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Oligopoly Basic Concepts
Oligopoly
Basic Concepts
Four market model
Four market model
Four market model Oligopoly Pure Monopolistic Competition Competition Pure Monopoly Market Structure Continuum
Four market model Oligopoly Pure Monopolistic Competition Competition Pure Monopoly Market Structure Continuum
Oligopoly
Oligopoly
Four market model Oligopoly Pure Monopolistic Competition Competition Pure Monopoly Market Structure Continuum
Pure Monopolistic Competition Competition
Pure
Monopolistic
Competition
Competition
Pure Monopoly
Pure
Monopoly
Four market model Oligopoly Pure Monopolistic Competition Competition Pure Monopoly Market Structure Continuum
Market Structure Continuum
Market Structure Continuum
Oligopoly  Definition:  an industry with only a few sellers selling an identical or differentiated

Oligopoly

Definition:

Oligopoly  Definition:  an industry with only a few sellers selling an identical or differentiated
  • an industry with only a few sellers selling an identical or differentiated product.

Product may be identical

  • aluminum

  • crude oil

  • or product may be differentiated

    • Automobile

    • cigarettes

possible explanation for the formation of oligopolies
possible explanation for the
formation of oligopolies
possible explanation for the formation of oligopolies  In oligopoly the size of the minimum efficient
possible explanation for the formation of oligopolies  In oligopoly the size of the minimum efficient

In oligopoly the size of the minimum efficient scale is large relative to market demand.

Typical LAC in Oligopoly
Typical LAC in Oligopoly
possible explanation for the formation of oligopolies  In oligopoly the size of the minimum efficient

£

LAC 2 LAC 3 LAC 1
LAC 2
LAC 3
LAC 1

Demand

Output

Characteristics of Oligopoly
Characteristics of Oligopoly
Characteristics of Oligopoly  A few characteristics of oligopoly :  small number of rival firms
Characteristics of Oligopoly  A few characteristics of oligopoly :  small number of rival firms

A few characteristics of oligopoly:

  • small number of rival firms (highly concentrated markets)

  • The actions of any one seller in the market can have a large impact on the profits of all the other sellers.

firms are interdependent

  • Each seller is large enough to influence price means each seller faces a downward sloping demand curve

  • substantial economies of scale

  • Usually high barriers to entry

Economies of scale Long run average cost Unit Cost Quantity per year

Economies of scale

Economies of scale Long run average cost Unit Cost Quantity per year
Long run average cost Unit Cost
Long run average cost
Unit Cost

Quantity per year

Barriers to Entry  Structural The cost advantage over entrants because of  Economies of scale

Barriers to Entry

Structural

Barriers to Entry  Structural The cost advantage over entrants because of  Economies of scale

The cost advantage over entrants because of

  • Economies of scale

  • Economies of scope

  • Control over key input

  • Government regulations

Strategic

The action of incumbents that may deter entry

  • Over investment in capacity

  • Limit pricing

Price and Output Under Oligopoly  Because of interdependence and diversity No general theory exists for

Price and Output Under Oligopoly

Price and Output Under Oligopoly  Because of interdependence and diversity No general theory exists for

Because of interdependence and diversity No general theory exists for price and output under oligopoly.

  • If the firms operated independently, they would drive down the price to the per unit cost of production.

  • If the firms colluded perfectly, the price would rise to the monopoly price.

  • The outcome is usually between these two extremes.

Price and Output Under Oligopoly
Price and Output Under
Oligopoly
Price and Output Under Oligopoly  If oligopolists compete with one another, price cutting drives price
Price and Output Under Oligopoly  If oligopolists compete with one another, price cutting drives price
  • If oligopolists compete with one another, price cutting drives price down to P C , and expands total output to Q C .

  • In contrast, perfect cooperation among firms leads to a higher price P M and a smaller market output of Q M .

 Due to the difficulty to perfectly collude, when firms try to coordinate their activity, price
Due to the difficulty to perfectly collude, when firms try to
coordinate their activity, price is typically between P C and
P M and output between Q M and Q C .
P M
Profits to oligopoly
with perfect
collusion.
P C
MR
LRAC = LRMC
Demand
Q M
Q C
Incentive to Collude  Firms would be better off cooperating and jointly maximizing their profits However,

Incentive to Collude

Incentive to Collude  Firms would be better off cooperating and jointly maximizing their profits However,

Firms would be better off cooperating and jointly maximizing their profits However, each firm has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand

curve.

This conflict makes collusive agreements difficult to maintain.

Gaining from Cheating  Using industry demand D i and marginal revenue MR , oligopolists maximize

Gaining from Cheating

  • Using industry demand

    • D i

and marginal revenue MR i ,

oligopolists maximize their joint profit where MR i = MC

at output Q i and price P i .

  • Demand facing each firm

    • d f

(where no other firms cheat)

would be much more elastic than industry demand D i .

Gaining from Cheating  Using industry demand D i and marginal revenue MR , oligopolists maximize
  • The firm maximizes its profit where MR f = MC by expanding output to q f and lowering its price to P f from P i

P i

Industry MC MR i D i Q i
Industry
MC
MR i
D
i
Q i
Firm P i P f MC MR f d f
Firm
P i
P f
MC
MR f
d
f

q f

Gaining from Cheating
Gaining from Cheating

Gaining from Cheating    Using industry demand D and marginal revenue MR , oligopolists

Using industry demand D i and marginal revenue MR i , oligopolists maximize their joint profit where MR i = MC at output Q i and price P i .

Demand facing each firm

would be much more elastic than industry demand D i .

The firm maximizes its profit where MR f = MC by

expanding output to q

Gaining from Cheating    Using industry demand D and marginal revenue MR , oligopolists
Individual firms have d (where no other firms cheat) f an intensive to cheat by cutting
Individual firms have
d
(where no other firms cheat)
f
an intensive to cheat
by cutting price to
and lowering its price to P f from P i
f
expand out put
Industry
Firm
P i
P f
MC
MC
MR i
D
MR f
d
f
i

P i

Gaining from Cheating    Using industry demand D and marginal revenue MR , oligopolists

Q i

q f

Nash Equilibrium  The Nash equilibrium is a non-cooperative equilibrium - each firm makes the decision

Nash Equilibrium

Nash Equilibrium  The Nash equilibrium is a non-cooperative equilibrium - each firm makes the decision

The Nash equilibrium is a non-cooperative equilibrium - each firm makes the decision that gives it the maximum possible profit, given the actions of its competitors.

As demonstrated, this does not produce a monopoly outcome.

Only if firms can prevent entry by potential new firms and collude with existing firms can they realize a monopoly outcome.

Strategic Behavior  Strategic behavior is firm behavior that takes into account the market power and

Strategic Behavior

Strategic Behavior  Strategic behavior is firm behavior that takes into account the market power and

Strategic behavior is firm behavior that takes

into account the market

power and reactions of other firms in the industry

Strategic Behavior  Strategic behavior is firm behavior that takes into account the market power and
Strategic Behavior  Strategic behavior is firm behavior that takes into account the market power and
Strategic Behavior  Strategic behavior is firm behavior that takes into account the market power and
Collusive Strategy  Repeated interaction provides opportunities for firms to learn and deploy an array of

Collusive Strategy

Collusive Strategy  Repeated interaction provides opportunities for firms to learn and deploy an array of

Repeated interaction provides opportunities for firms to learn and deploy an array of strategies to enforce collusion. These include: tit-for-tat and trigger

strategies

Tit-for-tat strategy: firm colludes in current period only if other firm colluded in previous period;

otherwise choose not to collude, e.g. price war.

Trigger strategy: firm colludes if the other firm colludes, but reverts to Nash equilibrium strategy in every future period if the other firm chooses not to

collude.

Collusive Strategy  Since each firm learns that it makes a larger profit by sticking to

Collusive Strategy

Collusive Strategy  Since each firm learns that it makes a larger profit by sticking to

Since each firm learns that it makes a larger profit by sticking to collusion, both firms do so and the monopoly outcome prevails.

This outcome results from each firm responding rationally to the credible threat of the other firm to inflict damage if the agreement to collude is broken.

Types of Collusive Arrangements
Types of Collusive Arrangements
Types of Collusive Arrangements  A collusive agreement can be overt or tacit  Overt agreements

A collusive agreement can be overt or tacit

Overt agreements can take the form of a cartel which are formal arrangements to fix prices, divide up or share the market or limit competition.

Tacit agreements are less formal arrangements and can take the form of a verbal gentlemans agreementto fix prices and output.

Obstacles to Collusion
Obstacles to Collusion
Obstacles to Collusion  As the number of firms in an oligopolistic market increases, the likelihood
Obstacles to Collusion  As the number of firms in an oligopolistic market increases, the likelihood

As the number of firms in an oligopolistic market increases, the likelihood of effective collusion declines.

When it is difficult to detect cheating (secret price cuts), effective collusion is less likely.

Low entry barriers also make effective collusion less likely because profit attracts additional rivals.

Unstable demand conditions lead to honest differences among firms about the size of shares and price that maximizes total profit.

Rigorous enforcement of antitrust law makes collusion potentially more costly.