OLIGOPOLY

Definition
• An oligopoly is a market dominated by a small
number of firms, whose actions directly affect
one another’s profits.
• In this sense, the fates of oligopoly firms are
interdependent.
 Industry Concentration
• An oligopoly is dominated by a small number
of firms.
• This “small number” is not precisely defined,
but it may be as small as two (a duopoly) or as
many as eight to ten.
• One way to grasp the numbers issue is to
appeal to the most widely used measure of
market structure: the concentration ratio.
 Industry Concentration
• Concentration
  ratios measures the combined
market share percentage of the ith leading firms,
• The four-firm concentration ratio is the
percentage of sales accounted for by the top four
firms in a market or industry. (Eight-firm and
twenty-firm ratios are defined analogously.)
• Concentration ratios can be computed from
publicly available market-share information.
 Industry Concentration
• The higher the concentration ratio, the greater is
the degree of market dominance by a small
number of firms.
• A common practice is to distinguish among
different market structures by degree of
concentration.
• Example:
– Effective Monopoly (CR1 > 90%)
– Effective Competitive (CR4 < 40%)
– Loose Oligopoly or Monopolistic Competition (40% < CR4 < 60%)
– Tight Oligopoly (90% > CR4 > 60%)
 Industry Concentration
• Using
  a concentration ratio is not the only way
to measure market dominance by a small
number of firms.
• An alternative and widely used measure is the
Herfindahl-Hirschman Index (HHI), defined as
the sum of the squared market shares of all
firms:

where sn = market share of nth firm

 Industry Concentration
• For instance, if a market is supplied by five
firms with market shares of 40, 30, 16, 10, and
4 percent, respectively.
HHI = 402 + 302 + 162 + 102 + 42 = 2,872
• HHI = 10,000 for pure monopolist
• HHI ≈ 0 for perfectly competitive firms
• If a market is shared equally by n firms, HHI is
the n-fold sum of (100/n)2 = 10,000/n.
 Industry Concentration
• The Herfindahl-Hirschman Index has a number of
noteworthy properties:
1. The index counts the market shares of all firms, not
merely the top four or eight.
2. The more unequal the market shares of a collection
of firms, the greater is the index because shares
are squared.
3. Other things being equal, the more numerous the
firms, the lower is the index.
• Because of these properties, the HHI has advantages
over concentration ratios;
 Concentration and Prices
• Concentration is an important factor affecting
pricing and profitability within markets.
• Increases in concentration can be expected to be
associated with increased prices and profits,
other things being equal.
• Low concentration leads to minimum prices and
zero profits like pure competition.
• High concentration leads to higher prices and
excess profits like pure monopoly.
 Stackelberg Oligopoly
• Price leadership means that one firm possesses a
dominant market share and acts as a leader by
setting price for the industry.
– Examples: General Motors (automobile), eBay (online
auctions), Federal Express (overnight delivery),
Microsoft (PC software), to name just a few.
• This method was formulated by the German
economist Prof. Heinrichvon Stackelberg.
• This is also known as leadership solution or
followership solution.
 Stackelberg Oligopoly
• Three important cases of price leadership:
1. Price Leadership by a Low-Cost Firm, and
2. Price Leadership by a Dominant Firm.
3. The Barometric Price Leadership Model

• In the low-cost price leadership model, an

oligopolistic firm having lower costs than the other
firms sets a lower price which the other firms have
to follow. Thus the low-cost firm becomes the
price leader.
 Stackelberg Oligopoly
• The barometric price leadership, there is no leader firm
as such but one firm among the oligopolistic firms with
the wisest management announces a price change first
which is followed by other firms in the industry.
• The barometric price leader may not be the dominant
firm with the lowest cost or even the largest firm in the
industry. It is a firm which acts like a barometer in
forecasting changes in cost and demand conditions in
the industry and economic conditions in the economy as
a whole.
 A Dominant Firm
• The accepted model assumes that the
dominant firm establishes the price for the
industry and the remaining small suppliers sell
all they want at this price.
• The small firms have no influence on price and
behave competitively; that is, each produces a
quantity at which its marginal cost equals the
market price.
A Dominant Firm
The dominant firm’s
net demand curve is
the difference
between industry
demand and the
competitive supply of
small firms (for any
given price P*), the
horizontal distance
between D and S.

Q = QD - QS
 A Dominant Firm
Numerical Example:
Suppose that total market demand is given by QD
= 248 – 2P and that the total supply curve of the 10
small firms in the market is given by QS = 48 + 3P.
The dominant firm’s marginal cost is MC = 0.1Q.
a. Determine the optimal quantity (Q*) and price of
the dominant firm (P*).
b. Determine the quantity of the 10 small firms (QS).
 Cournot Oligopoly
• Augustin Cournot, a nineteenth-century French
economist developed a simple but important
model of quantity competition between
duopolists (i.e., two firms).
• Cournot oligopoly consists of a small number of
equally (symmetrically) positioned competitors.
• Knowing the industry demand curve, each firm
must determine the quantity of output to
produce independently.
 Cournot Oligopoly
Numerical Example:
Consider a two-firm duopoly facing a linear
demand curve: P = 1,600 – Q
where: P = price
Q = total output of the market, thus, Q = QA +
QB
Assume MCA = MCB = AC = 100. Find the profit-
maximizing output (Cournot equilibrium output) and
Cournot equilibrium price of Firm A and Firm B.
 PRICE COMPETITION:
Price Rigidity and Kinked Demand
2 Basic Models:
1. A model of stable prices based on kinked demand.
2. A model of price wars based on the paradigm of the
prisoner’s dilemma.

• Competition within an oligopoly is complicated by the

fact that each firm’s actions affect the profitability of its
rivals.
• Thus, actions by one or more firms typically will trigger
competitive reactions by others; indeed, these actions
may trigger “second round” actions by the original firms.
Price Rigidity and Kinked Demand
• Price rigidity (relatively stable prices over extended periods of
time ) can be explained by the existence of kinked demand
curves for competing firms.
Price Rigidity and Kinked Demand
• Consider a typical oligopolist that currently is charging
price P*.
• Lowering the firm’s price (lower than P*) will generate a
small increase in its sales. (The firm will not succeed in
gaining market share from its rivals, although it could
garner a portion of the increase in industry sales owing).
Demand is relatively inelastic.
• Raising the firm’s price (higher than P*) and not
following the rival firm’s price P* will find its sales falling
quickly even small price increases. The rivals can be
acquired the market share from the price raisers. In
short, demand is elastic for price increases.
Price Rigidity and Kinked Demand
• This explains the demand curve’s kink at the firm’s
current price.
• In view of kinked demand, the firm’s profit-maximizing
price and quantity are simply P* and Q* at vertical
discontinuity portion of MR curve as long as the firm’s
marginal cost curve crosses MR within the gap.
• The dotted MC curve shows that MC could decrease
without changing the firm’s optimal price. In short,
each firm’s price remains constant over a range of
changing market conditions. The result is stable
industry-wide prices.
Price Rigidity and Kinked Demand
Numerical and Graphical Example
An oligopolist’s demand curve is P = 30 – Q for
Q smaller than 10 and P = 36 – 1.6Q for Q greater
than or equal to 10. Its marginal cost is 7.
1. Graph this kinked demand curve and the
associated MR curve.
2. What is the firm’s optimal output?
3. What if MC falls to 5?
 PRICE COMPETITION:
Price Wars and the Prisoner’s Dilemma

• When the competing goods or services are

close substitutes, price is a key competitive
weapon and usually the most important
determinant of relative market shares and
profits.
• Some immediate examples of product lines
that are dominated by two firms (duopolists)
having close substitute products/services: Nike
vs. Reebok (running shoes) and Disney-MGM
vs. Universal (movie theme parks).
Price Wars and the Prisoner’s Dilemma
As a concrete example, consider a pair of duopolists
engaged in price competition. Suppose that each
duopolist can produce output at a cost of $4 per unit:
AC = MC = $4.
Furthermore, each firm has only two pricing options:
charge a high price of $8 or charge a low price of $6.
If both firms set high prices, each can expect to sell
2.5 million units annually. If both set low prices, each
firm’s sales increase to 3.5 million units. Finally, if one
firm sets a high price and the other a low price, the
former sells 1.25 million units, the latter 6 million units.
Price Wars and the Prisoner’s Dilemma

• Each firm must determine its pricing

decision privately and independently of the
other. Naturally, each seeks to maximize its
profit.
• The optimal pricing policy should each firm
adopt is that each should set a low price.
Price Wars and the Prisoner’s Dilemma

• In short, self-interest dictates that each firm

set a low price; this is the better strategy for
each, regardless of the action the other takes.
• If both firms set low prices, both can gain
$7million profits. Whereas, both can gain $10
million profits if both firms set high prices.
Thus, both firms preferred larger profits under
a high-price regime.
• Are these firms achieve the beneficial, high-
price outcome?
Price Wars and the Prisoner’s Dilemma
• These situations (like the preceding example) in
which individual and collective interests are in
conflict are commonly referred to as the prisoner’s
dilemma.
• The origin of the term comes from a well-known
story of two accomplices arrested for a crime. The
police isolate each suspect in a room and ask each
to confess and turn state’s evidence on the other in
return for a shortened sentence. The Table shows
the possible jail terms the suspects face.
 Price Wars and the Prisoner’s Dilemma

• If the police can garner dual confessions, the suspects

will be charged and convicted of a serious crime that
carries a 5-year sentence.
• Without confessions, convictions will be for much
shorter jail terms.
• Obviously, each suspect seeks to minimize time spent
in jail. A careful look at Table shows that each
prisoner’s best strategy is to confess.
Price Wars and the Prisoner’s Dilemma
• The prisoner’s dilemma should be viewed as a
general model rather than as a special case.
Once one has the model in mind, it is easy to
identify countless situations in which it applies:
1. In the superpowers’ arms race, it is
advantageous for one country to have a larger
nuclear arsenal than its rival. But arms
escalation by both sides improves neither
side’s security (and probably worsens it).
Price Wars and the Prisoner’s Dilemma

2. The utilization of public resources, most

commonly natural resources, presents similar
dilemmas. For instance, many countries fish
at the West Philippine Sea. Each country’s
fleet seeks to secure the greatest possible
catch. But the simultaneous pursuit of
maximum catches by all countries threatens
depletion of the world’s richest fishing
grounds.
Price Wars and the Prisoner’s Dilemma
• In each of these cases, there is a significant
collective benefit from cooperation. However, the
self-interest of individual decision makers leads to
quite different, noncooperative, behavior.
• The key to overcoming the prisoner’s dilemma is to
form an agreement that binds the parties to take
the appropriate cooperative actions.
• To stop the arms race, the interested parties must
bind themselves to a verifiable arms control treaty.
A negotiated treaty on fishing quotas is one way to
preserve the West Philippine Sea.
 Assignment
In a ½ yellow pad paper, answer each payoff table.
Determine each oligopolist’s most profitable price.