Instructor’s Notes

Instructor: Rasha Fattouh

Chapter 14 : Oligopoly
I. Introduction
• In this chapter we study oligopoly: a form of industry (market) structure
that is characterized by a few dominant firms.
• There dominant firms are large enough to influence market price
• Products are either homogenous (perfect substitutes) or differentiated.
• Oligopolists compete using: Pricing, Advertising, and marketing.

II. Market Structure in an Oligopoly

• It is a way to understand how the competition works between oligopolists

• Some oligopoly markets have only a few firms (are concentrated industry),
whereas others have many firms, but a few large ones dominate
• There is some sort of interdependence among these industries in a way that
the behavior of one firm depends on the reaction it expects from the other
• This is what is described as a complex interdependence

Michael Porter’s Five Forces model :

To understand the five forces that determine the level of competition and profitability in an
industry

1. The Box in the Middle: centers around competition among the existing firms in the
industry. In an oligopoly market structure, there are small number of firms and each
of those firms will spend time thinking which the best way is to compete against the
other firms.

How to think about how competitive an industry is:

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Instructor’s Notes
Instructor: Rasha Fattouh
a. Number and Size Distribution: an important structural feature is the
number and size distribution of those firms: do the top firms have 90% of
the market? 20% of the market? Is there one extremely large firm and a
few smaller competitors? Are firms similar in size?
b. Concentration Ratio: to measure the extent to which large firms dominate
an industry, economists use a concentration ratio which is the share of
industry output in sales, or employment accounted for by the top firms.
- They are used to determine market structure and competitiveness of
the market
c. Product Differentiation: questions to consider are whether all firms are
making the same product or are they different from one another? As the
degree of product differentiation increases, each firm has more monopoly
power.

2. Potential Entrants:
a. When there are low barriers to entry, new firms have easier access to come in
and compete. The threat of the new entry is an important factor in the
competition.
b. this threat can lead the oligopoly to behave like a perfectly competitive
industry. Contestable Markets are born. They are a way in which entry and
exit are easy enough to hold prices to a competitive level, even if no entry
actual occurs.
3. Substitutes: describes the number and closeness of substitutes products. The
availability of multiple substitutes outside the industry will restrict the ability of firms
to earn high profits.
4. Supplies: describes the market structure of the firm’s supplies. If some input
suppliers have market power, the ability of the firm to earn profits maybe diminished.
5. Buyers: from our perspective it is demand. However, market structure is very
important here, because if there are only specific few buyers for the firm’s products,
buyers will have some market power.

III. Oliogopoly Models

A. The Collusion Model

• When a group of profit maximizing oligopolists colludes on price output, the result is
exactly as if one firm is controlling the entire industry
• It is the act of firms working with other firms in an effort to limit competition and
increase joint profits

When does collusion arise?

• If quantity demand is only large enough for a single firm to operate, and can fit
multiple firms (e.g. you give patents to three different but similar products →
competition → oligopolies)

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Instructor’s Notes
Instructor: Rasha Fattouh
• The demand should be inelastic because if substitutes are available, the attempts to
raise the price will probably reduce total revenue

→ after collusion? A cartel is formed:

If quantities and price are fixed but the agreement is implicit → Tacit collusion

B. Price-Leadership Model

• Simply, it is a specific form of Oligopoly where one firm sets the price, and all other
firms follow its pricing policy.
• The dominant firm has the privilege of pushing other firms out of the industry
How?
• Basically, it can sell its product at an artificially lower price in which a smaller firm
cannot keep up, pushing it outside the market.

C. The Cournot Model

• Originally, it is assumed to be a duopoloy: a two firm oligopoly

• Both seek to maximize profit under realistic and given outputs.

• The Cournot model, or the dupoloy, clearly illustrates the interdependency of two
firms. It is the first that introduced reaction functions
• The equilibrium is the best-response equilibrium
IV. Game theory

A branch of applied mathematics that analyzes strategic situations in which rival

firms/gov/organizations etc. choose various actions to maximize their return
→ it explains why cooperation is difficult to maintain for oligopolists even when it is
mutually beneficial.

Prisoner’s Dilemma: A game that shows two individuals might not cooperate, even if it is in
their best interests.

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Instructor’s Notes
Instructor: Rasha Fattouh

Few Definitions:

Dominant Strategy: is a strategy that is best no matter what the opposition does
Nash equilibrium: is a strategy that is best no matter what the opposition does.