Oligopoly
Learning Objectives:
• What is an oligopoly?
• What are different types of oligopoly?
• What is collusion?
• Are collusions sustainable all the time?
• How does credible signaling transform a firm into a market leader?
• Example: How the Meat Industry Keeps Chicken Prices High
What is an Oligopoly?
• A few firms controlling the entire market
• Products sold by the firms in an oligopolistic market may either be
identical or differentiated
• A firm’s strategy will depend on what it thinks about the strategy of
other firms in the market
Demand curve for a firm in an oligopolistic market
• A firm’s demand curve will depend upon how its rivals will react to
price changes by this firm
• If rivals change prices in response to a price change by the firm, then
the demand curve for this firm will be steeper, and vice versa
Types of oligopolistic markets based on response of
rivals to price or output changes
• Sweezy
• Cournot
• Stackelberg
• Bertrand
Sweezy Oligopoly
• Only a few producers, and many consumers
• Products are differentiated
• Rivals cut prices following price reduction, but not after a price hike
• There exist barriers to entry
Criticism of Sweezy Model
• How does a firm or industry arrive at the initial price point (point of
kinked demand curve)?
Cournot Oligopoly
• Only a few producers, and many consumers
• Products are homogeneous or differentiated
• Each firm’s belief is that the rivals will not change their output
following a change in its own output
• There exist barriers to entry
Reaction function or Best response function
• Profit maximizing level of output of one firm given the different output
levels of the other firm
• Cournot equilibrium: no firm has an incentive to change its own output
given the output level of the other firm
Isoprofit curves
• Traces the combinations of outputs from other firms that will result in
the same level of profit for one firm
• If marginal cost for a firm falls, then the firm will be able to produce
more output and earn more profit at the cost of other firms
Collusion
• Firms benefit by restricting output, either implicitly or explicitly
• Collusive outcome is difficult to sustain
• Example: De Beers and Beyond: The History of the International
Diamond Cartel
• Example: The Envelope Cartel Has Finally, Finally Been Brought To
Justice
• Example: OPEC: No cut in oil production and prices keep falling
Stackelberg Oligopoly
• Only a few producers, and many consumers
• Products are homogeneous or differentiated
• The leader (firm making the first move) chooses its output level first
• The followers consider the leader’s output as given and make their
output decisions
• There exist barriers to entry
Signalling in Stackelberg oligopoly
• The leader has to provide credible signalling about its output
• If the cost to observe leader’s output is too high, then the leader might
have to produce lower output and earn lower profit
Bertrand Oligopoly
• Only a few producers, and many consumers
• Products are identical
• Marginal cost is constant across firms
• There is price competition among firms
• There are perfect information and zero transaction costs in the market
• There exist barriers to entry
• Example: Britannica vs Encarta
Entry Barriers
• There are technological advantages for incumbents
• There are sunk costs in the production
• Incumbents can lower their price successfully to make entrant
unprofitable
• Consumers cannot respond to price changes
• Example: Airbus vs Boeing (B), 2006