1. Market Structure: Oligopoly
Chapter 9

2. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Oligopoly
Oligopoly firms typically have market power derived from barriers to entry. 
The key characteristic is that there are a small number of firms competing with each other so their behavior is mutually interdependent.
The interdependence means that the strategies and decisions by managers of one firm affect managers of other firms, whose subsequent decisions then affect the first firm.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

3. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Oligopoly
Industry
# of Firms
Market Share (%)
Cigarettes 3 80
Movies 6 85
Record Music 4
Soft Drinks
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

4. Examples of Oligopolistic Industries
Airlines
Soft Drinks
Doughnuts
Parcel and Express Delivery
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

5. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Oligopoly Models
Noncooperative oligopoly models are models of interdependent oligopoly behavior that assume that firms pursue profit-maximizing strategies based on assumptions about rivals’ behavior (retaliate) and the impact of this behavior on the given firm’s strategies.
Cooperative oligopoly models are models of interdependent oligopoly behavior that assume that firms explicitly or implicitly cooperate with each other to achieve outcomes that benefit all the firms.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

6. Noncooperative Oligopoly Models
The Kinked Demand Curve Model
Game Theory Models
Strategic Entry Deterrence
Predatory Pricing
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

7. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Kinked Demand Curve
The kinked demand curve model of oligopoly incorporates assumptions about interdependent behavior and illustrates why oligopoly prices may not change in reaction to either demand or cost changes. $ Q
D2: Rivals don’t
follow
D1: Rivals do follow
MR1
MR2 P1 Q1 MC
D1 is the demand curve if rivals do follow the price changes of the given firm and D2 represents one where rivals don’t follow. if price is at P1 and the firm decides to increase the price, then if other firms increase their price as well then we are moving along D1. However, if they don’t follow the firm then we move to Demand D2 since all other firms will have lower prices. For the area to the right of Q1, if the firm decides to lower the price and others follow then the demand will be D2 whereas if the don’t follow the demand will be D1. Since here the goals of all other firms is to maximize the damage done to that one firm, they will never follow and as a result, the Demand curve in the market will be the highlighted one which is a mix of D1 and D2. As a result of all this MR curve will also be discontinuous and actually will “jump” at P1. since the MC is cutting the discontinuity of MR at that point, the profit maximizing firm will pick P1 as price and Q1 as quantity.
This result is different from the standard model of a firm with market power, where changes in demand and in MR or MC result in a new profit maximizing price-quantity combination.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

8. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Kinked Demand Curve
Assumption: rivals follows price decrease but not follow price increase.
Purpose: to show that oligopoly prices are sticky. Do not change as much as other market structure.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

9. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Game Theory Models
A set of mathematical tools for analyzing situations in which players make various strategic moves and have different outcomes or payoffs associated with those moves.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

10. Dominant Strategies and the Prisoner’s Dilemma
This payoff matrix shows the various prison terms for Bonnie and Clyde that would result from the combination of strategies chosen when questioned about a crime spree.
The Prisoner’s Dilemma
Bonnie
Clyde
Don’t Confess
Confess
Don’t
2 yr,
2 yr
10 yr,
0 yr
0 yr,
10 yr
5 yr,
5 yr
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

11. Prisoner’s Dilemma – Dominant Strategy
A dominant strategy is one that results in the best outcome or highest payoff to a given player no matter what action or choice the other player makes.
The Prisoner’s Dilemma
Bonnie
Clyde
Don’t Confess
Confess
Don’t
2 yr,
2 yr
10 yr,
0 yr
0 yr,
10 yr
5 yr,
5 yr
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

12. Cigarette Television Advertising (Pay offs are Profits)
Dominant Strategy
Cigarette Television Advertising (Pay offs are Profits)
Company A
Company B
Do not
Advertise
50,50
20,60
60,20
27,27
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

13. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Nash Equilibrium
Nash equilibrium is a set of strategies from which all players are choosing their best strategy, given the actions of the other players.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

14. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Nash Equilibrium
Firm 2
Do not expand
Small Expansion
Large Expansion
18, 18
15, 20
9, 18
Firm 1
20, 15
16, 16
8, 12
18, 9
12, 8
0, 0
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

15. Strategic Entry Deterrence$ Q D MR MC
ATC
Pπmax
Qπmax
PLP =
ATCEN
QLP
Limit pricing is a policy of charging a price lower than the profit-maximizing price to keep other firms from entering the market.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

16. Strategic Entry Deterrence
The profit maximum price for the establishment firm is PM. And it produces QM.
This firm will charge a price at the MIN or below of the ATC for Potential Entrant.
This price is not profitable from the point of view of the Potential Entrant.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

17. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Predatory Pricing
A strategy of lowering prices below cost (AVC) to drive firms out of the industry and scare off potential entrants.
The firm which adopts this strategy achieve losses. But, it hope when it controls the market it will raise the prices and achieve profits.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

18. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Predatory Pricing
Zenith company (U.S.) accused Matsushita company and other six Japanese electronic companies for:
charging monopoly prices for television in Japan and then using those profits to subsidize below cost television exports to U.S.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

19. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Predatory Pricing
PC and QC is the competition price and quantity in the U.S.
Japs imposed a Predatory price PP. American will cutback production to be QUS, thus Japs produce Qp-QUA.
When predation is over, American continue to produce at QUS and Japs produce at MR=MC and PJ.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

20. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Predatory Pricing
Predatory pricing:
Japanese share of market QP - QUS = NM = RG
Loss per unit to Japanese firms PC - PP = NR
Total loss to Japanese firms NRGM $ Q
PUS PJ PC PP
QUS Qc QJ QP K L J G M N E R S T
o: navigation, search
In business and economics, predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. If competitors or potential competitors cannot sustain equal or lower prices without losing money, they go out of business or choose not to enter the business. The predatory merchant then has fewer competitors or is even a de facto monopoly.
This is not as widespread as often believed because the firm practicing predation must lower its price below cost and therefore incur losses itself with the expectation that these losses will be offset by future profits.
The predatory firm must also convince other firms that it will leave the price below cost until the other firms leave the market.
Pc here is ATC -
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

21. Cooperative Oligopoly Models
Cartels
Tacit Collusion
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

22. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Cartels - Examples
OPEC
Diamond Cartel
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

23. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Cartel Behavior
A cartel is an organization of firms that agree to coordinate their behavior regarding pricing and output decisions in order to maximize the joint profits for the organization.
Joint Profit Maximization: A strategy that maximizes profits for a cartel but may create incentives for individual members to cheat.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

24. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Cartel Behavior
The marginal cost for the cartel, MCC, is derived through the horizontal summation of marginal cost curves of the individual firms, as is illustrated in the below Figure.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

25. Model of Joint Profit Maximization
MC1 $ Q
MC2
MCc PC MR QC
Q2*
Q1*
Firm 1
Firm 2
Cartel
MC2 D
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

26. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Cheating Cartel
Cartel members have an incentive to cheat on the cartel agreement.
The reason for this incentive is the restriction of the output that causes the marginal cost of each firm to be less than the cartel price. Recall that profit maximization requires that MC equals MR, and in the case of a carter, each firm sees the cartel price as its MR. Of course, this starts to change as cheating expands and causes the price to decrease.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

27. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Success in Cartels
A cartel is likely to be the most successful when:
It can raise the market price without inducing significant competition from noncartel members.
The expected punishment for forming the cartel is low relative to the expected gains.
The costs of establishing and enforcing the agreement are low relative to the gains.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

28. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
OPEC Experience
is the most well-known cartel. Saudi Arabia is the dominant player given its vast oil reserves.
In recent years, competition from non-cartel members has severely limited the strength of OPEC.
its strength is reduced when member countries could not come to an agreement on the production quota and the target price for a barrel of oil.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

29. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Tacit Collusion
Because cartels are illegal in the United States due to the antitrust laws, firms may engage in tacit collusion, coordinated behavior that is achieved without a formal agreement.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

30. Practices that facilitate tacit collusion
Uniform prices: Charging the same price to all customers make it difficult of the rivals to offer discounts.
A penalty for price discounts
Advance notice of price changes
Information exchanges
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

31. Formal price leadership
Price Leadership: An oligopoly strategy in which one firm in the industry institutes price increases and waits to see if they are followed by rival firms.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall