CHAPTER
12
Oligopoly and Strategic
Behavior
1
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
Oligopoly

An oligopoly is a market with just a few
firms.

Economists use concentration ratios to
measure the degree of concentration, or
just how few firms exist in a market.
2
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Oligopolies in the United States
Beverages
Music
Tobacco
Phone Service
Cars
Coca-Cola
(45%)
Universal/
Polygram
(26%)
Philip
Morris
(49%)
AT&T/TCI
(47%)
General
Motors
(29%)
Pepsi
(31%)
Warner Music
(18%)
RJR
Nabisco
(24%)
Bell
Atlantic/GTE
(24%)
Ford
(25%)
Cadbury
Schweppes
(14%)
Sony Music
(17%)
Brown and
Williamson
(15%)
SBC/Ameritech
(18%)
Daimler
Chrysler
(16%)
EMI Group PLC
(13%)
MCI WorldCom
(12%)
BMG
Entertainment
(12%)
3
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Concentration Ratios in Selected
Manufacturing Industries
Industry
Four-firm
Concentration
Ratio (%)
Eight-firm
Concentration
Ratio (%)
Cigarettes
93
Not available
Guided missiles and space vehicles
93
99
Beer and malt beverages
90
98
Batteries
87
95
Electric bulbs
86
94
Breakfast cereals
85
98
Motor vehicles and car bodies
84
91
Greeting cards
84
88
Engines and turbines
79
92
Aircraft and parts
79
93
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4
Strategic Behavior

The key feature of an oligopoly is that
firms act strategically.

Firms in an oligopoly are interdependent.
The actions of one firm affect the profits of
the other firms.
5
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O’Sullivan & Sheffrin
Barriers to Entry in an Oligopoly
Most firms in an oligopoly earn economic profit, yet
additional firms do not enter the market, for three
reasons:
 Economies of scale large enough to generate a
natural oligopoly but not a natural monopoly

Government barriers to entry

Substantial investment in an advertising
campaign in order to enter the market
6
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Oligopolistic Firms

A duopoly is a market with two firms.

A cartel is a group of firms that coordinate
their pricing decisions, often charging the same
price for a particular good or service.

The arrangement under which two or more
firms act as one, coordinating their pricing
decisions, is also known as price fixing.

The equilibrium price and quantity in the
oligopolistic market depend on the strategic
behavior of the firms in the oligopoly.
7
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Cartel Pricing
In a cartel arrangement,
two firms act as one. In
this case, they split the
market output—each
serving 75 passengers
per day, and charge
$400 per ticket.


The firms also split the profit.
Each firm earns
$7,500 = [(400-300) x 150]/2.
8
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Duopoly Pricing

When two firms compete
against one another,
they end up serving 100
passengers each, at a
price of $350.

Each firm earns a profit
of $5,000, compared to a
profit of $7,500 if they
had acted as one firm.
9
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Duopoly Versus Cartel Pricing

The duopoly produces more output and charges a lower
price than the cartel.
10
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O’Sullivan & Sheffrin
The Game Tree

A game tree provides a
visual representation of the
consequences of alternative
strategies. Firms can use
it to develop pricing
strategies.
11
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O’Sullivan & Sheffrin
Cartel and Duopoly Outcomes in the
Game Tree
12
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The Outcome of Underpricing
Jack captures large
share of market
Jill captures large
share of market
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Jill: Low Price
Jack: High Price
Price
$350
$400
Quantity
170
10
Average cost
$300
$300
Profit per passenger
$50
$100
13
$1,000
Total profit
Economics: Principles and Tools, 2/e
$8,500
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The Dominant Strategy
Irrational for Jack to
choose high price

Jack chooses the
low price when
Jill chooses the
high price.
14
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The Dominant Strategy

Jack chooses the
low price when
Jill chooses the
low price.
Irrational for Jack to
choose high price

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Dominant
Strategy: Jack
chooses the low
price regardless
of Jill’s choice.15
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The Duopolists’ Dilemma

Knowing that Jack will choose the low price no matter
what, will Jill choose the high price or the low price?
Irrational for Jill to be
underpriced.

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Jill will choose
the low price,
and the trajectory
of the game is X
to Z to 4.
16
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The Duopolists’ Dilemma

The duopolists’ dilemma is
that although both firms
would be better off if they
chose the high price, each
firm chooses the low price.
17
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The Prisoners’ Dilemma


The prisoners’
dilemma is the
duopolists’
dilemma.
Although both
criminals would
be better off if
they both kept
quiet, they
implicate each
other because the
police reward
them for doing so.
18
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Guaranteed Price Matching

To eliminate the incentive for underpricing, one
firm can guarantee that it will match its
competitor’s price.

How will Jack respond to Jill’s price-matching
policy?


Choose the high price: Jack matches Jill’s high price
in which case both will earn maximum (cartel) profits.
Choose the low price: if Jack chooses the low price,
Jill will match the low price and both firms will earn
minimum (duopoly) profits. Therefore, Jack has no
reason to choose the low price.
19
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Guaranteed Price Matching

Price matching eliminates the duopolists’
dilemma and makes cartel profits and
pricing possible, even without a formal
cartel.

Guaranteed price matching leads to
higher prices. It guarantees that
consumers will pay the high price!
20
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Repeated Pricing

When firms play the price-fixing
game repeatedly, price fixing is
more likely because firms can
punish a firm that cheats on a
price-fixing agreement.
21
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Economics: Principles and Tools, 2/e
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Retaliation for Underpricing
Schemes to punish Jack if he underprices:

Duopoly price: Jill also lowers price; abandons
the idea of cartel profits, and settles for duopoly
profits which are better than the profits when
she is underpriced by Jack.

Grim Trigger: Jill drops her price to the level
that will result in zero economic profit.

Tit-for-tat: Jill chooses whatever price Jack
chose the preceding month.
22
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O’Sullivan & Sheffrin
Tit-for-Tat Response to Underpricing
 Jill
chooses whatever
price Jack chose the
preceding month.
 After Jack lowers
price, profits sink to
the duopoly level.
Jack increases price in
the fourth month,
which restores the
cartel pricing in the
fifth month.
23
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Leadership

Price leadership is an arrangement
under which a group of firms selects a
firm to serve as a price leader,
observes the price chosen by the
leader, and then matches it.
24
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Leadership

The problem with an implicit pricing agreement
is that price signals sent by the leader may be
misinterpreted.

Firms could interpret a price cut in two ways:

A change in market conditions, in which
case firms just match the lower price and
price fixing continues

Underpricing, in which case a price war
may be triggered, destroying the price-fixing
agreement
25
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Kinked Demand Curve

The kinked demand curve is an
oligopoly model of price
leadership that assumes the
worst about how other firms will
respond to price changes.
26
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The Kinked Demand Curve
After the initial price of $6, the firm
has two options:


Increase price: the other firms
will not change their prices and
quantity will decrease by a large
amount (elastic)
Decrease price: the other firms
will decrease their prices, so
quantity will increase only by a
small amount
27
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Kinked Demand Curve

The demand curve of the typical
firm has a kink at the prevailing
price. It is relatively flat for
higher prices, and relatively
steep for lower prices.

There is little evidence that
oligopolistic firms really act this
way—that firms will not go along
with a higher price but only
match a lower price.
28
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Entry Deterrence by an Insecure
Monopolist

An insecure monopolist fears the entry of a
second firm, and could react in one of two
ways:



A passive strategy: allow the second firm to
enter the market
An entry-deterrence strategy: try to prevent
the firm from entering
The threat of entry will force the monopolist to
act like a firm in a market with many firms,
picking a low price and earning a small profit.
29
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The Passive Strategy

If Jane adopts a
passive strategy,
it will allow Dick
to enter the
market, and each
will earn the
duopoly profits of
$5,000 each.
30
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The Entry-deterrence Strategy

Jane can prevent
Dick from entering by
incurring a large
investment and
committing herself to
serving a large
number of customers
at a low price.

If Dick enters anyway,
market output will be
very large and the firms
will lose $1,300 each.
31
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The Insecure Monopolist Strategy

If Jane produces a
large quantity and
Dick stays out,
Jane’s profits will
be $12,600.
32
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Game Tree for the Entry Game

In order to keep
Dick from
entering, will Jane
choose to serve a
small or a large
quantity of
customers?
33
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Outcome of the Entry-deterrence
Game


If Jane is
passive and
chooses a
small quantity,
Dick will enter.
If Jane chooses
a large quantity,
Dick would
suffer losses,
thus he would
stay out.
34
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Outcome of the Entry-deterrence
Game—Limit Pricing


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Jane’s profit is
higher if she
maintains the
insecure monopoly
position by
choosing a large
quantity.
The strategy of
picking a price
lower than the
normal monopoly
price to deter
entry is know as
limit pricing. 35
O’Sullivan & Sheffrin
Entry Deterrence and Contestable
Markets

The threat of entry will force a monopolist to charge a
price that is closer to the one that would occur in a
market with many firms.

The threat of entry underlies the theory of market
contestability. Firms can enter or leave a contestable
market when the cost of entry is insignificant.

In the extreme case of perfect contestability, firms can
enter and exit at zero cost, and the market price would
be the same as the perfectly competitive price.
36
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O’Sullivan & Sheffrin
Characteristics of Different Types of
Markets
37
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O’Sullivan & Sheffrin