OLIGOPOLY
Chapter 27
What determines how much market
power a firm has?
How do firms in an oligopoly set
prices and output?
What problems does an oligopoly
have in maintaining price and profit?
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
Industry
marginal
cost
Profitmaximizing
price
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
What does market power really mean?



Market power is the key to control.
Monopoly is a type of power that all firms
dream of, yet pure monopoly is not
permitted in our economy.
The next best thing is to PUSH the power
base to the very edge of government
acceptance. Gaining market share is a
common term we hear from businesses
and Wall Street.
MARKET POWER

Tom Thumb wants to gain
market share from
Albertsons.

Wal-Mart wants market
share from Kmart… boy
did they get it!

Central Market wants
market share from Whole
Foods
Google wants market
share from Facebook.

“Defending the Lead”
World-wide PC vender
market share for third
quarter. DMN- 10/16/08
 HP 18.4%
 Dell 13.6%
 Acer 12.5
 Lenova 7.3
 Toshiba 4.6
 Others 43.7%
Top 5 Worldwide PC
Vendors, Market Share
4Q12 (unit shipment)
World-wide quarterly
report – 1/2013
http://www.icharts.net/chartc
hannel/top-5-worldwidepc-vendors-market-share4q12-unitshipment_m37bzspdc
Share of market- pizza and
Iphones
Market Share-North Texas July
2013
Grocery Store
% of market share
Walmart
27.8
Kroger
Tom Thumb
14.5
10.1
Albertsons
Target ,super
6.9
6.7
Sam’s
Costco
5.2
5.2
HEB Central Market
Whole Foods
2.5
1.2
Market Street
1.0
Who is sharing?

Oligopoly is no exception… Outstanding feature
of Oligopoly is “fewness”

OLI (derivation actually means few.. (do you
remember your Oligarchy in government?)

Oligopoly has few sellers- so few that at least one firm is
large enough to INFLUENCE PRICE

The vast amount of GDP is accounted for by
firms in oligopolistic industries.
Oligopoly (cont'd)

Oligopoly

A market situation in which there are very few
sellers.

Each seller knows that the other sellers will react
to its changes in prices and quantities.
Oligopoly (cont'd)

Strategic Interdependence

A situation in which one firm’s actions with respect
to price, quality, advertising, and related changes
may be strategically countered by the reactions of
one or more other firms in the industry

Such dependence can exist only when there are a
limited number of firms in an industry.
Oligopolist


The oligopolist is a price searcher.
It produces the quantity of output at which
MR = MC.
Characteristics of Oligopoly
1.
2.
3.
4.
5.
Few firms control the market
High barriers to entry
Produce either differentiated or
homogeneous products
Lack of available substitutes
Name some examples!
Barriers to entry




Patents
Control distribution
outlets
(ticketmaster)(shelfspace for Fritos)
Mergers and
acquisitions
Government regulation



Nonprice Competition (big
buck advertising)
Training (technology knowhow-training employees to
use a certain
product..changing is difficult
Network Economies-get
there first with the most
(don’t buy a phone if your
friends don’t have one.)
Industries that are oligopolies







Steel industry
Aluminum
Film
Television
Cell phone
Gasoline
Airline
Companies - oligopolies






Four music companies control 80% of the market Universal Music Group, Sony Music Entertainment,
Warner Music Group and EMI Group
Six major book publishers - Random House, Pearson,
Hachette, HarperCollins, Simon & Schuster and
Holtzbrinck
Four breakfast cereal manufacturers - Kellogg, General
Mills, Post and Quaker
Two major producers in the beer industry - AnheuserBusch and Miller/Coors (reason why it is not FTC
watched)
Two major providers in the healthcare insurance market
- Anthem and Kaiser Permanente
Small transportation – UPS, Fed X
Oligopoly (cont'd)

Why oligopoly occurs

Economies of scale

Barriers to entry

Mergers

Vertical mergers

Horizontal mergers
Price and Output Under 3 Oligopoly
Theories



Cartel Theory - oligopolistic firms act as if there were
only one firm in the industry.
Kinked Demand Curve Theory - assumes that if a
single firm in the industry cuts prices, other firms will
do likewise, but if it raises price, other firms will not
follow suit. The theory predicts price stickiness or
rigidity.
Price Leadership Theory - the dominant firm in the
industry determines price, and all other firms take
their price as given.
Why are certain industries composed of
only a few firms?



cost economies and other barriers to entry keep the
numbers small
mergers keep out the smaller guys) (enter the
political key on who decides if mergers are not
eliminating competition)
if economies of scale are substantial, reasonably
efficient production will be possible only with a small
number of producers… efficiency requires that the
productive capacity of each firm be large relative to
the total market. (large market share)
Continued





Technological progress has made more
and more economies of scale attainable
over time.
Other barriers such as:
patents,
control of strategic raw materials,
in some cases prodigious advertising
(Budweiser) outlays which add a financial
barrier to entry for other firms.
What does prodigious mean?
http://www.youtube.com/watch?v=or4Z1K_LDc
What do we see in the 21St Century?
Many big corporations seeking more market
share have been following a simple rule.
“Don’t build what you can buy.”
WSJ, February13,2006
Part of this zeal to purchase is to fill some of
the empty production space created in the
building boon of late 90’s…. This will allow
for movement to capacity production which
is more efficient. (translated- full
employment.)
Oligopoly (cont'd)

Vertical Merger


The joining of a firm with another to which it sells
an output or from which it buys an input
Horizontal Merger

The joining of firms that are producing or selling a
similar product
Oligopoly (cont'd)

Measuring industry concentration

Concentration Ratio

The percentage of all sales contributed by the leading
four or leading eight firms in an industry

Sometimes called the industry concentration ratio
Ways to measure degree of
Oligopolization
Concentration Ratio:
 This ratio tells the share of output (or combined
market share) accounted for by the largest firms
in an industry OR… the total percentage share of
industry sales that each firm possesses.
Sometimes the market share of one company in
the oligopoly is so great that it nearly resembles
a monopoly. (remember the cell phone chart?)
Computing the Four-Firm
Concentration Ratio
Referred as HHI Index
Are their other ways to get market
power?
Sure… several smaller firms
can act in unison in the
amount they supply and
price they charge..
Even in small towns firms can
have market power… (ACE
Hardware, Krispy Kreme, or
the Dunkin’Donut store in
Eastjapip, NJ)
Key Point
Concentration ratio is a quantitative measure of
oligopoly
The total percentage share of industry SALES of
the four leading firms is the industry
concentration ratio. (who has higher % of sales
Ford, GM, or Chrysler?) (the increased foreign
trade has minimized the impact of the HHI ratio.)
Obviously, the total aggregate sales are compiled =
$ Then the sales for each firm is calculated.
Come up with certain% of market share…
Herfindahl-Hirschman Index HHI
This is the sum of the square of the market
shares of each firm in the industry.
Example.. Monopolist – one company controls
entire industry = 100% market share. HHI would
be 100 (squared) 100x100 = 10,000 (All
monopolies have 10,000 HHI)
If firm A has 25% and firms B,C,D also have 25 %
Take 25 x 25= 625 Add them up
(625+625+625+625 =2,500 or the total number of
squares for industry power is 2,500
Each firm has 625 squares.
Market Power
Market Power
30
25
20
2005
2006
15
10
5
0
Walmart
Kroger
Kroger
Albertson’s
Tom
Albertsons Minyards
Thumb
Oligopoly (cont'd)


The more U.S. firms face competition from
the rest of the world, the less any current
oligopoly will be able to exercise market
power.
Any ideas that come to mind on this
concept?
So, where does government enter in this
equation?
The Anti-trust division of the Justice
Department and the applicable IRC has to
decide if a gain of X% of the market share is
destroying competition or not when a merger is
suggested.
HP/Compaq (will this destroy the competitive edge
for Dell?)
AMR/U.S. Air ????
1.
2.
In 1992 the Justice Dept decided to use other parameters in
determining anti-trust and destructive competition---barrier to entry. If low, then highly concentrated industry
might be compelled to behave more competitively. (hence,
contestability and structure were now added to the
merger equation.)
a) does it look like a monopoly?
b) does it behave like a monopoly?
What happens if one increases sales?


Increased Sales at the Prevailing Market Price
Increases in the market share of one oligopolist
necessarily reduce the shares of the remaining
oligopolists.
• It is possible that an increase in sales by lowering the
price may expand total market sales and increase the
sales of an individual firm without affecting the sales
of its competitors. But it doesn’t happen without
setting off alarms within the industry..(Delta lowers
its price- Southwest follows) (Pepsi lowers price to
sell more.. Coke follow? Kinked Demand Curve
concept
What is the objective here?
Then what happens???


Retaliation
Oligopolists respond to aggressive marketing by
competitors.
Step up marketing efforts.
 Cut prices on their product(s).
Rather than cut prices which causes a general “off the cliff
for all concept.” (hence kinked demand curve)
Oligopolists will engage in “non-price competition.”
Hint:
their products are differentiated for the most part.American Airlines- more leg room… LOL! 

The Kinked Demand Curve
Confronting an Oligopolist


The shape of the demand curve facing an
oligopolist depends on the responses of its
rivals to a change in the price of its own
output.
The demand curve will be kinked if rival
oligopolists match price reductions but not
price increases.
Game Theory

A mathematical technique used to analyze the
behavior of decision makers who try to reach an
optimal position for themselves through game
playing or the use of strategic behavior, are fully
aware of the interactive nature of the process at
hand, and anticipate the moves of other decision
makers.
Game Theory



Each oligopolist has to consider the potential
responses of rivals when formulating price or
output strategies.
The payoff to an oligopolist’s price cut depends
on how its rivals respond.
Game theory is the study of decision making in
situations where strategic interaction (moves and
countermoves) between rivals occurs.
Game Theory



Game theory: the study of how people
behave in strategic situations
Dominant strategy: a strategy that is
best for a player in a game regardless of
the strategies chosen by the other players
Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial
Prisoners’ Dilemma
Example


The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
The police question each in separate rooms,
offer each the following deal:
 If you confess and implicate your partner,
you go free.
 If you do not confess but your partner implicates
you, you get 20 years in prison.
 If you both confess, each gets 8 years in prison.
Prisoners’ Dilemma Example
Nash equilibrium:
both confess
Confessing is the dominant strategy
for both players.
Bonnie’s decision
Confess
Confess
Bonnie gets
8 years
Clyde
gets 8 years
Clyde’s
decision
Remain
silent
Remain silent
Bonnie goes
free
Clyde
gets 20 years
Bonnie gets
20 years
Clyde
goes free
Bonnie gets
1 year
Clyde
gets 1 year
Prisoners’ Dilemma Example

Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.

Both would have been better off if both
remained silent.

But even if Bonnie and Clyde had agreed
before being caught to remain silent, the logic
of self-interest takes over and leads them to
confess.
Moves in the economy
Pepsi meets to decide how to gain market
share
If they reduce Pepsi cost in Plano, and have
increased promotion, what will Coke respond
with? Are they looking over their shoulder?
Will any of that strategy be applied throughout
the U.S. or is it effective only regionally.
Dr. Pepper… what would strategy be in NE?
Price and Output
Checking the corporate pie for profit!



Price and Output
Price discounting can
destroy oligopoly
profits.
When it occurs, rival
oligopolists seek to end
it as quickly as
possible.
Price and Output


.
To maximize industry profit, the firms in an
oligopoly must agree on a monopoly price and
agree to maintain it by limiting production and
allocating market shares.===Illegal in U.S. – OPEC
is example of how this works (Cartel)
Drug Cartel in Mexico
Allocation of Market Shares
One way to distribute output is a cartel
agreement.
 A cartel is a group of firms with an explicit
agreement to fix prices and output shares
in a particular market.
Cartels are illegal in the United States…
OPEC (Organization of Petroleum Exporting
Countries) is the most famous now.(11
countries)
http://www.opec.org

Let’s Look at Cartels
Each producer is assigned a % they may
produce in the market. These are explicit
production-sharing agreements. (most cheat
due to high oil prices in market)
Saudi Arabia has increasingly violated the % they
were assigned by OPEC several times to:
increase their market share and to help out the
U.S.
They may be less willing to do this in the future
(continued war/Iraq)(new terrorism problems)
(other countries join to ostracize any Arab nation
that cooperates with U.S.) (supply/demand) (U.S.
reduces dependency on oil… OPEC won’t want
to stray too far.
The Cooperative Game: A
Collusive Cartel

Cartel

An association of producers in an industry that
agree to set common prices and output quotas to
prevent competition.
PRICE FIXING IS ILLEGAL
Price Fixing Examples


Electric Generators In 1961, General
Electric and
Westinghouse were
convicted of fixing
prices on electrical
generators.
They were charged
again in 1972 for
continued price fixing.

School Milk – Between
1988 and 1991, the
U.S. Justice
Department filed
charges against 50
companies for fixing the
price of milk sold to
public schools in 16
states.
So, you think they don’t fix prices?



Gasoline – Mobil, Chevron and Shell paid $77
million in 1993 to settle charges that they conspired
to fix gasoline prices.
Music CDs – In 2001, the FTC charged AOL-Time
Warner and Universal Music with fixing prices on the
“Three Tenors” CD.
The airline industry is being investigated as of
3/8/06 to see if they fixed prices on jet fuel
purchases.
WSJ- November 13, 2008
“LCD Makers Plead Guilty to Price Fixing”
 Sharp, LG Display, Chunghwa Fined $585
million for schemes affecting TV sets, other
products.
 Criminal charge
 Consumers paid higher prices for TVs,
cellphones, and other products using liquidcrystal displays.
Whirlpool, rivals face price fixing probe
 Michigan business news in brief: Whirlpool, rivals
face price fixing probe
February 19, 2009, Detroit Free Press

Wired PR News – Microsoft Corp. has been fined
for alleged price-fixing. As reported by the
Associated Press (AP), the company’s German
subsidiary was fined 9 million euros, which is the
equivalent of $11.8 million, for purportedly
illegally influencing the retail prices for their
Microsoft Office 2007 software programs.
April 13, 2009
TX Doctors agree to settle
price-fixing (2006)

The FTC’s complaint alleges that Health Care Alliance of
Laredo, LC (HAL), a multi-specialty IPA with about 80
physician members, restrained competition among the
members in violation of Section 5 of the FTC Act. HAL
claimed it employed a “messenger model” process to
negotiate contracts. If properly orchestrated, a
messenger model process does not restrain competition.
HAL engaged in collective bargaining, however, and did
nothing that might justify its challenged conduct.
2009

FTC Settles Price-Fixing Charges Against
San Francisco Bay Area Doctors’ Group
For Release: 02/28/2013
 Eight Puerto Rico Kidney Doctors Settle
FTC Price-Fixing Charges
Nephrologists Will No Longer Boycott
Insurers and Patients to Obtain Higher
Prices
April 11, 2012

Justice Department sues Apple,
publishers over e-book prices

The Justice Department on Wednesday
accused five of the nation’s largest publishing
houses and Apple of fixing prices on e-books,
forcing consumers to pay tens of millions of
dollars more for their favorite titles.
How do we know?
Price Leadership or Fixing?
Leadership is acceptable.. Fixing is not.
Sometimes they send up smoke signals to
alert their rivals about a price increase in
hopes the rivals will follow.
Whenever oligopolist successfully raises
prices, unit sales will decline. (old
theory)
This has become theory since Delta
began charging for baggage. Now
carry-on’s are being charged by Spirit
What happens if AA lowers airline fares?
Graph for a price-fixing oligopolist
The graph for a price-fixing oligopolist will
look exactly like the monopolist.
The Benefits of Cheating on the Cartel Agreement I




The situation for a
representative firm of a cartel:
in long-run competitive
equilibrium, it produces q1 and
charges P1, earning zero
economic profits.
As a consequence of the cartel
agreement, it reduces output to
qC and charges PC.
Its profits are the area CPCAB.
If it cheats on the cartel
agreement and others do not,
the firm will increase output to
qCC and reap profits of FPCDE.
The Benefits of Cheating
on the Cartel Agreement II

Note, however, that if this firm can cheat
on the cartel agreement, so can others.
Given the monetary benefits gained by
cheating, it is likely that the cartel will exist
for only a short time.
Predatory Pricing - illegal
A company decides to lower its prices for a
short period of time to force a competitor
out of business. After the competitor
leaves, the company then raises price
again.
(BroadBand Cable/Internet)
Utah Pie company (forced out by Mrs.
Smith’s pies)

http://www.youtube.com/watch?v=nGx4E8w5
VHg&NR=1
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
Industry
marginal
cost
Profitmaximizing
price
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
Reality of this


Coordination Problems
There is an inherent conflict in the joint
and individual interests of oligopolists.



Each oligopolist wants industry profits to be
maximized.
Each oligopolist wants to maximize it’s own
market share.
To avoid self-destructive behavior, each
oligopolist must coordinate production
decisions.
Table 27-3 Comparing Market Structures
QUESTIONS?