1. ECON 202: Principles of Microeconomics
Chapter 13
Oligopoly

2. Oligopoly Oligopoly and Barriers to Entry.
Using Game Theory to Analyze Oligopoly.
Sequential Games and Business Strategy.
The Five Competitive Forces Model.
ECON 202: Princ. of Microeconomics
Oligopoly

3. Introduction Oligopoly is market structure where:
Few competitors.
Identical or differentiated products.
Restrictions to entry.
In case of oligopolistic markets, revenues of the firms depend on actions of other competitors.
If a firm cut its price, number of units sold depends on how other firms react.
If other firms don’t do anything, sell more.
If other firms also cut prices, sales will not increase much or can even decrease.
Marginal revenue depends on actions of other firms.
Approach to analyze oligopolies: game theory.
ECON 202: Princ. of Microeconomics
Oligopoly

4. 1. Oligopoly and Barriers to Entry
Oligopolistic markets have few firms
How many firms is “few”?
US Bureau of Census publishes 4-firm concentration ratios per industry.
More than 40% indicates oligopolistic market.
Critics
Consider only sales by national firms
In some industries, competition is mainly local. (restaurants)
Some firms compete in different industries. (Wal Mart in discount department stores, supermarkets and retail toy stores)
Herfindahl-Hirschman Index (HHI)
Sum of squared shares: = 2,600
HHI > 1,800 : oligopolistic markets.
ECON 202: Princ. of Microeconomics
Oligopoly

5. 1. Oligopoly and Barriers to Entry
RETAIL TRADE
MANUFACTURING
INDUSTRY
FOUR-FIRM CONCENTRATION RATIO
FOUR-FIRM CONCENTRATION RATIO
Discount Department Stores
95%
Cigarettes
Warehouse Clubs and Supercenters
92%
Beer
91%
Hobby, Toy, and Game Stores
72%
Breakfast Cereal
82%
Athletic Footwear Stores
71%
Aircraft
81%
College Bookstores
70%
Automobiles
76%
Radio, Television, and Other Electronic Stores
69%
Dog and Cat Food
Pharmacies and Drugstores
53%
64%
ECON 202: Princ. of Microeconomics
Oligopoly

6. 1. Oligopoly and Barriers to Entry
Economies of scale
ECON 202: Princ. of Microeconomics
Oligopoly

7. 1. Oligopoly and Barriers to Entry
Ownership of a Key Input
Aluminum Company of America (Alcoa) access to high-quality bauxite.
De Beers Company of South Africa access to diamonds.
Government-imposed barriers
Occupational licensing (doctors and dentists)
Restrictions to international trade (tariffs and quotas)
Since entry is restricted, firms can sustain economic profits over a long period.
ECON 202: Princ. of Microeconomics
Oligopoly

8. 2. Using Game Theory to Analyze Oligopoly
The study of how people make decisions in situations in which attaining their goals depends on their interactions with others.
Games have three characteristics:
Rules.
Strategies.
Payoffs.
ECON 202: Princ. of Microeconomics
Oligopoly

9. 2. Using Game Theory to Analyze Oligopoly
Duopoly: price competition between two firms.
Firms can collude, but is against the law. (Sherman Act)
ECON 202: Princ. of Microeconomics
Oligopoly

10. 2. Using Game Theory to Analyze Oligopoly
For each firm, to charge $400 is a dominant strategy.
The best strategy for a player, regardless of what the other players decide.
($400, $400) is a Nash equilibrium.
A situation where each player is choosing its best strategy, given the others players’ strategies.
A situation where no player has an incentive to change of strategy.
Equilibrium is not best possible result for the firms, but it results because each firm pursues its own interest.
Noncooperative equilibrium.
If firms decide to cooperate and play ($600, $600), then result increases their mutual payoff.
Cooperative equilibrium.
ECON 202: Princ. of Microeconomics
Oligopoly

11. 2. Using Game Theory to Analyze Oligopoly
Types of games where individual maximization of payoff leaves everyone worse off are called prisoner’s dilemma.
Nash Equilibrium is (defect, defect).
Challenge to Adam Smith’s idea of self-interest.
ECON 202: Princ. of Microeconomics
Oligopoly

12. 2. Using Game Theory to Analyze Oligopoly
In most business situations games are played repeatedly.
Firms can collude implicitly to reach the cooperative equilibrium.
Example: “lowest price guarantee”
Firms send a signal to competitors that if they charge lower price, its strategy will be the same.
Firms have the incentive to keep the high price.
ECON 202: Princ. of Microeconomics
Oligopoly

13. 2. Using Game Theory to Analyze Oligopoly
ECON 202: Princ. of Microeconomics
Oligopoly

14. 2. Using Game Theory to Analyze Oligopoly
When firms can collude: cartels (OPEC)
However, firms can have incentives to stop cooperation, which makes difficult to sustain agreements.
ECON 202: Princ. of Microeconomics
Oligopoly

15. 3. Sequential Games and Business Strategy
Oligopolistic firms can deter the entry of new firms.
Best strategy for WalMart is to build the large store, deterring entry from Target.
ECON 202: Princ. of Microeconomics
Oligopoly

16. 3. Sequential Games and Business Strategy
Best strategy for firm is to build the small store and let Target entry the market.
ECON 202: Princ. of Microeconomics
Oligopoly

17. 3. Sequential Games and Business Strategy
Bargaining
If TruImage says that will not accept a deal at $20: noncredible threat.
ECON 202: Princ. of Microeconomics
Oligopoly

18. 4. The Five Competitive Forces Model
Forces that determine the level of competition in an industry.
ECON 202: Princ. of Microeconomics
Oligopoly

19. 4. The Five Competitive Forces Model
Competition from existing firms.
Educational testing service: SAT and ACT vs. GRE.
Threat from potential entrants.
Railways.
Competition from substitute goods or services.
Train vs. flight
Bargaining power of buyers.
Automobile makers and tire suppliers.
Bargaining power of suppliers.
Technicolor and color movies.
ECON 202: Princ. of Microeconomics
Oligopoly

20. ECON 202: Principles of Microeconomics
Chapter 13
Oligopoly