1. Oligopoly and Strategic Behavior
Chapter 14
Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. In this chapter, oligopoly, one of the two market structures that fall between the extremes is discussed. Oligopoly is a blend of greater monopoly power and less competition than we find in monopolistic competition.
Oligopoly is examined on possible choices of price, output, and advertising behavior that oligopolistic industries might follow. Then, oligopoly is assessed as to whether it is an efficient or inefficient market structure. The Last Word shows how a few big companies now compete with one another via the Internet as very competitive oligopolists.
Oligopoly and Strategic Behavior

2. Oligopoly Oligopoly A few large producers Homogeneous oligopoly
Differentiated oligopoly
Limited control over price
Strategic behavior
Mutual interdependence
Entry barriers and mergers
The entry barriers in oligopoly are not as great as in monopoly, thus we have a few producers. There are homogeneous or standardized oligopolies like the steel and aluminum markets. There are also differentiated oligopolies like the markets for automobiles, electronics equipment, and breakfast cereals. Control over price is limited because there are 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. So, firms use strategic pricing behavior which is how a firm’s decisions are based on the actions and reactions of rivals.
Mutual interdependence exists when each firm’s profit depends on its own pricing strategy and that of its rivals.
Entry barriers are more substantial than in monopolistic competition which 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 an oligopoly
Shortcomings
Localized markets
Interindustry competition
Import competition
Dominant firms
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. Here are four shortcomings to be aware of when using these ratios. 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. Interindustry competition occurs when industries like glass and plastic compete with each other. This competition is not reflected in their high 4-firm concentration ratios. Competition from imports due to world trade is not taken into account when calculating concentration ratios. There may be a dominant firm in the industry exhibiting domination 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
This table displays a few high-concentration U.S. manufacturing industries. A 4-firm concentration ratio of 40% or more is indicative of an oligopolist.
ND represents “not disclosed”. Source: Bureau of Census, Census of Manufacturers, 2012
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5. Oligopoly Behavior Game theory Collusion Incentive to cheat
Prisoner’s dilemma
Game theory is the study of how people behave in strategic situations. The Prisoner’s dilemma is a classic example of mutual interdependence and game theory.
Collusion is defined as cooperating with rivals and can benefit the firm. There is an incentive for firms to cheat on their agreement to collude because cheating can result in increased revenues for the cheater.
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6. Game Theory RareAir’s price strategy 2 competitors 2 price strategies
Each strategy has a payoff matrix
Greatest combined
profit
Independent actions
stimulate a response
High
Low A B
$12
$15
High
$12 $6
Uptown’s price strategy C D
This graph is a payoff matrix for a two-firm oligopoly and is used to show the payoff to each firm that would result from each combination of strategies. Each firm has two possible pricing strategies. RareAir’s strategies are shown in the top margin, and Uptown’s in the left margin. Each lettered cell of this four-cell payoff matrix represents one combination of a RareAir strategy and an Uptown strategy and shows the profit that combination would earn for each. See next slide. $6 $8
Low
$15 $8
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7. Game Theory Continued RareAir’s price strategy
Independently lowered prices in expectation of greater profit leads to worst combined outcome
Eventually low outcomes make firms return to higher prices.
High
Low A B
$12
$15
High
$12 $6
Uptown’s price strategy C D
Assuming no collusion, the outcome of this game is cell D, with both parties using low price strategies and earning $8 million in profits. However, this inferior profit level will eventually lead firms to higher prices. $6 $8
Low
$15 $8
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8. Three Oligopoly Models
Kinked-demand curve
Collusive pricing
Price leadership
Reasons for 3 models
Diversity of oligopolies
Complications of interdependence
There are two reasons that there is not just a single model to explain this type of market. Oligopoly encompasses a great range and diversity of market structures. Decisions made 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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9. Kinked-Demand Theory Non-collusive oligopoly
Uncertainty about rivals’ reactions
Rivals match any price change
Rivals ignore any price change
Assume combined strategy
Match price reductions
Ignore price increases
The kinked demand model is used for non-collusive oligopolies to explain their behaviors and pricing strategies. Since the firms do not collude, none of the firms know with certainty what their rivals are going to do. However, the firms assume that their rivals will match any price reductions in an effort to maintain their customers. On the other hand, it is reasonable to assume that if a firm raises its price, its rivals will ignore the price change in an effort to steal customers from the firm raising its price.
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10. Kinked-Demand Curve Rivals ignore price increase D2 MC1 e e P0 P0 MR2f f D2
MC2
MR2
Rivals match
price decrease g g
This graph shows the kinked-demand curve. (a) The slope of a noncollusive oligopolist’s demand and marginal-revenue curves depends on whether its rivals match (straight lines D1 and MR1) or ignore (straight lines D2 and MR2) any price changes that it may initiate from the current price P0.
(b) In all likelihood an oligopolist’s rivals will ignore a price increase but follow a price cut. This causes the oligopolist’s demand curve to be kinked (D2eD1) and the marginal-revenue curve to have a vertical break, or gap (fg). Because any shift in marginal costs between MC1 and MC2 will cut the vertical (dashed) segment of the marginal-revenue curve, no change in either price, P0, or output, Q0, will result from such a shift. In other words, competitors and rivals strategize against each other, consumers effectively have 2 partial demand curves and each part has its own marginal revenue resulting in a kinked-demand curve to the consumer; price and output are optimized at the kink. D1 D1 Q0
MR1 Q0
MR1
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11. Kinked-Demand Criticisms
Criticisms of this model
Explains inflexibility, not price
Prices are not that rigid
Price war
There are a few criticisms of the kinked demand theory. First, the demand curve was created around the current price that was 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. And, there is always a chance that changing prices could result in a price war.
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12. Cartels and Other Collusion
Price and costs
Quantity MC P0
ATC A0
MR = MC
Oligopolies tend to collude and this model shows how collusive oligopolists behave. Oligopolies are conducive to collusion and the tendency toward joint profit maximization. If oligopolistic firms face identical or highly similar demand and cost conditions, they may collude to limit their joint output and to set a single, common price. Thus, each firm acts as if it were a pure monopolist, setting output at Q0 and charging price P0. This price and output combination maximizes each oligopolist’s profit (green area) and thus, the combined or joint profit of the colluding firms. Collusion is most likely to occur when the good that is being produced is homogeneous.
Economic
profit MR D Q0
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13. Overt Collusion A cartel is a group of firms or nations that collude
Formally agreeing to the price
Sets output levels for members
Collusion is illegal in the United States
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. Cartels are illegal in the US; 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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14. OPEC Nations
This Global Perspective reflects the OPEC nations production. OPEC produces about 34 percent of the world’s oil.
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15. Obstacles to Collusion
Demand and cost differences
Number of firms
Cheating
Recession
New entrants
Legal obstacles
Because demand and cost differences exist between members, it will be difficult for all members to charge the same price.
The more firms included in the agreement, the harder it is to maintain.
There is always a tendency for members to cheat and this erodes the cartel’s power over time. See the Prisoner’s dilemma.
Overall demand declines during recessions making cheating more attractive.
New producers will be drawn to the industry because of the greater prices and profits which will increase market supply and decrease prices.
Laws prohibit cartels and price collusion in the United States.
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16. Price Leadership Model
Dominant firm initiates price changes
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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17. Oligopoly and Advertising
Oligopolies commonly compete through product development and advertising
Less easily duplicated than a price change
Financially able to advertise
In differentiated oligopolies advertising is the best way to communicate a firm’s product differences. Product improvements revealed through advertising can be successful in increasing market share and revenues because product innovations are more difficult to copy by a competitor than a price change. Oligopolists are financially able to advertise due to economic profits earned in the past.
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18. Positive Effects of Advertising
Low-cost way of providing information to consumers
Enhances competition
Speeds up technological progress
Can help firms obtain economies of scale
Advertising is a low-cost way of providing information to consumers about different options and it reduces the consumer’s search time for products. Advertising also enhances competition between firms and thus aids in economic efficiency. It speeds up technological progress by introducing new products. Advertising can help firms obtain economies of scale by reducing long run average costs.
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19. Oligopoly Advertisers
The Largest U.S. Advertisers, 2014
Company
Advertising Spending
Millions of $
Proctor & Gamble
$4,607
AT&T
3,272
General Motors
3,120
Comcast
3,029
Verizon
2,526
Ford Motor
2,467
American Express
2,364
Fiat Chrysler
2,250
L’Oréal
2,158
Walt Disney
2,109
Oligopolists have substantial financial resources with which to support advertising.
Source: Advertising Age
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20. Negative Effects of Advertising
Can be manipulative
Contain misleading claims that confuse consumers
Consumers may pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product
When advertising either leads to increased monopoly power, or is self-canceling, economic inefficiency results.
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21. Top Ten Brand Names
The brands identified here were based on the four criteria of brand’s market share, world appeal across age groups and nationalities, customer loyalty, and the ability to stretch beyond the original product.
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22. Oligopoly and Efficiency
Oligopolies are inefficient
Productively inefficient because P > min ATC
Allocatively inefficient because P > MC
Qualifications
Increased foreign competition
Limit pricing
Technological advance
Recall that 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. Neither efficiencies occur in oligopolistic markets. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have the financial means to invest in new technologies.
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23. A One-Time Game: Strategy
A simultaneous game
A positive-sum game
Zero-sum game
Negative-sum game
A firm’s dominant strategy
We begin by examining a one-time simultaneous positive sum game. A one-time game means that firms make their decisions in a single time period. A simultaneous game means that firms make their decisions simultaneously. A positive sum game means that the sum of the two firms’ outcomes is positive, a win-win situation. A zero sum game is a game in which the sum of the two firm’s outcomes is zero, an I win-you lose situation. A negative sum game means the sum of the outcomes is a result less than zero. A dominant strategy is an option that is better than any alternative option regardless of what the other firm does.
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24. A One-Time Game: Equilibrium
Nash equilibrium
Outcome from which neither firm wants to deviate
Current strategy viewed as optimal
Stable and persistent outcome
A Nash equilibrium is an outcome from which neither firm wants to deviate. And is described as where rivals see their respective current strategy as the optimal choice, given the other firm’s strategy, and is the only outcome that is considered stable and that will persist. If the outcome is not at the Nash equilibrium, then the firms will continue to modify their strategies until they reach the Nash equilibrium.
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25. A One-Time Game 2 competitors 2 price strategies
Dramco’s price strategy
2 competitors
2 price strategies
Each strategy has a payoff matrix
Independent actions stimulate a response
International
National A B
$11 $5
International
$11
$20
Chipco’s price strategy C D
In this single-period, positive-sum game, Chipco’s international strategy is its dominant strategy — the alternative that is superior to any other strategy regardless of whatever Dramco does. Similarly, Dramco’s international strategy is also its dominant strategy. With both firms choosing international strategies, the outcome of the game is Cell A, where each firm receives an $11 million profit. Cell A is a Nash equilibrium because neither firm will independently want to move away from it given the other firm’s strategy.
$20
$17
National
$17 $5
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26. Credible and Empty Threats
Credible threats
Threat that is believable by the other firm
Can establish collusive agreements
A strong enforcer can prevent cheating
Can generate higher profits
May be countered with threat by rival
Empty threats
A threat that is not believable by rival
In the actual economy it is difficult to establish a credible threat. A credible threat is a statement of coercion that is believable by the other firm. Often the rival firm will question the threat; for instance, why didn’t the firm just drive them out of business in the first place? why make the threat? So, it can be very difficult to make a threat that the other firm will view as serious. If the threat is considered to be credible, then firms will abandon their Nash equilibrium. A credible threat can lead to collusion and a strong “enforcer” of the threat can maintain the discipline needed to form cartels, price-fixing, or to establish territories for the individual firms. This would lead to higher profits for the firms. An empty threat is a statement of coercion that is not believable by the other firm and will just be ignored. Firms will remain in the original Nash equilibrium position they held before the empty threat was made.
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27. Repeated Games Repeated game is a game that recurs
May cooperate and not compete strongly
Rival reciprocates
Examples
Coca-Cola and Pepsi
Boeing and Airbus
Walmart and Target
Nike and Adidas
Often firms continually play the game. In this case, the optimal strategy for the firms is to cooperate and not compete as strongly as possible, as long as their rivals do the same.
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28. 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
Here is an example of two firms in a repeated game with reciprocity. As seen in the payoff matrix to the left, 2Cool introduces its new Cool Cola with a large promotional advertising budget, but its rival ThirstQ maintains its normal advertising budget even though it could counter 2Cool with a large advertising budget of its own and drive the outcome from Cell B to Cell A. ThirstQ forgoes this 2 million dollars of extra profit because it knows that it will soon be introducing its own new product (Quench It).
In the payoff matrix to the right, ThirstQ introduces Quench It with a large promotional advertising budget. 2Cool reciprocates ThirstQ’s earlier accommodation by not matching ThirstQ’s promotional advertising budget and instead allowing the outcome of the repeated game to be Cell C. The profit of both 2Cool and ThirstQ therefore is larger over the two periods than if each firm had aggressively countered each other’s single-period strategy. C D C D
$16
$12
$15
$13
Normal budget
Normal budget $8
$12
$10
$13
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29. Sequential Game Sequential game Firms apply strategies sequentially
Final outcome depends on who moved first
Rival must respond
First-mover advantage
Advantages for the firm that is first
May be better prepared
May preempt entry of rival
In a sequential game, one firm moves first and then the rival responds. Being first by a firm may lead to the establishment of a Nash equilibrium that works in its favor. Being a first mover can be advantageous, but it is also risky. Walmart has been successful at this. Krispy Kreme Donuts lost millions.
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30. First-Mover Advantages
Big Box strategies
Build
Don’t build A B
-$5 $0
Build
-$5
$12
Huge Box strategies
This is an example of a first-mover advantage and the preemption of entry. In this game, in which strategies are pursued sequentially, the firm that moves first can take advantage of the particular situation represented in which only a single firm can exist profitably in some geographical market. Here, we suppose that Big Box moves first with its “Build” strategy to achieve the $12 million profit outcome in Cell C. Huge Box then will find that it will lose money if it also builds because that will result in a $5 million loss, as shown in Cell A. C D
$12 $0
Don’t build $0 $0
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31. Summarizing A Game Strategic form
Using a payoff matrix to represent strategy choices
Extensive form
Using a game tree to display choices and also shows the order of the moves
Two different ways to display a game using a strategic form, like the payoff matrix ,or using the extensive form, which is a game tree that shows the order of the moves as well as who moved first.
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32. Extensive Form
Here the extensive form is displayed. This allows us to study the sequence in which decisions are made, moving from left to right. The shaded line segments indicate the subgame perfect Nash equilibrium path that shows how the game will be played out if both companies always do what is most profitable for themselves while also considering what is most profitable for their rival.
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33. Extensive Form Definitions
Decision nodes
Terminal nodes
Backward induction
Subgame
Subgame perfect Nash equilibrium
A leader-follower game
(Stackelberg Duopoly)
The decision tree has three circular decision nodes that represent choices. Once the choice is made, then the choice leads to the terminal nodes that show the amount of profit. Backward induction is a two-stage process that divides the game into subgames before working back from right to left. A subgame is a min-game that is within the overall game. The subgame perfect Nash equilibrium refers to the process of working backwards to identify the path that represents the rational profit maximizing choice made at every decision node relies on both firms having perfect information about the decisions that will be made in each subgame. The Stackelberg Duopoly is a strategic situation where the leader firm choses how big a factory to build and based on that decision the follower firm(s) then decides how big a factory to build. This type of strategy has been observed with Apple, the leader and then several other firms like Samsung, LG, and Google as followers.
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34. Stackelberg Duopoly LO6
Here the extensive form is used again. This time to display the leader firm and the follower firm that must sequentially decide on their respective factory sizes.
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35. Internet Oligopolies
The Internet became accessible to the average person in the mid 1990’s
Today it is dominated by a few very large firms
Google, Facebook, Amazon, Microsoft, Apple
Not satisfied with just revenues generated in their respective sectors
Compete for advertising $s
Compete with electronic devices
Google grew to be a near monopoly in search; Facebook advanced to be a near monopoly in social media; Amazon has established a near monopoly in retail; Microsoft has held a near monopoly in pc operating systems and software; Apple has dominance with its devices that run on Apple operating systems. These very successful technology companies are now competing outside of their respective sectors with each other in the quest to increase revenues and satisfy investors. They compete for revenues collected from advertising and they compete by designing new consumer electronic products; this has led to a very competitive environment.