Oligopoly and Strategic Behavior

 What is oligopoly?
 Oligopoly exist when a small number of firms sell a product in a market with significant
barrier to entry
 Oligopolies sell differentiated products but also enjoy significant barriers to entry with
few rivals
 Few rivals give the oligopolistic more market power than a firm operating under
monopolistic competition

Doupoly - There are two sellers

Pure Oligopoly - If the product is homogeneous (i.e., steel and aluminum)
Differentiated Oligopoly - If the product is differentiated. (i.e., automobiles,
cigarettes, breakfast cereals, soaps, and detergents.)

Sources of oligopoly and barriers to entry:

1. Economies of scales may operate over a sufficiently large range of outputs as to leave
only a few firms supplying the entire market.
2. Huge capital investments and specialized inputs are usually required to enter an
oligopolistic industry (say, automobiles, aluminum steel, and similar industries), and this
acts as an important natural barrier to entry.
3. A few firms may own a paten for the exclusive right to produce a commodity or to use a
particular production process.
4. Established firms may have a loyal following of customers based on product quality and
service that new firms would find very difficult to march.
5. A few firms may own or control the entire supply of a raw material required in the
production of the product
6. The government may give a franchise to only a few firms to operate in the market.
7. Limit pricing whereby existing firms charge a price low enough to discourage entry in to
the industry.

Measuring the Concentration of Industries

Concentration ratios: a measure of the oligopoly power present in an industry

○ Four-firm concentration ratio is the most common measure; it expresses the sales of the
four largest firms in an industry as a percentage of that industry’s total sales
○ Determined by taking the output of the four largest firms in an industry and dividing
that output by the total production in the entire industry

Herfindahl Index (H): An alternative measure of market concentration is the Herfindahl-

Hirschman Index (HHI). It is calculated by squaring the market share of each firm in the market
and then summing the resulting numbers. The higher the Herfindahl index, the greater is the
degree of concentration in the industry.

Theory of contestable markets - If entry is absolutely free and exit is entirely costless then
firms will operate as if they are perfectly competitive and the market is contestable.

The Kinked Demand Curve Model

○ Introduce by Paul Sweezy 1939. He postulated that if an oligopolist raised its price, it
would lose most of its customers because other firms in the industry would not follow
by raising their prices. On the other hand, an oligopolist could not increase its share of
the market by lowering its price because its competitors would quickly match price
cuts.
 The demand curve facing the oligopolist is D or
ABC and has a kink at the prevailing market price of
＄ 6 and quantity of 40 units (point B), on the
assumption that competitors match price cuts but not
price increases. The marginal revenue curve is MR or
AGEHJ. The best level of output of the oligopolist is
40 units and is given by point E at which the MC
curve intersects the discontinuous portion of the MR
curve. At Q=40. P=＄6 (point B on the D curve). Any
shift in the MC curve from MC' to MC'' would leave
price and output unchanged.

Collusion and Cartels in a Simple Duopoly Example

Oligopolies would like to act like monopolists, but they often end up competing like monopolistic
competitors.
o Simplified example is a duopoly: an industry consisting of only two firms; these are rare in national
and international markets, but not that uncommon in small, local markets
 Duopoly sits between two extremes; competition still exists, but it is not as extensive in
competitive markets; in an oligopoly, a small number of firms feel competitive pressures and
also enjoy some of the advantages of monopoly
 If duopolies cooperate, they collude
 Collusion is an agreement among rival firms that specifies the price each firm charges and the
quantity it produces; the firms collude and act like a monopoly to maximize its profits
 Cartel: when two or more firms act in unison; many countries prohibit cartels; antitrust laws
in the US prohibit collusion; though even if they were legal, they usually fail because things
like price-wars and distrust occur
 Mutual interdependence: a market situation in which the actions of one firm have an
impact on the firm price and output of its competitors
 As a result, a firm’s market share is determined by the products it offers, the price it
charges, and the actions of its rivals.
 Market-sharing Cartel: Gives each member the exclusive right to operate in a
particular geographical area.
 Centralized Cartel: This is a formal agreement among the oligopolistic producers of a
product to set the monopoly price, allocate output among its members, and determine
how profits are to be shared.

D is the total market demand cruve, and MR is the corresponding marginal revenue curve for the
two-firm centralized cartel. The ∑MC for the cartel is obtained by summing horizontally the MC curves
of the two member firms. The centralized authority will set P=＄8 and sell Q=50 units (given by point
E at which the ∑MC curve intersects the MR curve). If firm 1 sells 20 units at a profit of ＄1 per unit
and ＄20 in total (the shaded area) and firm 2 sells 30 units at a profit of ＄2 per unit and ＄60 in total,
we have the monopoly solution. The share of profits of each firm could, however, be determined by
bargaining.
Price Leadership
○ The firm that is recognized as the price leader
initiates a price change and then the other firms
in the industry quickly follow.
○ The price leader is usually the largest of the
dominant firm in the industry. It could also be
the low-cost firm or any other firm (called the
barometric firm).
DT (ABCFG) is the market demand curve for the
product, and ∑MCF is the marginal cost curve of all the
follower firms in the industry. Since the followers
always produce where P=∑MCF, DT - ∑MCF = DL
(HNFG) is the demand curve faced by the dominant
leader firm, and MRL is the corresponding marginal
revenue curve. With MCL as the marginal cost curve of
the leader, the leader will set P=＄6 (given by point N at
which MCL=MRL ) in order to maximize its total profits.
At P=＄6, the followers will supply JR=40 units of the
product and the leader RC = RN = 20 units.

Sales Maximization Model

○ Proposed by William Baumol
○ Postulates that managers of modern corporations
seek to maximize sales after an adequate rate of
return has been earned to satisfy stockholders.
TR, TC, and π refer, respectively, to the total revenue,
total cost, and total profits of the oligopolistic firm. π =
TR - TC and is maximized at ＄ 90 when Q=40 and
TR=＄240. On the other hand, TR is maximum at ＄250
when Q=50 and π =＄70. A minimum profit requirement
above ＄70 would be binding, and the firm would produce
less than 50 units of output. For example, if the minimum
profit requirement were ＄ 80, the firm would produce,
47.50 units of output with TR of nearly ＄250.

Strategic Behavior and Game Theory

 Strategic Behavior: the plan of action or behavior of an oligopolist, after taking into consideration all
possible reactions of its competitors as they compete for profits or other advantages.
 Game theory: a branch of mathematics that economists use to analyze the strategic behavior of decision-
makers; helps us determine what level of cooperation is most likely to occur
o A game consists of a set of players, available strategies, and a specification of the payoffs for
each combination of strategies.
o Game is usually represented by a payoff matrix that shows the players, strategies, and payoffs
o It is presumed that each player acts simultaneously or without knowing the actions of the other

Payoff Matrix A matrix or table that shows, for each possible outcome of a game, the consequences for
each player.

Dominant Strategy An action that is the best choice for a player, no matter what the other player does.
 Nash Equilibrium (named for mathematician John Nash) aka the second-best outcome occurs when an
economic decision-maker has nothing to gain by changing strategy unless it can collude. This is the
situation in which each player chooses his or her optimal strategy, given the strategy chosen by the other
player.
Prisoner’s dilemma: refers to a situation in which each
firm adopts its dominant strategy but each could do better
(i.e., earn larger profits) by cooperating.
 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.

Extension of Game Theory

Repeated Games: Many consecutive moves and countermoves by each player.

Tit-for-Tat: Best strategy for repeated or multiple-move prisoner’s dilemma game which refers to
doing to your opponent what he or she has just done to you. A player must show a commitment to
carry out a threat for it to be credible.

Entry Deterrence
○ One important strategy that an oligopolistic can use to deter market entry is to threaten to lower
its price and thereby impose a loss on the potential entrant. Such a threat, however, works only if
it is credible.