Oligopoly
Hall and Lieberman, 3rd edition, Thomson SouthWestern, Chapter 10
Overview
Oligopoly market characteristics
 Measure of market structure
 Barriers in oligopoly market
 Game theory approach to duopoly
 Cooperative collusion
 Cheating
 Future of oligopoly

2
Oligopoly

When just a few large firms dominate a market
– So that actions of each one have an important
impact on the others
– In such a market, each firm recognizes its strategic
interdependence with others

An oligopoly is a market dominated by a small
number of strategically interdependent firms
3
Number of Firms

Oligopoly requires that a few firms dominate the
market
– How few?

At some point, number of firms is large enough—
and interdependence weak enough—that oligopoly
becomes a poor description
– Monopolistic competition would fit better
– No absolute number at which oligopoly ends and
monopolistic competition begins
4
Market Domination

Strategic interdependence requires that a
few firms dominate the market
– Their share of market is large
As combined market share shrinks,
strategic interdependence becomes weaker
 Oligopoly is a matter of degree

– Not an absolute classification
5
Economies of Scale: Natural Oligopolies

When minimum efficient scale (MES) for a typical
firm is a relatively large percentage of market
– only a few large firms survive since small firms can’t
compete
– Market becomes an (natural) oligopoly
– Remember, MES is defined as the lowest level of
output at which it can achieve minimum cost per unit

The output level at which the LRATC first hits
bottom
6
Figure 1: Natural Oligopoly
Dollars
LRATCTypical Firm
H
$200
F
E
80
DMarket
0
25,000
100,000
Units per Month
7
Reputation as a Barrier

Established oligopolists are likely to have
favorable reputations

Investors decision: enter or not?
– Critical thing: is it worthy to take the risk of being a
new firm in such market?
– If expected profit is greater than the initial loss, enter
– If initial loss is too big, stay out.
8
Strategic Barriers

Strategies designed to keep out potential
competitors, for example:
– Maintain excess production capacity as a signal
– Make special deals with distributors to receive
best shelf space in retail stores
– Spend large amounts on advertising to make it
difficult for a new entrant to differentiate its
product
9
Legal Barriers
Patents and copyrights—which can be
responsible for monopoly—can also create
oligopolies
 Like monopolies, oligopolies are not shy
about lobbying government to preserve
their market domination

10
Measures of Market Structure
Concentration ratios: Aggregated market
share of the largest N firms in the industry
 Range: 0-100%
 4 Firm Concentration ratio: Market share
controlled by the largest 4 firms

11
Measured Industry Concentration in Manufacturing
D: Not disclosed
Second and third columns: Percentage in value added in the industry
Last column: Herfindahl index from the 50 largest firms
Data based on the 2002 Economic Census.
http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13
12
Measured Industry Concentration in Manufacturing
D: Not disclosed
Data based on the 2002 Economic Census.
http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13
13
Oligopoly vs. Other Market Structures

Oligopoly presents the greatest challenge to
economists
– essence of oligopoly is strategic interdependence
– economists have had to modify the tools used to
analyze other market structures and to develop
entirely new tools as well

One approach—game theory—has yielded rich
insights into oligopoly behavior
14
The Game Theory Approach

Game theory approach
– An approach to modeling strategic interaction of
oligopolists in terms of moves and countermoves
– Elements

Players

Strategies

Payoffs
– Pay off matrix
– Game tree
15
Game Theory Approach

Some situations to which game theory can
be applied:
–
–
–
–
–
firms competing for business
political candidates competing for votes
animals fighting over prey
bidders competing in an auction
legislators' voting behavior under pressure
from interest groups
16
Game Theory – Short History



John Von Neumann (1903-1957)
“Theory of Games and Economic
Behavior” with Oskar
Morgenstern
This book established game
theory as a field
“An introduction to game
theory” by Martin J.
Osborne. Oxford
University Press, 2002
17
Game Theory – Short History



John F. Nash, Jr.(1928- )
One of the contributions is
the introduction of the
equilibrium notion now
known as Nash equilibrium
1994 Nobel prize winner in
economics with the game
theorists John Harsanyi and
Reinhard Selten
“An introduction to game theory”
by Martin J. Osborne. Oxford
University Press, 2002
18
The Prisoner’s Dilemma


Simple example to explain why a technique
for obtaining confessions, commonly used by
police, is so often successful
Payoff matrix
– Players: Rose and Colin
– Payoffs: number in the matrix
– Strategies: Confess (C) / not confess (NC) for
either of the players
19
Figure 2: The Prisoner’s Dilemma

Rose
How to read the matrix?
– Players:{Rose, Colin}
– Strategies:{C, NC}
– Payoffs


What will Rose do?
What will Colin do?
Colin
C
NC
C
-20, -20
-3, -30
NC
-30, -3
-5, -5
20
The Prisoner’s Dilemma

A dominant strategy: the player’s best strategy
regardless of the other player’s strategy
– Rose’s dominant strategy is “confess” regardless
of Colin’s choice
– So is Colin
21
Nash Equilibrium

Outcome of this game is an example of a
Nash equilibrium
– Exists when each player is taking the best
action—given best actions taken by other
players
– Under the Nash Equilibrium, no players want
to deviate
22
Figure 3: Working on a joint project

Elements
– Players:{you, your
friend}
– Strategies:{work hard,
Goof off}
– Payoffs

What is the Nash
Equilibrium?
Friend
W
You
G
W
G
2, 2
0, 3
3, 0
1, 1
23
Figure 4: Battle of Sex

Elements
– Players:{Mr. R and
Mrs. R}
– Strategies:{ go
shopping, watch a
baseball game}
– Payoffs

What is the Nash
Equilibrium?
Mr. R
S
Mrs. R
B
S
B
2, 1
0, 0
0, 0
1, 2
24
Figure 5: Duopoly

Elements
– Players:{Firm A,
Firm B}
– Strategies:{ Low
price, High price}
– Payoffs

What is the Nash
Equilibrium?
Firm A
Firm B
L
H
L
10, 10
40, -5
H
-5, 40
20, 20
25
Simple Oligopoly Games - Duopoly


Duopoly - oligopoly market with only two sellers
Assume that Firm A and B must make their decisions
independently
– Without knowing in advance what the other will do

A’s dominant strategy is to charge a low price
– So is B’s dominant strategy
– Outcome is a Nash equilibrium (Low, Low)
26
Example: Price Competition for Duopoly



Duopoly firms A & B have the same cost structure,
produce the undifferentiated goods.
Suppose the MC and ATC is constant, equal to c.
If the two firms are going to set price to maximize
their profit, what is the Nash equilibrium?
27
Oligopoly Games in the Real World



Typically more than two strategies
Usually more than two players
In some games, one or more players may not have
a dominant strategy
– A game with two players will have a Nash equilibrium
as long as at least one player has a dominant strategy
– When neither player has a dominant strategy, we need a
more sophisticated analysis to predict an outcome to the
game
28
Oligopoly Games in the Real World
-- Static v.s. Dynamic

We’ve limited the players to one play of the
game
– In reality, for gas stations and almost all other
oligopolies, there is repeated play
Where both players select a strategy
 Observe the outcome of the trial
 Play the game again and again, as long as they
remain rivals

29
Oligopoly Games in the Real World
-- Cooperation in the long run

One possible result of repeated trials is
cooperative behavior
– Results may be very different from
equilibrium in a game played only once
– Explicit collusion

Simplest

Managers meet face-to-face to decide how to
set prices
– Tacit collusion

No formal discussion
30
Explicit Collusion

Most extreme form is creation of a cartel
– Group of firms that tries to maximize total profits of
the group as a whole

– OPEC
However, it is not commonly observed. Why?
– Usually illegal in U.S.A., EU & most of developed
countries

– Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways
31
Tacit Collusion

Two most common forms
– Tit for tat

A game-theoretic strategy of doing to another
player this period what he has done to you in
previous period
– Price Leadership

One firm—the price leader—sets its price and
other sellers copy that price
32
Tacit Collusion - Tit For Tat
– Prominent in airline industry
– However, gentle reminder of tit-for-tat is not
always effective in maintaining tacit collusion
– Oligopolist will sometimes go further

Attempting to punish a firm that threatens to
destroy tacit cooperation
– Lead to price wars
33
Tacit Collusion – Price Leadership
No formal agreement
 Rather the decisions come about because
firms realize—without formal
discussion—that system benefits all of
them

34
The Limits to Collusion

Oligopoly power—even with collusion—
has its limits
– demand constraints
– collusion—even when it is tacit—may be
illegal
– collusion is limited by powerful incentives to
cheat on any agreement
35
The Incentive to Cheat


Will firm stick to the collusion?
Maybe, and maybe not
– Problem—each player may conclude that he can do even
better by cheating, Figure 5
– Two players would be back to non-cooperative outcome
based on their dominant strategies
– May be in each player’s interest to cheat occasionally

Analyzing this sort of behavior requires some rather
sophisticated game theory models
– Economists are actively engaged in building them
36
When is Cheating Likely?

While no firm wants to completely destroy a
collusive agreement by cheating
– Since this would mean a return to the noncooperative
equilibrium wherein each firm earns lower profit
– Some firms may be willing to risk destroying agreement if
benefits are great enough
– Cheating is most likely to occur when there is



Difficulty observing other firms’ prices
Unstable market demand
Large number of sellers
37
The Future of Oligopoly


Some people think U.S. and other Western
economies are moving toward oligopoly as
dominant market structure
Prediction has not come true
– Today, there are hundreds and thousands of ongoing
businesses in United States

Possible reasons
– Antitrust law
– Globalization of markets
– Technological change
38
Antitrust Legislation and Enforcement

Three types of actions
– Preventing collusive agreements among firms

Such as price-fixing agreements
– Breaking up or limiting activities of large firms—
oligopolists and monopolists—whose market dominance
harms consumers
– Preventing mergers that would lead to harmful market
domination

While thrust of these policies is to preserve competition
– Type of competition preserved—and zeal with which
policies are applied—can shift
39
The Globalization of Markets

Globalization introduces competition
– By enlarging markets from national ones to global ones,
international trade can increase the number of firms in a market


Entry of U.S. producers has helped to increase
competition in foreign markets for movies, television
shows, clothing, household cleaning products, and
prepared foods
While consumers in each nation may have access to more
firms, these may be larger and more powerful firms
– Creating greater likelihood of strategic interaction and
danger of collusion
40
Technological Change

Technological change works
– To increase competition by creating new
substitute goods
– To reduce barriers to entry
– To increase size of market

However, technologies on the other hand
– encourage oligopoly by actually increasing MES
of typical firm

Result could be strategic interaction, or collusion,
among large national players
– Thereby encouraging formation of oligopolies
41
The Four Market Structures: A Postscript

Different market structures
–
–
–
–

Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Market structure models help us organize
and understand apparent chaos of realworld markets
42
Summary on four types of market
Market Structure
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Many
Many
Few
One
Identical
Differentiated
Either
No close substitute
Barriers to
Entry
None
None
Big
Insurmountable
Control over
Price
None
Some
Considerable
Considerable or
Regulated
Concentration
Ratio
0
Low
High
100
Long Run
Economic
Profit
0
0
0
0
Examples
Wheat
Processed
Food, Brand
Clothing
Automobiles
Local
Electricity, Water
# of Firms
Product
Differentiation
43
Summary

Oligopoly market characteristics
– Small number of large strategically interdependent firms
– No free entry or exit
– Either differentiated or standardized products


Measure of market structure
Barriers to enter the oligopoly market
– Favorable reputation / legal / strategy / substantial economy of scale

Game theory approach to duopoly
– Dominant strategy
– Nash equilibrium
– Prisoner’s dilemma

Repeated game: cooperative collusion
– Explicit : Cartel
– Implicit : Tit – for – Tat ; Price leadership


Cheating
Future of oligopoly depends on
– Antitrust legislation / globalization of market / technological change
44