INTRODUCTION

Questions examined in this chapter include:



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?
OLIGOPOLY
Chapter 10
2
CHARACTERISTICS
STRUCTURES
DEGREES OF POWER


OF
MARKET
Most firms possess some market power.
We classify firms into specific market structures
based on the number and relative size of firms in
an industry.

Market structure – The number and relative size of
firms in an industry.
In imperfect competition, individual firms have
some power in a particular product market.
 Oligopoly is a market in which a few firms
produce all or most of the market supply of a
particular good or service.

3
CHARACTERISTICS
STRUCTURES
OF
4
MARKET
DETERMINANTS OF MARKET POWER

The determinants of market power include:




5
Number of producers.
Size of each firm.
Barriers to entry.
Availability of substitute goods.
6
DETERMINANTS OF MARKET POWER
DETERMINANTS OF MARKET POWER
The numbers and size of firms determine the
extent that firms can withstand pressures and
threats to change prices or product flows.
 The barriers to entry determine to what extent
the market is a contestable market.
 Contestable market – An imperfectly
competitive industry subject to potential entry if
prices or profits increase.
The availability of substitute goods weakens any
firm’s market power.
 The standard measure of market power is the
concentration ratio.
 The concentration ratio is the proportion of
total industry output produced by the largest
firms (usually the four largest).
 The concentration ratio is a measure of market
power that relates the size of firms to the size of
the market.


7
MEASUREMENT PROBLEMS
Market power isn’t necessarily associated with
firm size.
 A small firm could possess a lot of power in a
relatively small market.
 A high concentration ratio or large firm size is
not the only way to achieve market power.
 Many smaller firms acting in unison can achieve
the same result.
 Measurements do not convey the extent to which
market power may be concentrated in a local
market.
OLIGOPOLY BEHAVIOR
Market structure affects market behavior and
outcomes.
 Assume that the computer market has three
oligopolists.


9
10
INITIAL CONDITIONS IN COMPUTER
MARKET
INITIAL EQUILIBRIUM
Initial conditions and market shares of each
firms are described in the following slides.

Market share - The percentage of total market
output produced by a single firm.
Price (per computer)

8
$1000
Market demand
0
11
20,000
Quantity Demanded (computers per month)
12
INITIAL MARKET SHARES OF
MICROCOMPUTER PRODUCERS
THE BATTLE FOR MARKET SHARES
In an oligopoly, increased sales on the part of one
firm will be noticed immediately by the other
firms.
 Increases in the market share of one oligopolist
necessarily reduce the shares of the remaining
oligopolists.

13
INCREASED SALES AT REDUCED PRICES
14
RETALIATION
Increases in sales by lowering the price may
expand total market sales and increase the sales
of an individual firm without affecting the sales
of its competitors.
 However, there simply isn’t any way that a firm
can do so without causing alarms to go off in the
industry.


Oligopolists respond to aggressive marketing by
competitors.



Step up marketing efforts.
Cut prices on their product(s).
One way oligopolists market their products is
through product differentiation.
 Product differentiation – Features that
make one product appear different from
competing products in the same market.
15
RETALIATION
I
RIVALRY FOR MARKET SHARES
An attempt by one oligopolist to increase its
market share by cutting prices will lead to a
general reduction in the market price.
Price (per computer)

16
This is why oligopolists avoid price
competition and instead pursue nonprice
competition.
$1000
900
G
Market
demand
0
17
F
20,000
25,000
Quantity Demanded (computers per month)
18
THE KINKED DEMAND CURVE
CONFRONTING AN OLIGOPOLIST
THE KINKED DEMAND CURVE
Close interdependence – and the limitations it
imposes on price and output decisions – is a
characteristic of oligopoly.
 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.
 Rival oligopolists may not match price increases
in order to gain market share.
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.


19
THE KINKED DEMAND CURVE
CONFRONTING AN OLIGOPOLIST
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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.
PRICE (per computer)

Demand curve facing
oligopolist if rivals match
price changes
$1100
1000
900
B
D
C
Demand curve facing
oligopolist if rivals
match price cuts but
not price hikes
0
M
A
Demand curve
facing oligopolist if
rivals don't match
price changes
8000
QUANTITY DEMANDED (computers per month)
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GAME THEORY

OLIGOPOLY PAYOFF MATRIX
The payoff to an oligopolist’s price cut depends on how
its rivals respond.
Each oligopolist is uncertain about its rival’s
behavior.
G
G
22
The collective interests of the oligopoly are
protected if no one cuts the market price.
But an individual oligopolist could lose if it
holds the line on price when rivals reduce
price.
23
24
OLIGOPOLY VS. COMPETITION

PRICE AND OUTPUT
Oligopolists may try to coordinate their behavior
in a way that maximizes industry profits.
An oligopoly will want to behave like a monopoly,
choosing a rate of industry output that
maximizes total industry profit.
 Price discounting can destroy oligopoly profits.
 When it occurs, rival oligopolists seek to end it as
quickly as possible.
 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.

25
MAXIMIZING OLIGOPOLY PROFITS
26
STICKY PRICES
Prices in oligopoly industries tend to be stable.
Like all producers, oligopolists want to maximize
profits by producing where MR = MC.
 The kinked demand curve is really a composite of
two separate demand curves.
Price or Cost (dollars per unit)

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)
27
28
AN OLIGOPOLIST’S MARGINAL REVENUE
CURVE
STICKY PRICES
There is a gap in an oligopolist’s marginal
revenue (MR) curve.
 As a result, modest shifts of the cost curve will
have no impact on the production decision of an
oligopolists.
Price (dollars per computer)
I
S
A
F
d1
G
mr2
0
29
d2
mr1
8000 H
Quantity Demanded (computers per month)
30
THE COST CUSHION
COORDINATION PROBLEMS
Price or Cost (dollars per unit)


Marginal revenue

MC2
MC1
MC3
0
There is an inherent conflict in the joint and
individual interests of oligopolists.
Quantity (units per period)

31
PRICE FIXING
Each oligopolist wants industry profits to be
maximized.
Each oligopolist wants to maximize it’s own market
share.
To avoid self-destructive behavior, each
oligopolist must coordinate production decisions
so that:
1. Industry output and price are maintained at
profit-maximizing levels.
2. Each oligopolistic firm is content with its
market share.
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EXAMPLES OF PRICE FIXING
The most explicit form of coordination among
oligopolists is called price fixing.
 Price fixing is an explicit agreement among
producers regarding the price(s) at which a good
is to be sold.
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.
 Cola – The Coca-Cola Bottling Co. of North
Carolina agreed to pay a fine and give consumers
discount coupons to settle charges of conspiring
to fix soft-drink prices from 1982 to 1985.
 Gasoline – Mobil, Chevron and Shell paid $77
million in 1993 to settle charges that they
conspired to fix gasoline prices.


33
PRICE LEADERSHIP
34
ALLOCATION OF MARKET SHARES
Some oligopolists use price leadership rather
than explicit agreements to coordinate their
prices.
 Price leadership is an oligopolistic pricing
pattern that allows one firm to establish the
market price for all firms in the industry.
When oligopolists raise their prices, they have to
deal with how the loss of output will be
distributed among them.
 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.


35
36
ALLOCATION OF MARKET SHARES

BARRIERS TO ENTRY
An oligopolist may resort to predatory pricing
when market shares are not being divided in a
satisfactory manner.
G
Above-normal profits cannot be maintained over
the long-run unless barriers to entry exist.
 Barriers to entry are obstacles that make it
difficult or impossible for would-be producers to
enter a particular market.

Predatory pricing - temporary price
reductions designed to alter market shares or
drive out competition.
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PATENTS
38
DISTRIBUTION CONTROL
Patents prevent potential competitors from
setting up shop.
 They either have to develop an alternative
method for producing a product or receive
permission from the patent holder to use the
patented process.
The control of distribution outlets can be
accomplished through selective discounts, longterm supply contracts, or expensive gifts at
Christmas.
 Visa and MasterCard prevent banks that issue
their credit cards from offering rival cards.
 Frito-Lay elbows out competing snacks by paying
high fees to “rent” shelf space in grocery stores.


39
METHODS OF ACCESS RESTRICTION
40
TRAINING
A firm can limit competition by acquiring
competitors through mergers and acquisition.
 Patents are issued by the federal government.
 Licensing requirements imposed by
government limit competition.
 Advertising not only strengthens brand loyalty,
but also makes it expensive for new producers to
enter the market.
Early market entry can create an important
barrier to later competition.
 Customers of training-intensive products (such
as computer hardware and software) become
familiar with a particular system.
 Switching to a different product may entail
significant cost.
 This cost is a barrier to entry to any competing
product trying to enter the market.


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42
NETWORK ECONOMIES
ANTITRUST GUIDELINES
The widespread use of a particular product may
heighten its value to consumers, thereby making
potential substitutes less viable.
 For example, software developers prefer to write
Windows based programs rather than for rival
operating systems.


Market power contributes to market failure when
it leads to resource misallocations or greater
inequity.

Market failure is an imperfection in the market
mechanism that prevents optimal outcomes.
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INDUSTRY BEHAVIOR
44
OBJECTIONS TO ANTITRUST
Antitrust law is government intervention
designed to alter market structure or prevent
abuse of market power.
 There are several problems with the behavioral
approach to antitrust law:
G Limited government resources.
G Public apathy.
G Difficulty of proving collusion.
Public efforts to alter market structure have been
less frequent than efforts to alter market
behavior.
 Some argue that we shouldn’t punish those who
achieved monopolies through hard work and
innovation.
 Noncompetitive behavior, not industry structure,
should be the only concern of antitrust.


45
OBJECTIONS TO ANTITRUST
46
THE HERFINDAHL-HIRSHMAN INDEX
Big firms are needed for U.S. firms to succeed in
international markets that are often dominated
by foreign monopolies and oligopolies.
 Both domestic and foreign firms will try to enter
a profitable industry.
 Eventually, competitive forces will prevail.
The broad mandates of the anti-trust laws must
be transformed into specific guidelines for
government intervention.
 The Herfindahl-Hirschman index (HHI) is a
measure of industry concentration that accounts
for number of firms and size of each.


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48
THE HERFINDAHL-HIRSHMAN INDEX

THE HERFINDAHL-HIRSHMAN INDEX
The Herfindahl-Hirshman Index of market
equals the sum of the squares of the market
shares of each firm in an industry.
49
OLIGOPOLY
End of Chapter 10
For policy purposes, the Justice Department
decided it would draw the line at a value of 1,800.
 In 1992, the Justice Department decided to begin
looking not only at existing market structure, but
also at the entry barriers.
 If entry barriers were low enough, even a highly
concentrated industry might be compelled to
behave more competitively.
 The FTC now also looks to see if a proposed
merger will allow for greater efficiencies and
lower costs.

50