Oligopoly Lesson 14 Sections 64, 66

Intro to Oligopoly An Oligopoly exists when there are a small number of competing firms, and the actions of one firm can have an effect on another firm. This is called interdependence. In a monopoly, there are no other firms to consider, and in perfect competition, there are so many firms that the actions of one firm have little or no effect on others.

Understanding Oligopoly Duopoly Example Two firms produce a chemical, and marginal costs are assumed to be zero. Based on this, there is a economy of scale, and both firms could produce enough to satisfy the market all the way to 0$ price. Because the quantity produced by one firm affects the price of the other firm, each firm has a stake in how much is produced. If too much is produced, profits go down to zero. These firms could engage in collusion to set quantities, and at the worst, form a cartel (illegal in the U.S.)

Table 64.1 Demand Schedule for Lysine Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Collusion and Competition In the previous slide, if both firms cooperated for a fair solution, each firm would produce 30 million pounds of lysene, which would create maximum profit overall, and $180 million in revenue for each corporations. Each firm, however, has an incentive to cheat. If one firm produced the agreed 30 million pounds, but the other firm cheated and produced 40 million pounds, the overall price would drop to $5 (from $6), profits for the firm producing 30 million pounds would drop to $150 million, but the profits for the cheater would go to $200 million. If both firms cheated and produced 40 million pounds, the price would drop to $4, and both firms would get $160 million, a loss of $20 million from revenue. Producing an additional unit of goods has two effects A positive quantity effect: One more unit is sold, increasing total revenue A negative price effect: In order to sell one more unit, the market price an all units goes down Price competition: Firms will compete for customers by reducing prices until prices are just above marginal cost Quantity competition: Firms will regard the outputs of their competitors as fixed, and will attempt to maximize profits by restricting quantity

Legal Framework Prior to 1890, there were no laws against price collusion or monopoly practices, and influenced many markets including oil, sugar, whisky, lead, cottonseed oil and linseed oil. The Sherman Anti-Trust Act of 1890 was created as a piece of anti-trust legislation to break up existing monopolies and prevent the creation of future monopolies. With the creation of the EU, the EU has also enforced anti-trust laws

Tacit Collusion and Price Wars Reality is messier than a model, and this makes tacit collusion a necessary part of the profits of oligopoly companies. When there are multiple firms, this makes it difficult to collude on prices, meaning that competition does have an effect on bringing prices down, though usually not to the level of perfect competition. The more firms there are, the less of an impact each firm makes and there is less incentive to act cooperatively. Complex Products and Pricing Schemes Some oligopolies like retailers have huge inventories of hundreds of thousands products, and have club prices, coupons, rebates that make tracking prices difficult. Differences in Interests Established businesses will likely not treat new competition as welcome and try to keep a larger portion of the market for themselves, and be less interested in tacit collusion. Bargaining Power of Buyers Businesses with market power can force other businesses to lower their prices. A price war could break out as each firm tries to maximize value by cutting costs which could bring the price down to a non-cooperative level, or even lower.

Product Differentiation and Price Leadership Because oligopolies in a tacit agreement might hold down production in order to keep prices higher, in order to gain competitive advantage they compete in other ways Product Differentiation Most oligopolies produce a recognizable brand name that is different from their competitors in the form of features, style, taste, that allows them some control of prices. Also, firms may spend lots of money advertising about how inferior their competitors product is, and how great their own product is. Price Leadership One firm sets the price and others follow (auto prices)