Principles of Economics
by Fred M Gottheil
Chapter 12
Price and Output
Determination Under
Oligopoly
PowerPoint Slides prepared by Ken Long
©1999 South-Western College Publishing
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What is Oligopoly?
A market structure
consisting of only a few
firms producing goods
that are close substitutes
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What are some examples
of Oligopoly?
Automobiles
Steel
Soup
Cereals
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What determines if a
market is an Oligopoly?
The concentration ratio
can be used as a guide
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What concentration ratio
constitutes an Oligopoly?
There is no magic
number, but if a large
percentage of the sales
are from the 4 largest
firms, it’s an Oligopoly
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What is an example of a
high concentration ratio?
Out of 151 firms in the
aircraft industry the
leading 4 constitutes
79% of total sales
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For more information on
industry concentration
check out these web pages • http://www.census.gov
• http://www.census.gov/econ/
www/manumenu.html
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What is the HerfindahlHirschman Index (HHI)?
A measure of industry
concentration, calculated as
the sum of the squares of
the market shares held by
each firm in the industry
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Calculation of the HHI
HHI =
2
+
2
+
…..
2
s1 s2
sn
where S
th firms market
=
the
i
i
share, n= number of firms
in industry
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Problems: For an
industry with only 1
firm, (monopoly), what
would be the HHI?
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Suppose the industry has
10 equal size firms, what
is the HHI?
What if the industry has
100 equal size firms?
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Answers:
Monopoly, HHI = 10,000
10 equal size firms, HHI = 1,000
100 equal size firms, HHI = 100
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How Oligopolistic is the
U.S. Economy?
Oligopoly is very much of
a fact of life in the U.S.
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Is the U.S. becoming more
Oligopolistic?
Answer appears to be NO to this
question. While there have been some
periods of time when industries
appeared to be getting more
concentrated into fewer firms, there
are other periods of history where just
the opposite happened.
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What is Market Power?
A firm’s ability to select
and control market
price and output
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What is an
Unbalanced Oligopoly?
An oligopoly in which
the sales of the leading
firms are distributed
unevenly among them
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What is a
Balanced Oligopoly?
An oligopoly in which the
sales of the leading firms
are distributed fairly
evenly among them
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In which type is market
power most concentrated?
Unbalanced Oligopoly
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Why do Oligopolies exist?
Mergers
Economies of scale
Reputation
Strategic barriers
Government barriers
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What is a
Horizontal Merger?
A merger between firms
producing the same good
in the same industry
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What is a
Vertical Merger?
A merger between firms
that have a supplier purchaser relationship
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What is a
Conglomerate Merger?
A merger between firms
in unrelated industries
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For more information on
mergers check out these sites:
• http://www.stocksmart.com/
newsipos.html
• http://www.antitrust.org
• http://www.usdoj.gov/atr/index.html
• http://www.usdoj.gov/atr/guidelin.htm
• http://www.ftc.gov
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Firms in Oligopoly are
said to be Mutually
Interdependent
Firms realize the large impact that other
firms behavior has on their profits
Leads to many models of oligopoly,
depending on how the firms deal with
the mutual interdependence issue
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One way to deal with the
Mutual Interdependence
problem is…..
LET’S CHEAT!!!!
THE COLLUSION
SOLUTION!!!
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What is Collusion?
The practice of firms to
negotiate price and
market decisions that
limit competition
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What is a Cartel?
A group of firms that
collude to limit
competition in a market
by negotiating and
accepting agreed-upon
price and market shares
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One model of collusion
that can be used is the
cartel model
• Internationally, some cartels like
OPEC exist
• Domestically, these would be
illegal
• If the cartel can collude perfectly,
would tend to charge the
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monopoly price
Ingredients for a
successful cartel
•
•
•
•
•
•
Control a large share of the market
Inelastic and stable demand for the product
Similar costs among cartel members
Fairly homogenous product
Few number of firms
Ways of preventing cheating on the
agreement
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Check out the Opec Cartel
• http://www.opec.org
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What is the relationship
between market
concentration and price?
A high concentration ratio in
an industry may translate
into noncompetitive prices
and behavior
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Kinked demand curve model of oligopoly:
assumption, rivals will match all price cuts
but not price increases. Under this
assumption, its as if each firm faces a
“kinked” demand curve, with 2 sections to
it: more elastic above the existing price,
since rivals won’t match a price increase,
and less elastic below the existing price,
since rivals quickly match price cuts.
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Price
Kinked Demand Curve
Starting price
P1
MR Gap
D
MR
Q1
Quantity
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Graph explanation: Let P1 and Q1 be
the existing price and quantity for
this oligopoly firm: due to the
assumptions of this model, the
demand curve has a kink in it at this
price and output. Because of the
strange shape of the demand curve,
the MR curve is discontinuous, or
has a gap in it.
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Kinked demand curve model is an
attempt to explain rigid prices in
oligopoly: That is, firms might not
change price very often. Why? Firm
is reluctant to raise price if its
competitors do not, since it could lose
sales to them, and little reason is seen
to lower price if competitors quickly
match the price cut, since little will be
gained.
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What does the kinked
demand curve illustrate?
There is a great deal of price
stability and nonprice
competition is important
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How do firms in an
Oligopoly set price?
Most often they practice
price leadership
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Price leadership in
Oligopoly
One firm, the dominant firm, sets
the price, others follow the leader
Often the dominant firm is the low
cost producer in the industry
Is this a form of “tacit” collusion?
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What is an example
nonprice competition?
Brand multiplication
when there are
variations on one good
to increase market share
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Game Theory Approach
to Oligopoly
Is Oligopoly best analyzed
as a strategic game like
chess?
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What is Game Theory?
A theory of strategy
ascribed to a firm’s
behavior in oligopoly
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For more information about
Game Theory • http://www.pitt.edu/~alroth/a
lroth.html
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Prisoner's Dilemma
Nathan’s Choices
Not Confess
Confess
1
Not
Confess
Nathan pays $2,000
Nathan pays $500
Bob pays $2,000
Bob’s
Choices
Confess
2
Bob pays $5,000
3
Nathan pays $5,000
Bob pays $500
4
Nathan pays $3,000
Bob pays $3,000
If the 2 people could collude,
would likely choose to not
confess, but self interest may
drive each to confess, hoping
the other does not, end up both
confessing, worse off for
both—many similar situations
perhaps for firms in oligopoly
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Two firm game
Hold to
Agreement
Firm A’s Choices
Break
Agreement
1
Hold to
Agreement
A earns $50,000 profits
B earns $50,000 profits
Firm B’s
Choices
Break
Agreement
2
A earns $100,000 profits
B earns $5,000 profits
3
A earns $5,000 profits
B earns $100,000 profits
4
A earns $10,000 profits
B earns $10,000 profits
What is a dominant
strategy?
A strategy that is best regardless
of what the opposition does.
For B, dominant strategy is to
break the agreement, and also
for A. Both firms avoid the
worst case scenario in this
manner.
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What is a Nash equilibrium?
(named for Mathematician John
Nash…did you see the film “A
Beautiful Mind?)
A situation where neither firm can
improve its payoff, given what the
other firm is doing…in this
example, breaking the agreement
is the Nash equilibrium
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Is there any way to get to box 1
where both firms are better off
short of outright collusion?
Possibility of a tit-for-tat
strategy….somehow indicate to
the other firm that although
you want to hold the
agreement, you will switch to
match what the other firm
does.
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For a forum that induces
the interactive Prisoner’s
Dilemma check out • http://serendip.brynmawr.edu/
~ann/pd.html
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What is
Price Discrimination?
The practice of offering a
specific good or service at
different prices to different
segments of the market
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Why would a firm want
to price discriminate?
Greater profits
possible!!
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Different types of Price
Discrimination
“Perfect” price
discrimination: Charge
each buyer the highest
price they are willing to
pay
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More usual type of price
discrimination
• Separate buyers into
groups (based perhaps on
age, sex, region of
country, etc.
• Groups should have
different elasticities of
demand
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Higher price to more
inelastic group, lower to
more elastic: must also
be able to prevent resale
of product
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• What is Oligopoly?
• What concentration ratio
constitutes an Oligopoly?
• What is an Unbalanced Oligopoly?
• What is a Balanced Oligopoly?
• What is Collusion?
• What is a Cartel?
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• What is the distinguishing feature
of Oligopoly?
• How do firms in an Oligopoly set
price?
• What is Game Theory?
• What is the Prisoner’s Dilemma?
• What is Price Discrimination?
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END
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