Market Structures:Oligopoly
Imperfect Competition
• The spectrum of competition:
Perfect Comp. ------------- Monopoly
Monop. Comp.-- Oligopoly
• Assumptions underlying oligopoly
– Few Sellers
• Interdependence – each seller must be aware that their actions
will provoke actions by rival firms
– Differentiated versus non-differentiated products (cars
or oil
• Differentiated products leads to non-price competition through
activities such as advertising, style changes, quality
Oligopoly
• Price competition vs. non-price competition
– Interdependence in pricing means that price
wars may develop and reduce profits
– Product differentiation avoids price competition
– Advertising is used to increase market share
• Informative
• Persuasive (self-cancelling)
• Modeling oligopoly is difficult because
interdependence can lead to different
behaviors
Duopoly Example
• Assumptions
– Two producers: Jack and Jill
– Zero marginal costs – (for simplicity revenue=profits
• Outcomes
– Competition: Maximum production, zero
price(remember there are no costs) , and no profits
– Monopoly: Reduced Output, highest price, positive
profits
– Oligopoly: Let the games begin!
Table 1 The Demand Schedule for Water
-Jack and Jill collude
with 30 gals each
Profit max = $3,600
split two ways $1,800
-Jack assumes Jill will
stay at 30 gals, increases
production to 40 gals.
price falls to $50, Jack’s
profit rises to $2,000, but
Jill may do the same and
price falls to $40, both
make $1,600
-If Jack tries to increase to
50 gals, price falls to $30
and his profits go to $1,500
Copyright © 2004 South-Western
Table 1 The Demand Schedule for Water
-At 40 gals. Neither Jack
nor Jill have an incentive
to change production.
-Nash Equilibrium :
choose the best strategy
given the strategies that the
other economic agents have
chosen.
-Note: when firms in a
duopoly act to max. profit
they chose a level of output
less than a competitive firm
but more than a monopolist
would produce.
Copyright © 2004 South-Western
• Duopoly (cont.)
– Collusion – form a cartel and act like a monopolist –
highest economic profit, in most cases in the US, this is
illegal.
– Pursuing own self-interest – actions depend on what
you think the other will do: not react or react
• The incentive to “cheat”:
– If you produce more (or charge a lower price and sell more),
assuming MR>MC, your profits will rise, that is, if the other firm
does not do the same thing.
• The incentive to “cooperate”
– If you produce more (or charge a lower price and sell more), the
other firm will do the same, and your profits will fall
Oligopolist’s Supply Decision
• Raising (or lowering) output produces two effects:
– Output effect: because P>MC, the additional output will raise
profits
– Price effect: additional output will lower the price and reduce
profits on all those units that would have been sold at the old price
• Rules for action:
– Raise output if OE>PE
– Don’t raise output if OE<PE
• As the number of firms increases, the PE falls, so output is
increased, many firms produce the competitive or efficient
solution.
– Freer trade has resulted in increasing number of firms in the
automobile market, the camera market, and the electronics
markets.
Cartels
• Explicit agreements among firms to fix output and prices
• Examples are OPEC, Electrical Conspiracy (Econ USA),
Shipping Cartel
• Incentive to cooperate – earn monopoly profits
• Incentive to cheat – increase individual profits if cheating
is not detected or punished.
• Sources of instability in cartels:
–
–
–
–
–
Number of Sellers
Cost differences
Potential competition
Recessions
Cheating
Links
• http://www.sunship.com/mideast/oil.html
• http://www.eia.doe.gov/emeu/cabs/chron.ht
ml
•
http://www.naseo.org/energy_sectors/fossil/oil/Supply_Graphs.htm#Prices,%201973-97
Game Theory
• Game theory is an attempt to model and
understand behavior given the presence of
interdependence
• Games have the following characteristics:
–
–
–
–
Rules
Strategies
Payoffs
Outcome
The Prisoner’s Dilemma
• Two criminals, Bill and Paul, are caught redhanded stealing a car, and will receive 2 year
sentences; however, they become suspects in a
previous bank robbery. The DA’s job is to see if
he can solve the bank robbery.
– Rules:
• Each player is held in separate rooms and cannot
communicate.
• Each is told that he is suspected of the larger crime and
– if both confess to the bank robbery, they get 5 year sentences
– if one rats on the other and the other does not confess to the bank
robbery, he gets off, and the other gets a 10 year sentence
– Strategies: Each player has two possible actions
• Confess to the bank robbery
• Do not confess to the bank robbery
– Payoffs: Two players with two outcomes  four
possible outcomes with the following payoffs
• Both confess – each get 5 year sentences
• Both deny – each get 2 year sentence
• Bill confesses and Paul denies – Bill gets off and Paul gets 10
years
• Paul confesses and Bill denies – Paul gets off and Bill gets 10
years.
Bill
BILL
Deny
Confess
5 years
P Confess
5 years
A
U
Paul
L
Deny
10 years
10 years
Off
Off
2 years
2 years
Paul – if Bill confesses I should too (5 vs 10), if Bill denies, I should
still confess (off vs 2)
Bill – if Paul confesses I should too (5 vs 10); if Paul doesn’t. I should
still confess (off vs 2)
• Nash Equilibrium – the player does what is best
for himself after he takes into account the other
players’ actions.
• Dominant solution – the outcome that is better
than all the rest.
• Dominant solution for Paul is to confess and the
same is true for Bill.
• The ‘best’ solution for both is to cooperate, but the
dilemma is that they can’t so they end up with a
second best solution.
Kinked Demand Curve Model
• Show a situation where the best situation for players is to
maintain current prices and that prices remain stable in
spite of firms with different cost structures.
• Asymmetry in price movements:
– If firm raises price, no one follows, therefore quantity demanded is
elastic
– If firm lowers price, all follow suit so the quantity demanded is
quite inelastic
• Marginal revenue curve is discontinuous and allows for
various marginal cost curves.
Kinked Demand Curve
– If the firm raises its
price above P, it faces
an elastic demand curve,
payoff low
– If the firm lowers its
price below P, it faces
an inelastic demand
curve, payoff low
Kinked Demand Curve
– Different firms can have
different MCs. As long as
they fall with in the
discontinuous MR, P will
remain stable.
– Output Effect < Price
Effect for price
movements with the
discontinuous MR curve.
– If MC increases enough,
all firms raise their prices
and the kink vanishes.
Dominant Firm Price Leadership
• A large dominant firm with lower costs that it
competitors becomes the price maker.
• A competitive fringe with many firms that are
price takers or followers.
• The dominant firm’s demand curve is the total
market demand minus the supply of the
competitive fringe.
• The dominant firm sets price and its quantity
based upon residual demand and this determines
the price for competitive firms and their supply.
(Examples OPEC).
Dominant Firm
– The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.
Dominant Firm’s
Demand Curve
Residual
Demand
Dominant Firm
– As long as the dominant firm has lower costs, it can act like
a monopolist over the residual demand.
Other Price Leadership Models
• Barometric price leadership - firms come to tacit
agreement to allow one firm to set the price
according to cost considerations. If cost move is
justified, others will follow and validate the price .
If not, or if some firm decides to defect, the price
change will not be validated.
• Rotating price leadership – firms come to tacit
agreement to allow the price leading firm to rotate
among key players in the industry.
Cartels and Government
• Monopoly power is often granted by government
via regulation. Example Ma Bell (Econ USA).
• Other examples are shipping and the airline
industry (pre-deregulation).
• Justifications for government regulation include
infant industry and natural monopoly.
• Criticisms include decreased competition,
increased costs due to x-inefficiency and lobbying,
and regulation outlives its usefulness.
Measuring Market Power :
Market Concentration
• One presumption is that as the number of sellers
decreases, market power increases.
• Concentration Ratios – percentage of market share
controlled by x number of firms, most commonly
a four-firm concentration ratio
• Four-firm concentration ratio = (Sales by four
largest firms in an industry/Sales by all firms in
the industry) x 100
Concentration Ratios
Primary Copper
Cigarettes
Beer
Breakfast Cereals
Motor Vehicles
Greeting Cards
Small-arms munitions
Household Refrigerators and
Freezers
98,95
93,99
90,90
85,83
84,83
84
84,89
82,82
Problems with Concentration
Ratios
• Do not take into account foreign
competition
• Fail to account for potential competition.
– Contestable markets – firms are able to enter
and exit at low cost. Potential entry acts as a
limit to market power.
US Auto Industry 2001
GM
Ford
Daimler-Chrysler
Toyota
Honda
Nissan
Mitsubishi
Mazda
Subaru
Suzuki
27
24
16
10
7
4
2
2
1
.3
4 US firms
Control
67%
Japanese Firms
Control
26%
WSJ 4/4/2001 and
Carbaugh page 201
Mergers – Increasing
Concentration
• Vertical Merger – merging with a firm that
supplies inputs
• Horizontal Merger – merging with a competitor
• Conglomerate Merger –merging with firms that
are not related
• Successful mergers – Boeing and McDonnellDouglas
• Unsuccessful Mergers – AOL Time Warner