, motor vehicles, soap and detergents, aircraft, roasted coffee,
etc.
Game Theory: Overview
Game theory is used to analyze the pricing behavior of the few firms that comprise an oligopoly.
The few firms in an oligopoly make strategic choices based on the actions and reactions of other
firms. Thus the behavior of these firms resembles game-playing strategy.
3 Basic Elements of Game Theory
(1)
(2)
(3)
Players -- firms or decision makers
Strategies -- courses of action
Payoffs -- in most cases these are measured monetarily
2 Types of Games
(1)
Cooperative -- players make binding agreements (Note: This is not covered in the text
example, but it would include collusion of the firms so as to assure higher payoffs).
(2)
Non-Cooperative -- agreements among the players are not possible. Hence the players
will be unsure of the action that will be taken by a rival firm. (Note: This example is
covered in the text, and it assumes that the players act independently in determining their
prices).
Example of a 2-Firm “Duopoly” -- each player makes choices based on its perception of the
best possible outcome, or “payoff”. The diagram, or “payoff matrix”, on the next page shows the $
payoffs that are a likely result of the pricing strategies of two firms, Uptown and RareAir.
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EC 201
Fall, 2002
Lecture 16
A. Bresnock
Rare Air’s Pricing Strategy
High Price
Low Price
$12
High
HighHigh
Price
$12
$15
$6
$6
Low
Price
$15
$8
$8
The payoffs to the left of the diagonal go to Uptown and the payoffs to the right of the diagonal go
to RareAir. There are 4 possible payoff combinations, A  D. If firms act independently, they
could end up at D with mutual “competitive” low-price strategies. With collusion, they could end
up at A. But incentives to cheat can lead to B or C.
Another Example
2 Firms = A and B
Option of Advertising Budget for Both Firms: H = High Budget
L = Low Budget
or
Both firm’s outcomes are dependent on the other firm’s advertising expenditures. The “tree
diagram” below shows the payoffs the two firms as ( A, B) in $.
B

A 
L
H
L (7,5)
H (5,4)

B
L (6,4)
H (6,3)
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EC 201
Fall, 2002
Lecture 16
A. Bresnock
The same results can be represented by the following “payoff table”
L
A’s
Strategies
L
H
B’s Strategies
H
(7,5)
(6,4)
(5,4)
(6,3)
Regardless of how the strategies are depicted above, B is better off with low advertising strategy
regardless of A’s strategy. Since A and B know the payoff matrix, A will choose the low ad
strategy as well.
3 Oligopoly Models -- There is a lot of diversity with oligopolies. Due to interfirm rivalry, firms
cannot accurately determine their profit max price and output as easily as most other types of firms.
Oligopolists do not usually decrease price (“sticky downward prices”), and tend to change prices
together.
(1)
Kinked-Demand Theory (Non-Collusive Oligopoly)
Given:
3 Independent firms (each with 1/3 of the market) = A, B, and C
Po,Qo = Initial Firm A price and quantity
Firm A’s demand depends on rival’s reaction
In general…
a) Rivals match A’s price decreases (which in an extreme could lead to a “price war”)
b) Rivals ignore A’s price increases (hoping to attract more customers)
And these general conclusions produce a “kinked D-Curve” for Firm A. This oligopoly
explains why oligopolistic firms have pricing inflexibility. The model does not explain:
(a) how the original price is determined, and (2) does not always behave the way stated
during unstable macroeconomic times.
The graph on the next page shows the assumed behavior of the kinked D-Curve model.
It depicts the two generalizations regarding rival firm pricing behavior. Notice that if the
marginal cost (MC) increases of decreases in this model, there will be no change in the
equilibrium quantity offered by the firm.
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EC 201
Fall, 2002
Lecture 16
A. Bresnock
Graph 1 Development of Firm A’s Kinked Demand Curve
(2)
Cartels (Collusive Oligopoly) -- Cartels are an example of a collusive industry.
Collusion occurs when firms in an industry agree to fix prices, divide the market
among themselves, or otherwise restrict competition in some way. As a result, the
firms in a cartel can: (a) decrease uncertainty, (b) increase profits, and (c) block
entry of new firms.
Assume:
3 Firms = A, B, and C, each have identical costs, each product a
homogeneous product
Each firm will match the other firms’ P s and s. Thus each
firm has a demand that is very similar to the other firms’ demand
curves.
Result:
Each of the collusive oligopolistic firms will behave like a pure
monopolist. That is, each firm will determine its quantity where
MR=MC so as to maximize its total economic profits. It will set its
price at that quantity. (See p. 250 for a reminder of this result).
Note:
The collusion may be overt (i.e. OPEC cartel), or covert (i.e. electrical
equipment manufacturers’ “phases of the moon” strategy”). Overt
collusion often works because short-run demand for the product is
highly inelastic. Covert collusion often entails illegal practices, such
as rigged or rotated minimum bids on contracts, “tacit agreements”,
“gentlemen’s agreements”.
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EC 201
Fall, 2002
Lecture 16
A. Bresnock
Obstacles to Collusion
(1)
(2)
(3)
(4)
(5)
(6)
(3)
Demand and Cost Differences -- hard to agree on price; firms have
different market shares, different product efficiencies,
# of Firms -- As the # of firms s, collusion becomes more difficult,
Cheating -- firms that successfully cheat may  their sales and profits, but
not for long as a “price war” may result,
Recession – can be a factor in causing firms to try to  P to offset lost
revenue as the demand for their product decreases and it becomes more
difficult to cover production costs. This can also start a “price war”.
Potential Entry -- economic profits earned by the incumbent firms will
attract new firms to enter the industry over time, and
Legal Obstacles -- In the U.S., cartels are prohibited by antitrust laws. But
even international cartels can lose control -- i.e. cheating among OPEC
nations.
Price Leadership Model -- No formal collusion among firms. The largest and/or
most efficient firm initiates price changes. Some of the leadership tactics used
include” (1) infrequent price adjustments, (b) leader communicates price changes,
i.e. speeches, trade publications, (c) “limit pricing” = leader may not choose price
that is profit maximizing to discourage entry.
Oligopoly and Economic Efficiency
Not Productive Efficiency
P  min ATC
Not Allocative Efficiency
P  MC
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