Oligopoly
BY: EMMA WISCHMEYER
& FLO CUADRA
Oligopoly
 Definition: A market dominated
by a few large producers of a
homogenous or differentiated
product.
Characteristics
 Because of the small number of oligopolists,
they have considerable control over their
prices, but each must consider rivals on the
topics of pricing, output, and advertising
decisions.
Characteristics
 Producers:
 Has few large producers which is pretty vague
because the market model of oligopoly covers
much ground, ranging from pure monopoly, on
one hand, and monopolistic competition, on the
other.
 For Example: oligopoly encompasses the US
aluminum industry, which 3 huge firms dominate
the entire national market, and 4-5 much smaller
auto-part stores enjoy roughly = shares of the
market in a medium size town.
Characteristics
 Products:
 An oligopoly can either be homogenous or
differentiated, depending on if the firm is
producing standardized or differentiated
products.
 Many industrial products (steel, zinc, copper) are
virtually standardized products.
 Many consumer good industries (tires, cereal,
cigarettes) are differentiated oligopolies,
engaging in non-price competition supported by
heavy advertising.
Characteristics
 Control Over Price:
 Each firm is a “price maker” because there is only
a few.
 They must consider how its rivals will react to
any change in price, output, product
characteristics, or advertising. (unlike the
monopolist)
 This is characterized by Mutual
Interdependence: a situation in which each firms
profit depends no entirely on its own price and
sales strategies, but also on those of its rivals.
Characteristics
 Entry Barriers:
 The same barriers to entry that create pure monopoly also
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contribute to the creation of oligopoly.
Economics of scale (important in rubber and cement
industry)
Large expenditure for capital- the cost of obtaining
necessary plant and equipment- required for entering
certain industries.
Ownership and control of raw materials.
Patents
Conclusion: entry of new competitors through preemptive
and retaliatory pricing and advertising strategies.
Characteristics
 Mergers:
 The merging/combining of 2 or more
competing firms may substantially increase
their market share, and may allow the new
firm to achieve greater economics of scale.
 Another motive for merging is the desire for
monopoly power.
Industry Concentration
 Most used measures are
concentration ratios and
Herfindahl Index.
Concentration Ratios

Concentration Ratios reveal he percentage of total output produced and
sold by an industry’s largest firms.

Short Comings of this method:

Localized Markets: concentration ratios pertain to the nation as a whole,
where the markets for some products are highly localized, so the
representation isn’t extremely accurate.
 Industry Competition: competition between 2 products associated with
different industries. Concentration ratio understates the competition in
some industries.
 World Trade: doesn't take into account import competition of foreign
suppliers. For example- the motorcycle and bicycle industry. A table
showed that four US firms produced 65% of the domestic output of
those goods, but ignored the fact that a very large portion of those 2
products bought in the US are imports.
Herfindahl Index
 This index is the sum of the squared percentage
market shares of all the firms in the industry, which
solves one of the shortcomings previously listed, and
explained below.
 Example: In industry X one firm produces all of the
output, in another industry, Y, there are four firms
who each have 25% of the market. The C-ratio for
both of these industries is 100%. Industry X is a pure
monopoly, and Y is an oligopoly facing significant
economic rivalry. Most economists would say that
market power is greater in X than Y, a fact disguised
by their identical 100% concentration ratios.
Herfindahl Index Formula
 (%S1)^2 + (%S2)^2 + (%S3)^2 + … + (%Sn)^2
 By squaring the percentage market shares of
all firms in the industry, the index gives much
greater weight to larger, and more powerful,
firms than smaller ones.
 To generalize, the larger the index, the grater
the market power within an industry.
Game-Theory Model
 Oligopoly pricing behavior has the
characteristics of certain games of strategy,
such as poker, chess, and bridge.
 The best way to play those games depends
on the way your opponent plays. (Again bringing up the
idea that you always have to take into account your rival in oligopoly)
 The study of how people behave in strategic
situations is called game theory.
Game-Theory Model
Game Theory Model to analyze pricing
behavior of Oligopolists
 We assume a duopoly (2 firm oli.) producing
athletic shoes. RareAir and Uptown each has
a choice of pricing high or pricing low.
 The profit each firm earns will depend on the
strategy its rival chooses.
Continued…
 There are 4 possible combinations of strategies for the two firms
shown below. For example: cell C represents a low-price strategy for
Uptown and a high-price strategy for RareAir. The figure below is
called a payoff matrix, because each cell shows the payoff (profit) to
each firm hat would result from each combo of strategies.
Mutual Interdependence
Revisited
 Oligopolistic firms can increase their profits, and
influence their rivals’ profits, by changing their
pricing strategies.
 Each firms profit depends on its own pricing
strategy and that of its rivals.
 This mutual interdependence is the most
obvious point demonstrated in the previous
slide.
 If Uptown adopts a high-price strategy, its profit
will be $12 million provided that RareAir also
employs a high-price strategy. (cell A)
Collusion
 Collusion = cooperation with rivals which is
beneficial to oligopolists in some cases.
 It is an agreement among firms or individuals to
divide a market, set prices, limit production or
limit opportunities.
 How can Oligopolists avoid low profit outcomes?
 The answer is that they establish prices
competitively independently. In the previous
example, the two firms could agree to establish
and maintain a high-price policy. So each firm
will increase its profit.
 Practices that suggest possible collusion
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include:
Uniform prices
A penalty for price discounts
Advance notice of price changes
Information exchange
Three Oligopoly Models
1) Kinked-demand curve
2) Collusive pricing
3) P Leadership
Why not a single model??? Two reasons, people:
1)
2)
Diversity of Oligopolies: great range and diversity of market
situations= tight/loose oligopoly; differentiated/standarized
products; collusive/non-collusive behavior; strong/weak barriers of
entry…
Complications of Interdependence: because firms cannot predict
the reactions of their rivals, they cannot estimate their own
demand and marginal-revenue data, without which they can’t set
their profit-maximizing P and Q.
Kinked-Demand Theory, a.k.a.
Noncollusive Oligopoly
 Say there are 3 independent firms: A, K and D, each having about
one-third of the total market for a differentiated product.
 What does de Demand curve look like???
 The location and shape of an oligopoly’s demand curve depend on
how the firm’s rivals will react to a P changed introduced by A.
 Again, two options:
 1) Match P changes: K and D will match A’s P change.
This will cause A to increase its sales modestly, since K
and D will also cut their P.
A’s Demand
Curve
A’s Marginalrevenue curve
Kinked-Demand Theory, a.k.a.
Noncollusive Oligopoly
 2) Ignore P Changes: K and D might choose to ignore A’s
P change. This will make A increase its sales.
 If A increases its P and K and D don’t, K and D will have
their sales increased. However, this doesn’t mean that A
will lose all of its customers Product differentiation
might cause some customers to prefer A’s product,
despite the P increase.
A’s Demand
Curve
A’s Marginalrevenue curve
Kinked-Demand Theory, a.k.a.
Noncollusive Oligopoly
 A Combined Strategy
A firm’s rivals will match P declines below P0, in order to
prevent the P cutter from taking their customers.
A firm will ignore P increases above P0, because the rivals of
P-increasing firm stand to gain business lost by the P
booster.
Demand is highly elastic above P0
Demand is less elastic or even inelastic below P0
Noncollusive
oligopolist’s
Demand Curve
Noncollusive
oligopolist’s
Marginalrevenue curve
Kinked-Demand Theory, a.k.a.
Noncollusive Oligopoly
 P Inflexibility:
Why are P’s generally stable in concollusive oligopolistic
industries???  Demand and cost reasons
1) Demand: oligopolists tend to believe that, because of the kinked-demand
curve, a change in P will be for the worse. If P , the sales won’t increase by
much because rivals will tend to P. If P , the firm will lose customers.
If Demand is inelastic, a
only total costs.
in P will
marginal revenue, and an
in P, will
2) Cost: the broken MR curve suggests that even if an oligopolist’s cost change
substantially, the firm may have no reason to change its P. in all positions of
the MC curve between MC1 and MC2 will result in the firm’s deciding on
exactly the same P and Q.
MR =MC at output
Q0, for which will
charge P0
Kinked-Demand Theory, a.k.a.
Noncollusive Oligopoly
 Criticisms of the Model:
The KD analysis doesn’t explain how the P is set at P0. It
only helps explain why oligopolists tend to stick with an
existing P.
When the macroeconomy is unstable, oligopoly prices are
not rigid. Ex: inflation periods (too many P ), recessions
(price war successive cut prices).
Cartels and Other Collusion
 Oligopolists might benefit from collusion (when firms in
an industry reach an agreement to fix prices, divide up
the market, or restrict competition among themselves.
 By controlling P through collusion, oligopolists may be
able to reduce uncertainty, increase profits, and prohibit
the entry of new rivals.
Cartels and Other Collusion
Consider 3 firms: F, L, and O.
 P and Output:
Each firm finds it most profitable to charge the same P, but only if its
rivals do so.
What can F, L, and O do???  collude!! (agree on P charged)
Collusion will reduce possibility of P wars and give each firm
the maximum profit.
…sounds like the industry is a pure monopoly composed of
3 identical firms…
Cartels and Other Collusion
 Overt collusion: Cartel
Cartel: a group of producers that typically creates a formal
written agreement specifying how much each member
will produce and charge.
Sufficient market power to control output and price (which
usually is set above the MC of production), and divide
market.
Most famous cartel: OPEC (Organization of Petroleum
Exporting Countries)
Cartels and Other Collusion
 Covert Collusion:
Cartels are illegal in the US (antitrust laws). Any collusion
that exist is secret.
Tacit understandings: agreements between competing
firms on product price made at cocktail parties, golf
courses, through phone calls…
Cartels and Other Collusion
 Obstacles to Collusion:
1)
Demand and Cost differences each oligopolist has different costs and
demand curves
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Industries that produce differentiated products experience frequent change.
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Industries that produce standardized products may produce with differing
degrees of productive efficiency.
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Profit-maximizing P differs among firms
2)
Number of Firms: the larger the number of firms, the more difficult it is to
collude.
3)
Cheating: There is still a tendency to offer a lower price to steal competition
4)
Recession: Slumping markets increase ATC
5)
Potential Entry: Higher prices attract more firms, usually smaller
6)
Legal Obstacles: Antitrust Law : prohibit cartels and price fixing
Price Leadership Model
 A dominant firm ( largest or most efficient)
initiates price changes and everyone else
follows the leader.
 This is a way in which oligopolies can
coordinate P’s without engaging in collusion.
Price Leadership Model
 Leadership Tactics :
1) Infrequent price changes :P is changed only when
demand and cost has been changed significantly
2) Communications : the P leader communicates the need
to raise/lower prices so other firms can react
3) Limit pricing: set prices below profit-maximizing level in
order to discourage other companies from entering the
industry
4) Breakdowns in Price Leadership: Price Wars : P leadership
usually ends when one company undercuts the other
companies and a price war results
Oligopoly and Advertising
 Each firms share of the total market is best
determined by product development and
advertising
- Product development and advertising are less
easily duplicated then price cuts and
therefore can produce longer lasting gains
- Oligopolists generally have capital to put into
product development
Oligopoly and Advertising
 Advertising is prevalent in monopolistic and
Oligopolistic competition
 Positive effects of advertisements: Spreading
information about products helps people make
rational discussions and break up monopolies,
enhances competition greater economic
efficiency
 Negative effects of advertising: some ads convey
little about product attributes, too costly advertising
campaigns can be canceling
Oligopoly and Efficiency
 Productive and Allocative efficiency:
The oligopolist’s production usually occurs where P exceeds
MC and ATC. Moreover, production is below the output
at which ATC is minimized.
Neither Productive efficiency (P=min. ATC) nor Allocative
efficiency (P=MC) is likely to occur.
Oligopoly and Efficiency
 Points of view:
Negative: informal collusion among oligopolists may yield P and output
results similar to those under pure monopoly, yet give the outward
appearance of competition involving independent firms.
Positive:
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Foreign competition has increased among different oligopolistic
industries (steel, photographic film, copy machines).
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Some oligopolists may intentionally keep their prices low.
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Oligopolistic industries may foster more rapid product development
and greater improvement of production techniques through
technological advance.