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Chapter 27 Oligopoly and Strategic Behavior

Overview
In this chapter the oligopoly model is presented and its major characteristics are discussed. The reason why oligopoly occurs is
discussed, and the concept of the concentration ratio is introduced. Strategic behavior under oligopolistic conditions along with game
theory is presented. The model of price leadership as a form of strategic behavior with implicit collusion is developed. The ways
oligopolists deter entry by potential competitors is analyzed. The nature and significance of network effects is then examined. Finally,
the various market structures are compared.
Outline
I.
Oligopoly: An oligopoly is a market structure in which there are very few sellers. Each seller knows the other sellers will
react to its changes in prices and quantities. An oligopoly market structure can exist for either a homogeneous or a differentiated
product.
A.
Characteristics of Oligopoly
1.
Small Number of Firms: An oligopoly exists when the few top firms account for an overwhelming percentage of total
industry output.
2.
Interdependence: This is also called strategic dependence, which is a situation in which one firms actions with respect to
output, price, quality, advertising, and related changes may be strategically countered by one or more other firms in the industry. Such
dependence can only exist when there are a few major firms in an industry.
B.
Why Oligopoly Occurs
1.
Economies of Scale: The strongest reason that has been offered for the existence of oligopoly is economies of scale.
Economies of scale are defined as a production situation in which a doubling of output results in less that a doubling of total costs. The
firms average total cost curve will slope downward as it produces more and more output. Average total cost can be reduced by
continuing to expand the scale of operation.
2.
Barriers to Entry: These barriers include legal barriers, such as patents, and control and ownership over critical supplies.
3.
Oligopoly by Merger: A merger is the joining of two of more firms under a single ownership or control. There are two types
of mergers. A horizontal merger involves firms producing or selling a similar product. A vertical merger occurs when one firm merges
with another from which it purchases an input or to which it sells an output.
C.
Measuring Industry Concentration
1.
Concentration Ratio: The percentage of all sales contributed by the leading four or leading eight firms in an industry:
sometimes called the industry concentration ratio. (See Table 271.)
2.
U.S. Concentration Ratios: The concept of an industry is necessarily arbitrary. As a consequence, concentration ratios rise as
we narrow the definition of an industry and fall as we broaden it. (See Table 272.)
D.
Oligopoly, Efficiency, and Resource Allocation: Some oligopolists charge prices that are greater than marginal cost. There is
no definite evidence of serious resource allocation in the United States. The more U.S. firms face competition from the rest of the
world, the less any oligopoly will be able to exercise market power.
III.
Strategic Behavior and Game Theory: When there are relatively few firms in an industry, each reacts to the price, quantity,
quality, and new product innovations that the others undertake. Each oligopolist has a reaction function which is the manner in which
one oligopolist reacts to a change in price (or output or quality) of another oligopolist. Game theory is the analytical framework in
which two or more individuals, companies, or nations compete for certain payoffs that depend on the strategy that the others employ.
The plans made by these individuals are known as game strategies.
A.
Some Basic Notions About Game Theory: Games can be cooperative or non-cooperative. They are classified by whether the
payoffs are negative, zero, or positive. A cooperative game is one in which players explicitly collude to make themselves better off.
With firms, it involves companies colluding in order to make higher than competitive rates of return. A non-cooperative game is a
game in which players neither collude nor negotiate in any way. Applied to firms, it is a situation in which there are few firms and
each firm has some ability to change price. A zero sum game is a game in which one players losses are exactly offset by the other
players gains. A negative-sum game is a game in which both players are worse off at the end of the game. A positive-sum game is a
game in which both players are better off at the end of the game.
1.
Strategies in Noncooperative Games: A strategy is any rule that is used to make a choice, e.g., always pick heads. The goal is
to devise a dominant strategy. A dominant strategy will yield the highest benefit for the player using it. These strategies are generally
successful no matter what actions other players take.
B.
Applying Game Theory to Pricing Strategies: An example of the use of game theory is presented. (See Figure 272.)
C.
Opportunistic Behavior: Actions that ignore possible long-run benefits of cooperation and focus solely on short-run gains.
This kind of behavior can be contrasted to tit-for-tat strategic behavior when repeat transactions are likely. Here a player will behave
well as long as others do likewise.

IV.
Price Rigidity and the Kinked Demand Curve: Assume that rivals will match all price decreases (in order not to be undersold)
but not price increases (because they want to capture more business). There is no collusion. The implications of this reaction function
are rigid prices and a kinked demand curve.
A.
Nature of the Kinked Demand Curve: An oligopoly firm will assume that if it lowers price, rivals will react by matching that
reduction to avoid losing their respective shares of the market. The oligopolist lowering the price will not greatly increase its quantity
demanded and total revenues will fall. If it increases price, rivals will not follow. Thus, a higher price will cause quantity demanded to
decease rapidly and total revenues will fall. There is a kink in the demand curve. The resulting marginal revenue curve has a
discontinuous portion. (See Figure 273.)
B.
Price Rigidity: The kinked demand curve analysis may help explain why price changes might be infrequent in an
oligopolistic industry without collusion. Each oligopolist can only expect lower revenues if it changes price. (See Figure 273.)
1.
A Break in the Marginal Revenue Curve: A theoretical reason for price inflexibility under the kinked demand curve model
has to do with the discontinuous portion of the marginal revenue curve. As long as the marginal cost curve passes through the
discontinuity, the firm will not change price. (See Figure 274.)
2.
A Theory of Price Rigidity: As long as the marginal cost curve is in the discontinuous portion of the firms marginal revenue
curve neither price nor quantity will change since the price and quantity are at the profit maximizing level. (See Figure 274.)
C.
Criticisms of the Kinked Demand Curve: If every oligopolistic firm faced a kinked demand curve, it would not pay to change
prices. The problem is that the kinked demand curve does not show us how supply and demand originally determined the going price
of an oligopolists product. Oligopoly prices do not appear to be as rigid, particularly in the upward direction, as the kinked demand
curve theory implies.
V.
Strategic Behavior with Implicit Collusion: A Model of Price Leadership: Price leadership is a model of a pricing practice in
many oligopolistic industries and is a form of tacit collusion.
A.
The Theory of Price Leadership: The largest firm publishes its price list ahead of its competitors, who then follow those
prices. This is also called parallel pricing. By definition, price leadership requires one firm to be the leader. Because of laws against
collusion, firms in an industry cannot communicate who the price leader will be directly. That is why the largest firm often becomes
the price leader.
B.
Price Wars: Price leadership may not always work. If the price leader ends up much better off than those firms that follow,
they may not set prices according to the dominant firm. A price war may result. A price war is a pricing campaign designed to capture
additional market share by repeatedly cutting prices.
VI.
Deterring Entry into an Industry: An important part of game playing has to do with how potential competitors might react to a
decision. Existing firms in an industry devise strategies to deter entrance into that industry. By getting a local, state, or federal
government to restrict entry, or by adopting certain pricing and investment strategies they may deter the entrance of new firms.
A.
Increasing Entry Costs: Any strategy undertaken by firms in an industry with the intent or effect of raising the cost of entry
into the industry by a new firm. To sustain a long price war, existing firms might invest in excess capacity so that they may expand
output during the price war, thus signaling potential competitors that they will engage in a price war. Existing domestic firms can also
raise the cost of entry by foreign firms by getting the U.S. government to pass stringent environmental or health and safety standards.
B.
Limit-Pricing Strategies: The existing firms may lower their market price until they sell the same quantity as before a new
firm entered the industry. Existing firms limit their price to be above competitive prices, but if there is a new entrant, the new limit
price will be below the one at which a new firm can make a profit. The limit-pricing model is a model that hypothesizes a group of
colluding sellers who together set the highest common price they believe they can charge without new firms seeking to enter the
industry.
C.
Raising Customers Switching Costs: If an existing firm can make it more costly for customers to switch from its product or
service to a competitors, the existing firm can deter entry. In the computer industry switching costs were high because computer
operating systems were not compatible across computer operating systems.
VII.
Network Effects: This is a situation in which a consumers willingness to purchase a good or service is influenced by how
many others also buy the item.
A.

Network Effects and Market Feedback

1.
Positive Market Feedback: A tendency for a good or service to come into favor with additional consumers because other
consumers have chosen to buy the item.
2.
Negative Market Feedback: A tendency for a good or service to fall out of favor with more consumers because other
consumers have stopped purchasing the item.
B.
Network Effects and Industry Concentration: In some industries a few firms can reap the benefits of positive market
feedback. These firms can then capture the bulk of the sales in the market.
VIII.

Comparing Market Structures: Market structures are compared in Table 273.