CHAPTER 15 Oligopoly

Four market structures: 1 - Perfect competition Imperfect competition 2 - Monopoly 3 - Oligopoly 4 - Monopolistic competition

Oligopoly Oligopoly an industry with only a small number of producers. A producer in such an industry is known as an oligopolist. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.

Some Oligopolistic Industries “Four-firm concentration ratio” which asks what share of industry sales is accounted for by the top four firms.

Understanding Oligopoly The simplest oligopoly = duopoly. Only two firms in the industry, each one drives down the market price by producing more. So each firm would, like a monopolist, realize that profits would be higher if it limited its production. So how much will the two firms produce?

Understanding Oligopoly Collusion— Sellers engage in collusion when they cooperate to raise each others’ profits by limiting output. The strongest form of collusion is a cartel. (OPEC) (An agreement among firms to limit output) They may also engage in non-cooperative behavior, ignoring the effects of their actions on each others’ profits.

Understanding Oligopoly A successful cartel works like a single monopolist. However, each firm has an incentive to cheat - to produce more than it is supposed to under the cartel agreement. So there are two principal outcomes: successful collusion or behaving non-cooperatively by cheating.

Competing in Prices vs. Competing in Quantities Firms may decide to engage in quantity or price competition: The basic insight of the quantity competition (or the Cournot model) is that it restricts output. This allows pricing above marginal cost and earns the firm economic profits.

Competing in Prices vs. Competing in Quantities The logic behind the price competition (or the Bertrand model) is that when firms produce perfect substitutes, each firm will be compelled to engage in competition by undercutting its rival’s price until the price reaches marginal cost—that is, perfect competition.

Game Theory When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. SEE SEPARATE POWER POINT ON GAME THEORY

Game theory in practice Repeated Interaction and Tacit Collusion When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusion. Repeated interaction can complicate the decision of each player!

The Kinked Demand Curve An oligopolist who believes he will lose a substantial number of sales if he reduces output and increases his price but will gain only a few additional sales if he increases output and lowers his price, away from the tacit collusion outcome, faces a kinked demand curve. It illustrates how tacit collusion can make an oligopolist unresponsive to changes in marginal cost within a certain range.

The Kinked Demand Curve This oligopolist believes that her demand curve is kinked at the tacit collusion price and quantity levels, P* and Q* if she increases her output and lowers her price her rivals will retaliate, increasing their output and lowering their prices as well, leading to only a small gain in sales. So her demand curve is very steep to the right of Q*. If an oligopolist lowers output and raises his price, his rivals might refuse to reciprocate and will steal a substantial number of her customers, leading to a large fall in sales. (Your firm loses by raising prices if other firms don’t raise their prices) The demand curve is very flat to the left of Q*. The kink in the demand curve leads to the break XY in the marginal revenue curve. The Kinked Demand Curve

The best example of a cartel: OPEC The Organization of Petroleum Exporting Countries (OPEC) is a legal cartel that has had its ups and downs. From 1974 to 1985 it succeeded in driving world oil prices to unprecedented levels; then it collapsed. In 1998 the cartel once again became effective.

Oligopoly in Practice The Legal Framework- Oligopolies operate under legal restrictions in the form of anti-trust policy. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors, including large numbers of firms, complex pricing (airlines) conflicts of interest among firms (incentive to cheat)

Oligopoly in Practice When collusion breaks down, there is a price war. To limit competition, oligopolists often engage in product differentiation. When products are differentiated, it is sometimes possible for an industry to achieve tacit collusion through price leadership. Oligopolists often avoid competing directly on price, engaging in non-price competition through advertising and other means instead.

The End of Chapter 15