Oligopoly
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By the end of this Section, you
should be able to:
Describe the characteristics of an oligopoly
 Discuss the efficiency of an oligopolist’s
actions
 Discuss the equilibrium conditions for an
oligopoly
 Define the 4-firm concentration ratio

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Definition
An Oligopoly is a market situation in which there
exists very few sellers of an identical good.
Each seller knows the other sellers will react to
its changes in price and quantity output.
 Game theory relates to an oligopoly because an
oligopoly is a “game” between the participating
firms, who interact by deciding how much of an
identical product to produce.

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Characteristics of an Oligopoly
Top few producing firms in the industry account
for an overwhelming percentage of the total
industry output.
 There exists strategic dependence which is a
situation in which one firm’s actions with respect
to price, quantity, advertising and related
changes may be strategically countered by the
reactions of one or more other firms in the
industry.
 Firms in an oligopoly must attempt to predict
their rival’s reactions to their actions.

– Not the case in a competitive market or a monopoly.
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Actions for Firms in an Oligopoly
Firms in an oligopoly have two options to choose
from when choosing their output and pricing
levels.
 They can:

– Co-operate with the other firms in the Oligopoly
 This is like pricing high in the activity.
 Firms can co-operate by choosing to charge a high price and
limiting output of the product.
 This results in monopolist profits spread among the
oligopolies.
– Act independently of the other firms in the Oligopoly
 This is like pricing low in the activity.
 Firms can act independently by increasing their output and
lowering their price.
 This results in competitive market conditions and profits for
the firms in the oligopoly.
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Actions for Firms: Co-operate

Firms in an Oligopoly co-operate with one another by
choosing to price high and limit their output.
– This results in an equilibrium quantity where MR=MC and
P>MR (just like a monopoly).
– The firms then split the monopoly level of profits among all
the firms in the industry.

When firms in an oligopoly co-operate, they collude.
– When firms collude, they form a cartel.
– A cartel is a group of firms acting together to limit output,
raise price and increase economic profit.
– Cartel’s are illegal, but some do operate in some
industries.
– Cartel’s tend to break down: we saw this in our exercise.6
Actions for Firms: Co-operate

So in summary:
– Firms who co-operate lead to monopolist level
prices and quantities in total.
– When looking at Oligopolies at a whole, this is
the Pareto solution.
 When all firms price high, the Oligopoly as a whole
will make the highest profit.
– However, when looking at society as a whole,
Oligopolies who co-operate cause a DWL.
 If firms are acting like a monopolist, quantity
supplied is too low and price is too high, and there
exists a DWL; just like in a monopoly.
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Actions for Firms: Act
Independently


If firms choose not to collude, they must guess and react for
how others are going to act.
Example: Suppose there exists 2 gas stations in a small town.
You are the owner of one of them.
– You decide to decrease your price to increase the amount of gas you sell
and your profit.
– Then in response the other station decreases their price more to sell
more gas than you and capture more of the profit.
– Then in response you may choose to retaliate and decrease your price
even more.
– We saw this in our exercise.

Firms who work independently will continue to decrease their
price until they can not decrease their price any more.
– This is the point where P=MR=MC (the competitive firm equilibrium).
– Or where the firms in an oligopoly are acting like competitive firms. 8
Actions for Firms: Act Independently

So in summary:
– Firms who act independently lead to competitive level prices
and quantities in total.
– This means they price and produce where P=MR=MC.
– This means the firm may have short run profits but in the
long run, their economic profit = 0.

When looking at Oligopolies at a whole, this is the
Nash solution.
– Regardless of what the other firms do, each firm has an
individual incentive to price low
– However, this results in the lowest profits for the oligopoly
as a whole.
Actions for firms: Act
Independently

However, when looking at society as a whole,
Oligopolies who act independently maximize
social welfare.
 If firms are acting like a competitive market, quantity
supplied is high and price is low, and there exists no
DWL; just like in a competitive market.
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Nash Equilibrium and Pareto
Optimum

The decisions of an Oligopoly can be expressed in a
game.
– For example, suppose there are two firms. These firms have the
option to produce at Monopolistic output or Competitive output.
– The profit of each choice can be represented in a game
(numbers here are just an example).
Nash Equilibrium = (Comp. Output, Comp. Output)
Pareto Outcome = (Monop. Output, Monop. Ouput)
Firm 2’s Actions
Monopoly
Output
Firm 1’s Actions
Competitive
Output
Monopoly
Output
36, 36
30, 40
Competitive
Output
40, 30
32, 32
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Cournot vs. Bertrand Oligopoly

There exists two competing theories on how
Oligopolies decide what price to charge and how
much quantity to produce.
– The difference between these two theories is the order in
which they decide price and quantity.
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Bertrand Oligopoly

A Bertrand Oligopoly exists when firms choose
the price to charge.
– For example the activity where you decided to price
high or low.
– Once each firms has picked a price, how much
quantity they produce in total is dependent on the
industry demand curve.
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Cournot Oligopoly

A Cournot Oligopoly exists when firms choose
the amount of quantity to produce.
– For example the game on the previous slide.
– Once each firm has picked their quantity they are
going to produce, the industry price is determined by
the industry demand curve.
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How to tell what kind of market
you have:
The type of market (competitive, monopolist or
oligopoly) is dependent on how much market
power firms have.
 Market power is the ability to set the price of the
output above marginal cost.

– The higher the market power, the higher the price.

To determine the type of market, we evaluate
the market power of firms in the market by
evaluating firm’s percentage of market sales.
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How to tell what kind of market
you have:
There exists many types of measuring
techniques and ratios to determine market
type.
 One is the Four Firm Concentration Ratio.

– Evaluates the percentage total of sales
contributed by the leading four firms in an
industry.
– The higher the percentage of sales, the more
market power a firm has.
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Four Firm Concentration Ratio
= sum of sales of top 4 firms
sum of sales in industry
 Example: Suppose the sum of sales of an
industry for a particular good is 450. Meanwhile
the top four firms have the following amount in
sales: 150, 100, 80, 70.
– 4 firm concentration ratio = 150+100+80+70 = .889
450
This means almost 90% of total output is
produced by the 4 largest firms.
 What does this percentage mean?

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4 Firm Concentration Ratios by
Market Type




4 Firm Concentration
Ratio Percentage Range
100%
Market Type
Perfect Monopoly
60%-99%
Oligopoly/Monopoly
0%
Competitive market
All other percentages are indeterminate
Note: the higher the ratio, the more market power exists and
the less the efficiency of the market
Note: the lower the ratio, the less market power exists and the
more efficient the market
Summary handout comparing market types will be posted. 18