Copyright
ACDC Leadership 2015
1
OLIGOPOLY
FOUR MARKET MODELS
Perfect
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Characteristics of Oligopolies:
Copyright
ACDC Leadership 2015
2
• A Few Large Producers (Less than 10)
• Homogeneous or Differentiated
Products
• High Barriers to Entry
• Control Over Price (Price Maker)
• Mutual Interdependence
•Firms use Strategic Pricing
EXAMPLES
• Tennis Balls: Wilson, Penn, Dunlop and
Spalding.
• Cars: GM, Ford, DaimlerChrysler
• Cereal: Quaker, Ralston Food, Kellogg, Post
and General Mills.
• Aircraft: Boeing (McDonnell Douglas) and
Lockheed Martin
• Grocery stores: (Giant Eagle, Shopn’Save,
Wal-Mart)
HOW DO OLIGOPOLIES OCCUR?
• Oligopolies occur when only a few large
firms start to control an industry.
• High barriers to entry keep others from
entering.
• What are some Barriers to Entry?
1. Economies of Scale
2. High Start-up Costs
3. Ownership of Raw Materials
4. Patents
Copyright
ACDC Leadership 2015
???
6
• Mergers…
HORIZONTAL MERGER
Announced, March 2011
How does the
government
decide if it will
allow a merger?
Does it reduce
competition in a
way that will
hurt
consumers?
Abandoned, Dec. 2011
HORIZONTAL MERGER
HORIZONTAL MERGER
GAME THEORY
How do firms in Oligopoly behave
strategically to choose
price/output?
Mutual interdependence
• Pricing policy
Collusion
• Enhances profit
Incentive to cheat
Prisoner’s dilemma
11-10
Game Theory
The study of how people behave in
strategic situations
Copyright
ACDC Leadership 2015
11
An understanding of game theory helps
firms in an oligopoly maximize profit.
JOHN NASH AND
GAME THEORY
Copyright
ACDC Leadership 2015
VIDEO: SPLIT OR
STEAL
Copyright
ACDC Leadership 2015
The Prisoner’s Dilemma
Charged with a crime, each
prisoner has one of two choices:
Deny or Rat
Prisoner 2
Deny
Both Deny = 5
Deny Years in jail each
Confess
Rat = Free
Deny =20 Years
Prisoner 1
Confess
Copyright
ACDC Leadership 2015
Deny = 20 Years
Both Rat = 10
Years in jail each
14
Rat = Free
What did we learn?
1. Oligopolies must use strategic
pricing (they have to worry about
the other guy)
2. Oligopolies have a tendency to
collude to gain profit.
3. Collusion results in the incentive to
cheat.
4. Firms make informed decisions
based on their dominant strategies
Copyright
ACDC Leadership 2015
16
(Collusion is the act of cooperating with
rivals in order to “rig” a situation)
2008 Audit Exam
2007 FRQ #3
Copyright
ACDC Leadership 2015
18
Payoff matrix for two competing bus companies
2007 FRQ #3
Copyright
ACDC Leadership 2015
Copyright
ACDC Leadership 2015
20
OLIGOPOLY
GRAPHS
Because firms are interdependent
Copyright
ACDC Leadership 2015
21
There are 3 types of Oligopolies
1. Price Leadership (no graph)
2. Colluding Oligopoly
3. Non Colluding Oligopoly
Copyright
ACDC Leadership 2015
22
#1. PRICE
LEADERSHIP
Example: Small Town Gas Stations
OPEC does this with OIL
Who is the “leader” with OPEC?
Copyright
ACDC Leadership 2015
23
To maximize profit what will they do?
Price Leadership
•Collusion is ILLEGAL.
•Firms CANNOT set prices.
•Price leadership is a strategy used by
firms to coordinate prices without
outright collusion
Copyright
ACDC Leadership 2015
24
General Process:
1. “Dominant firm” initiates a price change
2. Other firms follow the leader
PRICE LEADERSHIP MODEL
Leadership tactics
o Usually largest/most efficient
firm
o Infrequent price changes
o Communications
o Limit pricing to keep barriers to
entry
o How might Price Leadership
break down?:
11-25
Price Leadership
Copyright
ACDC Leadership 2015
26
Breakdowns in Price Leadership
• Temporary Price Wars may occur if
other firms don’t follow price
increases of dominant firm.
• Each firm tries to undercut each
other.
Examples…
Copyright
ACDC Leadership 2015
27
#2. COLLUDING
OLIGOPOLIES
A cartel is a group of producers that
create an agreement to fix prices high.
Why didn’t your cartel work?
1. Cartels set price and output at an
agreed upon level
2. Firms require identical or highly
similar demand and costs
3. Cartel must have a way to punish
cheaters
4. Together they act as a monopoly
Copyright
ACDC Leadership 2015
28
Cartel = Colluding Oligopoly
Firms in a colluding oligopoly act as a
monopoly and share the profit
**easier with homogenous product
MC
ATC
D
MR
Q
29
P
CARTELS AND OTHER
COLLUSION
Covert collusion
•Tacit understandings
Obstacles to collusion
•Demand and cost differences
•Number of firms
•Cheating
•Recession (increases in ATC)
•Potential entry of new firms
•Legal obstacles: antitrust law
11-30
Copyright
ACDC Leadership 2015
31
#3. NONCOLLUDING
OLIGOPOLIES
Kinked Demand Curve Model
The kinked demand curve model shows how
noncollusive firms are interdependent
If firms are NOT colluding they are likely to
react to competitor’s pricing in two ways:
1. Match price-If one firm cuts it’s prices, then
the other firms follow suit causing inelastic
demand
2. Ignore change-If one firm raises prices,
others maintain same price causing elastic
demand
Copyright
ACDC Leadership 2015
If this firm increases it’s price, other firms
will ignore it and keep prices the same
As the only firm with high prices, Qd for this firm
will decrease a lot (Qe to Q1)
P
Copyright
ACDC Leadership 2015
Q1
Qe
D
Q
33
P1
Pe
If this firm decreases it’s price, other firms
will match it and lower their prices
Since all firms have lower prices, Qd for this firm
will increase only a little (Qe to Q2)
P
Copyright
ACDC Leadership 2015
Q1
Qe Q2
D
Q
34
P1
Pe
P2
Where is Marginal Revenue?
MR has a vertical gap at the kink. The result is that
MC can move and Qe won’t change. Price is sticky.
P
MC
MR
Copyright
ACDC Leadership 2015
Q
D
Q
35
Pe
Kinked-Demand Curve
Criticisms of the model
•How does price get to P0
•Explains inflexibility, not price
• Price/Quantity remains the
profit maximizing level for a
wide range of cost structures
•Prices are not that rigid (unstable
economy)
•Price wars
(often due to recession)
11-36