1. Oligopoly and Strategic Behavior14
Oligopoly and Strategic Behavior
Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. In this chapter, the two market structures that fall between the extremes are discussed. Monopolistic competition contains a considerable amount of competition mixed with a small dose of monopoly power. Oligopoly, in contrast, implies a blend of greater monopoly power and less competition.
First, monopolistic competition is defined, listing important characteristics, typical examples, and efficiency outcomes. Next we turn to oligopoly, surveying the possible courses of price, output, and advertising behavior that oligopolistic industries might follow. Finally, oligopoly is assessed as to whether it is an efficient or inefficient market structure.
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Homogeneous or differentiated products Limited control over price
Oligopoly
A few large producers
Homogeneous or differentiated products
Limited control over price
Mutual interdependence
Strategic behavior
Entry barriers
Mergers
Entry barriers are not as great as in monopoly thus we have a few producers. We may have homogeneous or standardized oligopolies like the steel and oil markets. We may have differentiated oligopolies like the markets for breakfast cereal, beverages, and automobiles. Control over price is limited because there is just a few sellers in the market and rivals may respond in a way that would be detrimental to the firm that just changed the price. Entry barriers are more substantial than in monopolistic competition that is why there are just a few producers in the market. Although some firms have become dominant as a result of internal growth, others have gained dominance through mergers.
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3. Oligopolistic Industries
Four-firm concentration ratio
40% or more to be oligopoly
Shortcomings
Localized markets
Inter-industry competition
World price
Dominant firms – Herfindahl Index
To be an oligopoly, the 4-firm concentration ratio must be at least 40%. Based on this rule of thumb, about 50% of U.S. manufacturing is oligopolistic. Localized markets may have just one producer which is a monopoly while a low 4-firm concentration ratio indicates a lot of competition in the national industry. Inter-industry competition occurs when industries like glass and plastic compete with each other. This competition is not reflected in their high 4-firm concentration ratios. World Trade is not taken into account when calculating concentration ratios. Dominant Firms in the industry exhibit dominance that may be disguised and not reflected in the 4-firm concentration ratio.
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4. High Concentration Industries
(1)
Industry
(2)
4-Firm Concentration Ratio
(3)
Herfindahl
Index
Household laundry equipment
100 ND
Primary aluminum 74
2089
Household refrigerators and freezers 93
Tires 73
1531
Cigarettes 88
2897
Bottled water 71
1564
Beer
3561
Gasoline pumps 70
1611
Glass containers 86
Bar soaps
2250
Phosphate fertilizers 85
3152
Burial caskets 69
1699
Small-arms ammunition 84
2848
Printer toner cartridges 67
1449
Electric light bulbs
3395
Alcohol distilleries 65
1394
Aircraft 80
3287
Turbines and generators 61
1263
Breakfast cereals 79
2333
Motor vehicles 60
1178
Aerosol cans 75
1667
Primary copper 50
879
U.S. manufacturing industries. A 4 firm concentration ratio of 40% or more is indicative of an oligopolist.
Source: Bureau of Census, Census of Manufacturers, 2002
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5. Oligopoly Behavior Game theory Profit matrix Collusion
Shows the profits for each firm based on the firm’s actions and his rivals actions.
Collusion
Incentive to cheat
Prisoner’s dilemma
To be an oligopoly, the 4-firm concentration ratio must be at least 40%. Based on this rule of thumb, about 50% of U.S. manufacturing is oligopolistic. Localized markets may have just one producer which is a monopoly while a low 4-firm concentration ratio indicates a lot of competition in the national industry. Inter-industry competition occurs when industries like glass and plastic compete with each other. This competition is not reflected in their high 4-firm concentration ratios. World Trade is not taken into account when calculating concentration ratios. Dominant Firms in the industry exhibit dominance that may be disguised and not reflected in the 4-firm concentration ratio.
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6. Game Theory RareAir’s price strategy Uptown’s price strategy High LowB
$12
$15
High
$12 $6
Uptown’s price strategy C D $6
U.S. manufacturing industries. A 4 firm concentration ratio of 40% or more is indicative of an oligopolist.
Source: Bureau of Census, Census of Manufacturers, 2002 $8
Low
$15 $8
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7. Diversity of oligopolies Complications of interdependence
3 Oligopoly Models
Kinked Demand Curve
Collusive Pricing
Price Leadership
Reasons for 3 models
Diversity of oligopolies
Complications of interdependence
There are two reasons that we don’t have just a single model to explain this type of market. Oligopoly encompasses a great range and diversity of market structures. The decisions depend on the actions of the rivals, making it more difficult to explain the behaviors without several models. Each of these models are described on the following slides.
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8. Explains inflexibility, not price Prices are not that rigid Price wars
Kinked Demand Curve
Criticisms
Explains inflexibility, not price
Prices are not that rigid
Price wars
There are a few criticisms of the kinked demand curve. First, the demand curve was created around the current price that is already being charged, but it never actually explained how the current price was determined. This is very similar to putting the cart before the horse. We have seen that prices are rigid for reasons on the demand and cost side, but prices in oligopolies are not nearly as rigid as this model implies. Lastly, there is always a chance that changing prices could result in a price war.
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9. Cartels - a group of firms or nations that collude
Overt Collusion
Collusion reduces uncertainty, improves control of price, profits rise, and prevents entry of firms
Cartels - a group of firms or nations that collude
Formally written agreement
Sets output levels and price for members
OPEC
A cartel is defined as a group of firms or nations joining together and formally agreeing as to the price they will charge and the output levels of each member. It is illegal here, however, business with the OPEC cartel is conducted every day. In the past, OPEC has been successful in increasing the price of the oil they sell by restricting supply.
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10. Gentleman’s agreements
Covert Collusion
Gentleman’s agreements
Informal understandings often in social settings between firms about price and output
Demand and cost differences – because cost and demand differences exist between the members it will be difficult for all members to charge the same price.
Number of firms – the more firms who are part of the agreement the harder it is to maintain.
Cheating – there is always a tendency for members to cheat and this erodes the cartel’s power over time. See the Prisoner’s dilemma
Recession – overall demand declines during recessions making cheating more attractive.
New entrants – new producers will be drawn to the industry because of the greater prices and profits which will increase market supply and decrease prices.
Legal obstacles – laws prohibit cartels and price collusion.
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11. Obstacles to Collusion
Demand and cost differences
Number of firms
Cheating
Recession
New entrants
Legal obstacles
Golden Balls
Demand and cost differences – because cost and demand differences exist between the members it will be difficult for all members to charge the same price.
Number of firms – the more firms who are part of the agreement the harder it is to maintain.
Cheating – there is always a tendency for members to cheat and this erodes the cartel’s power over time. See the Prisoner’s dilemma
Recession – overall demand declines during recessions making cheating more attractive.
New entrants – new producers will be drawn to the industry because of the greater prices and profits which will increase market supply and decrease prices.
Legal obstacles – laws prohibit cartels and price collusion.
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12. Global Perspective
The Global Perspective reflects the 12 OPEC Nations, Daily Oil Production, October 2009.
The OPEC nations produce about 41 percent of the world’s oil and about 43 percent of the oil sold in world markets.
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13. Price Leadership Model
Dominant firm initiates price changes
Communicates price change
Other firms follow the leader
Use limit pricing to block entry of new firms
Possible price war
Price Leadership is an economic model where a dominant firm initiates price changes and the others in the industry follow the leader. The leader communicates price changes through speeches, press releases, or articles in trade journals. One result is infrequent price changes since the leader is never certain that the other firms will follow and there is always the threat of a price war.
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14. Positive Effects of Advertising
Low cost way of providing information to customers
Enhances competition
Speeds up technological progress
Helps firms attain economies of scale
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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15. Negative Effects of Advertising
Can be manipulative
Contains misleading claims that confuse consumers
Consumers may pay high prices for a good while forgoing a better, lower priced, unadvertised good
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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16. Oligopoly and Efficiency
Oligopolies are inefficient
Productively inefficient P > minATC
Allocatively inefficient P > MC
Qualifications
Increased foreign competition
Limit pricing
Technological advance
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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17. One-Time Game: Strategy
Simultaneous game
Positive sum game
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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18. One-Time Game: Strategy
Simultaneous game
Positive sum game
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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19. One-Time Game Dramco’s price strategy Chipco’s price strategy
International
National A B
$11 $5
International
$11
$20
Chipco’s price strategy C D
$20
$17
National
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
$17 $5
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20. A One-Time Game: Equilibrium
Nash Equilibrium
Outcome from which neither firm wants to deviate
Current strategy viewed as optimal
Stable and persistent outcome
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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21. Credible and Empty Threats
Credible threats
Threat is believable
Can be used for collusion
A strong enforcer can prevent cheating
Can generate higher profits
May be countered by rival firm
Empty threats
Threat is not believable
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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22. May cooperate and choose not to compete strongly Rival reciprocates
Repeated Games
Game recurs
May cooperate and choose not to compete strongly
Rival reciprocates
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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23. Repeated Game with Reciprocity
ThirstQ’s advertising strategy
ThirstQ’s advertising strategy
Promo budget
Normal budget
Promo budget
Normal budget A B A B
$10 $8
$11
$10
Promo budget
Promo budget
$10
$16
$11
$14
2Cool’s advertising strategy
2Cool’s advertising strategy C D C D
$16
$12
$15
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
$13
Normal budget
Normal budget $8
$12
$10
$13
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24. Firms move sequentially Final outcome is dependent on who moves first
Sequential Game
Firms move sequentially
Final outcome is dependent on who moves first
First Mover Advantage
Advantages for the firm that is first
May be better prepared
May preempt entry of rival
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
LO7

25. First-Mover Advantages
Big Box strategies
Build
Don’t build A B
-$5 $0
Build
-$5
$12
Huge Box strategies C D
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
$12 $0
Don’t build $0 $0
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26. First-Mover Advantages
Extensive Form
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
LO7

27. Subgame perfect Nash Equilibrium Stackelberg Duopoly
Extensive Form
Subgame
Subgame perfect Nash Equilibrium
Stackelberg Duopoly
Leader-follower game
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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28. Extensive Form
Productive Efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices than otherwise. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
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