1. Principles of Economics by Fred M Gottheil Chapter 12
Price and Output Determination Under Oligopoly
PowerPoint Slides prepared by Ken Long
©1999 South-Western College Publishing

2. What is Oligopoly?
A market structure consisting of only a few firms producing goods that are close substitutes
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3. What are some examples of Oligopoly?
Automobiles
Steel
Soup
Cereals
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4. What determines if a market is an Oligopoly?
The concentration ratio can be used as a guide
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5. What concentration ratio constitutes an Oligopoly?
There is no magic number, but if a large percentage of the sales are from the 4 largest firms, it’s an Oligopoly
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6. What is an example of a high concentration ratio?
Out of 151 firms in the aircraft industry the leading 4 constitutes 79% of total sales
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7. For more information on industry concentration check out these web pages -
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8. What is the Herfindahl-Hirschman Index (HHI)?
A measure of industry concentration, calculated as the sum of the squares of the market shares held by each firm in the industry
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9. where Si = the ith firms market share, n= number of firms in industry
Calculation of the HHI
HHI = s12 + s22 + …..sn2
where Si = the ith firms market share, n= number of firms in industry

10. Problems: For an industry with only 1 firm, (monopoly), what would be the HHI?

11. Suppose the industry has 10 equal size firms, what is the HHI?
What if the industry has 100 equal size firms?

12. Answers: Monopoly, HHI = 10,000 10 equal size firms, HHI = 1,000

13. How Oligopolistic is the U.S. Economy?
Oligopoly is very much of a fact of life in the U.S.
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14. Is the U.S. becoming more Oligopolistic?
Answer appears to be NO to this question. While there have been some periods of time when industries appeared to be getting more concentrated into fewer firms, there are other periods of history where just the opposite happened.

15. What is Market Power?
A firm’s ability to select and control market price and output
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16. What is an Unbalanced Oligopoly?
An oligopoly in which the sales of the leading firms are distributed unevenly among them
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17. What is a Balanced Oligopoly?
An oligopoly in which the sales of the leading firms are distributed fairly evenly among them
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18. In which type is market power most concentrated?
Unbalanced Oligopoly
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19. Why do Oligopolies exist?
Mergers
Economies of scale
Reputation
Strategic barriers
Government barriers
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20. What is a Horizontal Merger?
A merger between firms producing the same good in the same industry
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21. What is a Vertical Merger?
A merger between firms that have a supplier - purchaser relationship
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22. What is a Conglomerate Merger?
A merger between firms in unrelated industries
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23. For more information on mergers check out these sites:
newsipos.html
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24. Firms in Oligopoly are said to be Mutually Interdependent
Firms realize the large impact that other firms behavior has on their profits
Leads to many models of oligopoly, depending on how the firms deal with the mutual interdependence issue

25. One way to deal with the Mutual Interdependence problem is…..
LET’S CHEAT!!!!
THE COLLUSION SOLUTION!!!

26. What is Collusion?
The practice of firms to negotiate price and market decisions that limit competition
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27. What is a Cartel?
A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares
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28. One model of collusion that can be used is the cartel model
Internationally, some cartels like OPEC exist
Domestically, these would be illegal
If the cartel can collude perfectly, would tend to charge the monopoly price

29. Ingredients for a successful cartel
Control a large share of the market
Inelastic and stable demand for the product
Similar costs among cartel members
Fairly homogenous product
Few number of firms
Ways of preventing cheating on the agreement

30. Check out the Opec Cartel

31. What is the relationship between market concentration and price?
A high concentration ratio in an industry may translate into noncompetitive prices and behavior
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32. Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts but not price increases. Under this assumption, its as if each firm faces a “kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals quickly match price cuts.

33. Kinked Demand Curve
Price
Starting price P1
MR Gap D MR Q1
Quantity 33

34. Graph explanation: Let P1 and Q1 be the existing price and quantity for this oligopoly firm: due to the assumptions of this model, the demand curve has a kink in it at this price and output. Because of the strange shape of the demand curve, the MR curve is discontinuous, or has a gap in it.

35. Kinked demand curve model is an attempt to explain rigid prices in oligopoly: That is, firms might not change price very often. Why? Firm is reluctant to raise price if its competitors do not, since it could lose sales to them, and little reason is seen to lower price if competitors quickly match the price cut, since little will be gained.

36. What does the kinked demand curve illustrate?
There is a great deal of price stability and nonprice competition is important
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37. How do firms in an Oligopoly set price?
Most often they practice price leadership
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38. Price leadership in Oligopoly
One firm, the dominant firm, sets the price, others follow the leader
Often the dominant firm is the low cost producer in the industry
Is this a form of “tacit” collusion?

39. What is an example nonprice competition?
Brand multiplication when there are variations on one good to increase market share
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40. Game Theory Approach to Oligopoly
Is Oligopoly best analyzed as a strategic game like chess?

41. What is Game Theory?
A theory of strategy ascribed to a firm’s behavior in oligopoly
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42. For more information about Game Theory -
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43. Prisoner's Dilemma

44. If the 2 people could collude, would likely choose to not confess, but self interest may drive each to confess, hoping the other does not, end up both confessing, worse off for both—many similar situations perhaps for firms in oligopoly

45. Two firm game

46. What is a dominant strategy?
A strategy that is best regardless of what the opposition does. For B, dominant strategy is to break the agreement, and also for A. Both firms avoid the worst case scenario in this manner.

47. What is a Nash equilibrium
What is a Nash equilibrium? (named for Mathematician John Nash…did you see the film “A Beautiful Mind?)
A situation where neither firm can improve its payoff, given what the other firm is doing…in this example, breaking the agreement is the Nash equilibrium

48. Is there any way to get to box 1 where both firms are better off short of outright collusion?
Possibility of a tit-for-tat strategy….somehow indicate to the other firm that although you want to hold the agreement, you will switch to match what the other firm does.

49. For a forum that induces the interactive Prisoner’s Dilemma check out -
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50. What is Price Discrimination?
The practice of offering a specific good or service at different prices to different segments of the market
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51. Why would a firm want to price discriminate?
Greater profits possible!!

52. Different types of Price Discrimination
“Perfect” price discrimination: Charge each buyer the highest price they are willing to pay

53. More usual type of price discrimination
Separate buyers into groups (based perhaps on age, sex, region of country, etc.
Groups should have different elasticities of demand

54. Higher price to more inelastic group, lower to more elastic: must also be able to prevent resale of product

55. What is Oligopoly?
What concentration ratio constitutes an Oligopoly?
What is an Unbalanced Oligopoly?
What is a Balanced Oligopoly?
What is Collusion?
What is a Cartel?

56. What is the distinguishing feature of Oligopoly?
How do firms in an Oligopoly set price?
What is Game Theory?
What is the Prisoner’s Dilemma?
What is Price Discrimination?

57. END
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