OLIGOPOLY

Market Structure

Most firms possess some market power.

Degrees of Power

We classify firms into specific market structures

based on the number and relative size of firms in
an industry.
Market

structure The number and relative size of

firms in an industry.

Degrees of Power

In imperfect competition, individual firms have some

power in a particular product market.

Oligopoly is a market in which a few firms

produce all or most of the market supply of
a particular good or service.

Characteristics of Market Structures

Market Structure
Characteristics

Perfect
Competition

Monopolistic
Competition

Oligopoly

Number of firms

Very large
number

Many

Few

Barriers to entry

None

Low

High

Market power
(control over price

None

Some

Substantial

Type of product

Standardized Differentiated Standardized

or
differentiated

Characteristics of Market Structures

Market Structure
Characteristics

Perfect
Competition

Duopoly

Monopoly

Number of firms

Very large
number

Two

One

Barriers to entry

None

High

High

Market power
(control over price

None

Substantial

Substantial

Type of product

Standardized Standardized Unique

or
differentiated

Determinants of Market Power

The determinants of market power include:

Number

of producers.
Size of each firm.
Barriers to entry.
Availability of substitute goods.

Determinants of Market Power

Market power increases:

The

fewer the number of firms in the market.

The larger the relative size of the firms in the market.
The higher the entry barriers.
The fewer the substitutes.

Determinants of Market Power

Barriers to entry determine to what extent the

market is a contestable market.
Contestable market An imperfectly
competitive industry subject to potential entry
if prices or profits increase.

Measuring Market Power

The standard measure of market power is the

concentration ratio.
The concentration ratio is a measure of market
power that relates the size of firms to the size of
the market.

Concentration Ratio

The concentration ratio is the proportion of total

industry output produced by the largest firms
(usually the four largest).

Firm Size

Market power isnt necessarily associated with firm

size.
A small firm could possess a lot of power in a
relatively small market.

Measurement Problems

Many smaller firms acting in unison can achieve

market power.
Concentration ratios do not convey the extent to
which market power may be concentrated in a local
market.

Oligopoly Behavior

Market structure affects market behavior and

outcomes.
Assume that the computer market has three
oligopolists.

Initial Equilibrium

Initial conditions and market shares of each firms

are described in the following slides.
Market

share - The percentage of total market output

produced by a single firm.

Price (per computer)

Initial Conditions in Computer Market

$1000
Market demand

Industry output

20,000
Quantity Demanded (computers per month)

Initial Market Shares of Microcomputer

Producers

Producer

Output

Market Share

Universal Electronics

8,000

40.0%

World Computers

6,500

32.5%

International
Semiconductor

5,500

27.5%

20,000

100.0%

Total industry output

The Battle for Market Shares

In an oligopoly, increased sales on the part of one

firm will be noticed immediately by the other firms.

Increased Sales at the Prevailing

Market Price

Increases in the market share of one oligopolist

necessarily reduce the shares of the remaining
oligopolists.

Increased Sales at Reduced Prices

Lowering price may expand total market sales and

increase the sales of an individual firm without
affecting the sales of its competitors.
There simply isnt any way that a firm can do so
without causing alarms to go off in the industry.

Retaliation

Oligopolists respond to aggressive marketing by

competitors.
Step

up marketing efforts.
Cut prices on their product(s).

Retaliation

One way oligopolists market their products is

through product differentiation.
Product differentiation Features that make
one product appear different from competing
products in the same market.

Retaliation

An attempt by one oligopolist to increase its market

share by cutting prices will lead to a general
reduction in the market price.

This is why oligopolists avoid price

competition and instead pursue nonprice
competition.

Price (per computer)

Rivalry for Market Shares

$1000
900

F
G

Market
demand

20,000

25,000

Quantity Demanded (computers per month)

The Kinked Demand Curve

Close interdependence and the limitations it

imposes on price and output decisions is a
characteristic of oligopoly.

Rivals Response to Price Reductions

The degree to which sales increase when the price is

reduced depends on the response of rival
oligopolists.
We expect oligopolists to match any price
reductions by rival oligopolists.

Rivals Response to Price Increases

Rival oligopolists may not match price increases in

order to gain market share.

The Kinked Demand Curve Confronting

an Oligopolist

The shape of the demand curve facing an

oligopolist depends on how its rivals responded to a
change in the price of its own output.
The demand curve will be kinked if rival oligopolists
match price reductions but not price increases.

PRICE (per computer)

The Kinked Demand Curve Confronting

an Oligopolist
Demand curve facing
oligopolist if rivals match
price changes
$1100
1000
900

C
Demand curve facing
oligopolist if rivals
match price cuts but
not price hikes

M
A

Demand curve
facing oligopolist if
rivals don't match
price changes

8000
QUANTITY DEMANDED (computers per month)

Game Theory

Each oligopolist has to consider the potential

responses of rivals when formulating price or output
strategies.
The payoff to an oligopolists price cut depends on
how its rivals respond.

Game Theory

Game theory is the study of decision making in

situations where strategic interaction (moves and
countermoves) between rivals occurs.

Game Theory

Each oligopolist is uncertain about its rivals

behavior.
The collective interests of the oligopoly are
protected if no one cuts the market price.
But an individual oligopolist could lose if it
holds the line on price when rivals reduce
price.

The Payoff Matrix

The payoff to an oligopolists price cut depends on

how its rivals respond.

The Payoff Matrix

The decision to initiate a price cut requires a risk

assessment.

Expected = Probability of Size of loss

value
rivals matching from price cuts
Probability of
Gain from lone
+

rivals
not
matching
price
cut

Oligopoly Payoff Matrix

Rivals Actions
Universals Options

Reduce Price

Dont Reduce
Price

Reduce price

Small loss for

everyone

Huge gain for

Universal; rivals
lose

Dont reduce price

Huge loss for

Universal; rivals
gain

No change

Oligopoly vs. Competition

Oligopolists may try to coordinate their behavior in

a way that maximizes industry profits.

Price and Output

An oligopoly will want to behave like a monopoly,

choosing a rate of industry output that maximizes
total industry profit.

Price and Output

To maximize industry profit, the firms in an

oligopoly must agree on a monopoly price and
agree to maintain it by limiting production and
allocating market shares.

Price or Cost (dollars per unit)

Maximizing Oligopoly Profits

Industry
marginal
cost
Profitmaximizing
price

Industry
average
cost
Market
demand

Profits

Average cost
at profitmaximizing
output

J
Industry marginal
revenue

Profit-maximizing output
0
Quantity (units per period)

Sticky Prices

Prices in oligopoly industries tend to be stable.

Like all producers, oligopolists want to maximize
profits by producing where MR = MC.

Sticky Prices

The kinked demand curve is really a composite of

two separate demand curves.

There is a gap in an oligopolists marginal

revenue (MR) curve.
Marginal revenue The change in total
revenue that results from a one-unit increase
in the quantity sold.

Sticky Prices

As a result, modest shifts of the cost curve will have

no impact on the production decision of an
oligopolists.

Price (dollars per computer)

An Oligopolists Marginal Revenue

Curve

The kink in the demand curve

A
F
d1

The MR gap

G
mr2
0

d2

mr1

8000 H
Quantity Demanded (computers per month)

Price or Cost (dollars per unit)

The Cost Cushion

Marginal revenue
MC2
MC1
MC3

Quantity (units per period)

Coordination Problems

There is an inherent conflict in the joint and

individual interests of oligopolists.
Each

oligopolist wants industry profits to be maximized.

Each oligopolist wants to maximize its own market
share.

Coordination Problems

To avoid self-destructive behavior, each oligopolist

must coordinate production decisions so that:

Industry output and price are maintained at

profit-maximizing levels.
Each oligopolistic firm is content with its
market share.

Price Fixing

The most explicit form of coordination among

oligopolists is called price fixing.
Price fixing is an explicit agreement among
producers regarding the price(s) at which a good is
to be sold.

Price Leadership

Price leadership is an oligopolistic pricing pattern

that allows one firm to establish the market price
for all firms in the industry.

Allocation of Market Shares

One way to allocate market share is a cartel

agreement.
A cartel is a group of firms with an explicit
agreement to fix prices and output shares in a
particular market.

Allocation of Market Shares

An oligopolist may resort to predatory pricing when

market shares are not being divided in a
satisfactory manner.
Predatory pricing - temporary price
reductions designed to alter market shares or
drive out competition.

Barriers to Entry

Above-normal profits cannot be maintained over

the long-run unless barriers to entry exist.
Barriers to entry are obstacles that make it difficult
or impossible for would-be producers to enter a
particular market.

Patents

Patents prevent potential competitors from setting

up shop.
They either have to develop an alternative method
for producing a product or receive permission from
the patent holder to use the patented process.

Distribution Control

The control of distribution outlets can be

accomplished through selective discounts, long-term
supply contracts, or expensive gifts at Christmas.

Mergers and Acquisition

A firm can limit competition by acquiring

competitors through mergers and acquisition.

Government Regulation

Patents are issued by the federal government.

Licensing requirements imposed by government limit
competition.

Nonprice Competition

Advertising not only strengthens brand loyalty, but

also makes it expensive for new producers to enter
the market.

Training

Early market entry can create an important barrier

to later competition.
Customers of training-intensive products (such as
computer hardware and software) become familiar
with a particular system.

Network Economies

The widespread use of a particular product may

heighten its value to consumers, thereby making
potential substitutes less viable.

Antitrust Enforcement

Market power contributes to market failure when it

leads to resource misallocations or greater inequity.
Market failure is an imperfection in the market
mechanism that prevents optimal outcomes.

Industry Behavior

Antitrust law is government intervention designed to

alter market structure or prevent abuse of market
power.

Industry Behavior

There are several problems with the behavioral

approach to antitrust law:
Limited government resources.
Public apathy.
Difficulty of proving collusion.

Industry Structure

Public efforts to alter market structure have been

less frequent than efforts to alter market behavior.

Objections to Antitrust

Some argue that we shouldnt punish those who

achieved monopolies through hard work and
innovation.
Noncompetitive behavior, not industry structure,
should be the only concern of antitrust.

The Herfindahl-Hirshman Index

The Herfindahl-Hirshman index (HHI) is a measure of

industry concentration that accounts for number of
firms and size of each.

The Herfindahl-Hirshman Index

The Herfindahl-Hirshman Index of market equals the

sum of the squares of the market shares of each
firm in an industry.

share of

HHI = firm i

i=1
2

share of share of
share of

HHI = firm 1
+
+

firm 2
firm n

The Herfindahl-Hirshman Index

For policy purposes, the Justice Department decided

it would draw the line at a value of 1,800.

Contestability

If entry barriers were low enough, even a highly

concentrated industry might be compelled to
behave more competitively.