17 Oligopoly

8/7/2019 17 Oligopoly

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OligopolyOligopoly

Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10


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OverviewOverview Oligopoly market characteristics

Measure of market structure

Barriers in oligopoly market

Game theory approach to duopoly

Cooperative collusion

Cheating

Future of oligopoly


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OligopolyOligopoly When just a few large firms dominate a

market

In such a market, each firm recognizes its strategicinterdependence with others

So that actions of each one have an important

impact on the others

An oligopoly is a market dominated by a smallnumber ofstrategically interdependentfirms


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Number of Fir

msNumber of Fir

ms

Oligopoly requires that a few firms dominate themarket

How few?

At some point, number of firms is large enoughand interdependence weak enoughthat oligopolybecomes a poor description

Monopolistic competition would fit better

No absolute number at which oligopoly ends and

monopolistic competition begins


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Market Do

mination

Market Do

mination

Strategic interdependence requires that afew firms dominate the market

Their share of market is large

As combined market share shrinks,strategic interdependence becomes weaker

Oligopoly is a matter of degree Not an absolute classification


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Econo

m

ies

of Sca

le:Na

tu

ra

l OligopoliesEc

onom

ies

of Sca

le:Na

tu

ra

l Oligopolies

When minimum efficient scale (MES) for a typical

firm is a relatively large percentage of market

only a few large firms survive since small firms cantcompete

Market becomes an (natural) oligopoly

Remember, MES is defined as the lowest level of

output at which it can achieve minimum cost per unit The output level at which the LRATC first hits

bottom


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Figure 1:

Natura

l OligopolyFigure 1:

Natura

l Oligopoly

E

H F

25,000

Units per Month

100,0000

80

$200

Dollars

DMarket

LRATCTypical Firm


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Repu

ta

tionas

a

Ba

rrierR

epu

ta

tionas

a

Ba

rrier Established oligopolists are likely to have

favorable reputations

Investors decision: enter or not? Critical thing: is it worthy to take the risk of being a

new firm in such market?

If expected profit is greater than the initial loss, enter

If initial loss is too great, stay out.


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Strategic BarriersStrategic Barriers

Strategies designed to keep out potentialcompetitors, for example:

Maintain excess production capacity as a signal

Make special deals with distributors to receive

best shelf space in retail stores

Spend large amounts on advertising to make it

difficult for a new entrant to differentiate itsproduct


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Legal Ba

rriers

Legal Ba

rriers

Patents and copyrightswhich can beresponsible for monopolycan also create

oligopolies Like monopolies, oligopolies are not shy

about lobbying government to preservetheir market domination


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Measu

res

ofMa

rket Structure

Measu

res

ofMa

rket Structure

Concentration ratios: Aggregated marketshare of the largest N firms in the industry

Range: 0-100% 4 Firm Concentration ratio: Market share

controlled by the largest 4 firms

Others reported by the U.S. Census: 8 Firm

20 Firm

50 Firm


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Measures ofMarket StructureMeasures ofMarket Structure

Herfindahl-Hirschman Index: summed squares ofall firm market shares in the industry

Si = market share (in percent) of the ith firm

HHI = (Si )2

Range: 0 (perfect competition) to 10,000(monopoly)

i


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Data

on Firm

Numb

ersand SizeD

ata

on Firm

Numb

ersand Size

Compiled by the U.S. Bureau of the Census

Every 5 years

Surveys of domestic firms

Data monitored by Federal Government

Competitive environment Merger advisability


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Databased on the 2002 Economic Census.

http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13

Measured Industry Concentration in Manufacturing

D: Not disclosed

Second and third columns: Percentage in value added in the industry

Last column: Herfindahl index from the 50 largest firms


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D: Not disclosed


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D: Not disclosed


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Oligopoly vs. OtherMarket StructuresOligopoly vs. OtherMarket Structures

Oligopoly presents the greatest challenge toeconomists

essence of oligopoly is strategic interdependence economists have had to modify the tools used to

analyze other market structures and to developentirely new tools as well

One approachgame theoryhas yielded richinsights into oligopoly behavior


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The Game Theory ApproachThe Game Theory Approach

Game theory approach

An approach to modeling strategic interaction of

oligopolists in terms of moves and countermoves

Elements

Players

Strategies

Payoffs

Pay off matrix

Game tree


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Gam

eT

heory ApproachG

ameT

heory Approach

Some situations to which game theory canbe applied:

firms competing for business

political candidates competing for votes

animals fighting over prey

bidders competing in an auction

legislators' voting behavior under pressure

from interest groups


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Gam

eT

heoryGam

eT

heory Short HistoryShort History

John Von Neumann (1903-1957)

Theory of Games and EconomicBehavior with OskarMorgenstern

This book established gametheory as a field

An introduction to gametheoryby Martin J.Osborne. OxfordUniversity Press, 2002


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Gam

eT

heoryGam

eT

heory Short HistoryShort History

John F. Nash, Jr.(1928- )

One of the contributions is

the introduction of theequilibrium notion now

known as Nash equilibrium

1994 Nobel prize winner in

economics with the game

theorists John Harsanyi and

Reinhard SeltenAn introduction to game theory

by Martin J. Osborne. OxfordUniversity Press, 2002


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The Pri

soner

sDile

mmaThe Pri

soner

sDile

mma

Simple example to explain why a techniquefor obtaining confessions, commonly used by

police, is so often successful Payoff matrix

Players: Rose and Colin

Payoffs: number in the matrix Strategies: Confess (C) / not confess (NC) for

either of the players


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Figure 2: The Prisoners DilemmaFigure 2: The Prisoners Dilemma

How to read the matrix?

Players:{Rose, Colin}

Strategies:{C, NC} Payoffs

What will Rose do?

What will Colin do?

Rose

Colin

C NC

C -20, -20 -3, -30

NC -30, -3 -5, -5


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The Prisoners DilemmaThe Prisoners Dilemma

A dominant strategy: the players best strategy

regardless of the other players strategy

Roses dominant strategy is

confess

regardlessof Colins choice

So is Colin


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Nash Eq

uilibriumNas

h Equilibrium

Outcome of this game is an example of aNash equilibrium

Exists when each player is taking the bestactiongiven best actions taken by otherplayers

Under the Nash Equilibrium, no players wantto deviate


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Figure 3:Figure 3: Working on a joint project

Elements

Players:{you, your

friend} Strategies:{work hard,

Goof off}

Payoffs

What is the NashEquilibrium?

Friend

You

W G

W2, 2 0, 3

G 3, 0 1, 1


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Figure 4:Figure 4: Battle of Sex

Elements

Players:{Mr. R and

Mrs. R} Strategies:{ go to see

a movie, watch a

baseball game}

Payoffs


Mr. R

Mrs. R

M B

M2, 1 0, 0

B 0, 0 1, 2


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Figure 5:Figure 5: Duopoly

Elements

Players:{Firm A,

Firm B} Strategies:{ low price,

High price}

Payoffs


Firm A

Firm B

L H

L 10, 10 40, -5

H -5, 40 20, 20


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Simple Oligopoly GamesSimple Oligopoly Games -- DuopolyDuopoly

Duopoly - oligopoly market with only two sellers

Assume that Firm A and B must make their decisions

independently Without knowing in advance what the other will do

As dominant strategy is to charge a low price

So is B s dominant strategy

Outcome is a Nash equilibrium (Low, Low)


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Example: Price Competition for DuopolyExample: Price Competition for Duopoly

Duopoly firms A & B have the same cost structure,

produce the undifferentiated goods.

Suppose the MC and ATC is constant, equal to c. If the two firms are going to set price to maximize

their profit, what is the Nash equilibrium?


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Oligopoly Games in the Real WorldOligopoly Games in the Real World

Typically more than two strategies

Usually more than two players

In some games, one or more players may not have

a dominant strategy A game with two players will have a Nash equilibrium

as long as at least one player has a dominant strategy

Whether the other has a dominant strategy or not

When neither player has a dominant strategy, we need a

more sophisticated analysis to predict an outcome to thegame


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---- Static vs DynamicStatic vs Dynamic

Weve limited the players to one play of thegame

In reality, for gas stations and almost all otheroligopolies, there is repeated play

Where both players select a strategy

Observe the outcome of the trial

Play the game again and again, as long as they

remain rivals


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---- Cooperation in the long runCooperation in the long run

One possible result of repeated trials iscooperative behavior

Results may be very different fromequilibrium in a game played only once

Explicit collusion

Simplest

Managers meet face-to-face to decide how toset prices

Tacit collusion

No formal discussion


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Explicit Collus

ionExplicit Collus

ion Most extreme form is creation of a cartel

Group of firms that tries to maximize total

profits of the group as a whole However, it is not commonly observed. Why?

Usually illegal

Penalties, if the oligopolists are caught, can

be severe

But oligopolists can collude in other, implicit

ways


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Tacit CollusionTacit Collusion

Two most common forms

Tit for tat

A game-theoretic strategy of doing to anotherplayer this period what he has done to you in

previous period

Price Leadership

One firm

the price leader

sets its price andother sellers copy that price


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Tacit Coll

usion

Tacit Coll

usion --

Tit For

Tat

Tit For

Tat

Prominent in airline industry

However, gentle reminder of tit-for-tat is not

always effective in maintaining tacit collusion

Oligopolist will sometimes go further

Attempting to punish a firm that threatens to

destroy tacit cooperation

Lead to price wars


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Tacit CollusionTacit Collusion Price LeadershipPrice Leadership

No formal agreement

Rather the decisions come about because

firms realize

without formaldiscussionthat system benefits all ofthem

Example: U.S. Steel


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The Li

mits

to Collus

ionT

he Lim

its

to Collus

ion Oligopoly powereven with collusion

has its limits

demand constraints

collusioneven when it is tacitmay be

illegal

collusion is limited by powerful incentives tocheat on any agreement


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When is Cheating Likely?When is Cheating Likely?

While no firm wants to completely destroy acollusive agreement by cheating

Since this would mean a return to the noncooperative

equilibrium wherein each firm earns lower profit Some firms may be willing to risk destroying agreement if

benefits are great enough

Cheating is most likely to occur when there is

Difficulty observing other firmsprices

Unstable market demand

Large number of sellers


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The F

utu

re of OligopolyT

he Fu

tu

re of Oligopoly Some people think U.S. and other Western

economies are moving toward oligopoly asdominant market structure

Prediction has not come true Today, there are hundreds and thousands of ongoing

businesses in United States

Possible reasons

Antitrust law Globalization of markets

Technological change


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Antitrust Legislation and EnforcementAntitrust Legislation and Enforcement

Three types of actions

Preventing collusive agreements among firms

Such as price-fixing agreements

Breaking up or limiting activities of large firms

oligopolists and monopolistswhose market dominance

harms consumers

Preventing mergers that would lead to harmful market

domination While thrust of these policies is to preserve competition

Type of competition preservedand zeal with which

policies are appliedcan shift


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T

he Globa

liza

tion ofMa

rketsT

he Globa

liza

tion ofMa

rkets

Globalization introduces competition

By enlarging markets from national ones to global ones,

international trade can increase the number of firms in a market

Entry of U.S. producers has helped to increase

competition in foreign markets for movies, television

shows, clothing, household cleaning products, and

prepared foods

While consumers in each nation may have access to more

firms, these may be larger and more powerful firms

Creating greater likelihood of strategic interaction and

danger of collusion


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Technological ChangeTechnological Change

Technological change works

To increase competition by creating newsubstitute goods

To reduce barriers to entry To increase size of market

However, technologies on the other hand

encourage oligopoly by actually increasing MES

of typical firm Result could be strategic interaction, or collusion,

among large national players

Thereby encouraging formation of oligopolies


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The FourMarket Structures: A PostscriptThe FourMarket Structures: A Postscript

Different market structures

Perfect competition

Monopoly

Monopolistic competition

Oligopoly

Market structure models help us organizeand understand apparent chaos of real-world markets


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Market Structure

Perfect

Competition

Monopolistic

Competition Oligopoly Monopoly

# of Firms Many Many Few ne

Product

Differentiation

Identical Differentiated Either No close substitute

Barriers to

Entry

None None Big Insurmountable

Control over

Price

None Some Considerable Considerable or

Regulated

Concentration

Ratio

0 Low High 100

Long Run

Economic

Profit

0 0 0 0

Examples Wheat rocessedFood, Brand

Clothing

Automobiles LocalElectricity,Water

Summary on four types ofmarketSummary on four types ofmarket


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SummarySummary

Oligopoly market characteristics Small number of large strategically interdependent firms No free entry or exit

Either differentiated or standardized products

Measure of market structure - HHI Barriers to enter the oligopoly market

Favorable reputation / legal / strategy / substantial economy of scale

Game theory approach to duopoly Dominant strategy

Nash equilibriu

Prisoners dilemma

Repeated game: cooperative collusion Explicit : Cartel

Implicit : Tit for Tat ; Price leadership Cheating Future of oligopoly depends on

Antitrust legislation / globalization of market / technological change

17 Oligopoly

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