Oligopoly

Hall and Lieberman, 3rd edition, Thomson South-

Western, Chapter 10
Overview
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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Oligopoly
When just a few large firms dominate a market
So that actions of each one have an important
impact on the others
In such a market, each firm recognizes its strategic
interdependence with others
An oligopoly is a market dominated by a small
number of strategically interdependent firms

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Number of Firms
Oligopoly requires that a few firms dominate the
market
How few?
At some point, number of firms is large enough
and interdependence weak enoughthat oligopoly
becomes a poor description
Monopolistic competition would fit better
No absolute number at which oligopoly ends and
monopolistic competition begins

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Market Domination
Strategic interdependence requires that a
few 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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Economies of Scale: Natural 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 cant
compete
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: Natural Oligopoly

Dollars
LRATCTypical Firm
$200 H F

E
80
DMarket

0 25,000 100,000
Units per Month
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Reputation as a Barrier
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 big, stay out.

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Strategic Barriers
Strategies designed to keep out potential
competitors, 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 its
product

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Legal Barriers
Patents and copyrightswhich can be
responsible for monopolycan also create
oligopolies
Like monopolies, oligopolies are not shy
about lobbying government to preserve
their market domination

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Measures of Market Structure
Concentration ratios: Aggregated market
share of the largest N firms in the industry
Range: 0-100%
4 Firm Concentration ratio: Market share
controlled by the largest 4 firms

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 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

Data based on the 2002 Economic Census.

http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13 12
 Measured Industry Concentration in Manufacturing

D: Not disclosed

Data based on the 2002 Economic Census.

http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13 13
Oligopoly vs. Other Market Structures

Oligopoly presents the greatest challenge to

economists
essence of oligopoly is strategic interdependence
economists have had to modify the tools used to
analyze other market structures and to develop
entirely new tools as well
One approachgame theoryhas yielded rich
insights into oligopoly behavior

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The 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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Game Theory Approach
Some situations to which game theory can
be 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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Game Theory Short History
John Von Neumann (1903-1957)
Theory of Games and Economic
Behavior with Oskar
Morgenstern
This book established game
theory as a field

An introduction to game
theory by Martin J.
Osborne. Oxford
University Press, 2002
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Game Theory Short History
John F. Nash, Jr.(1928- )
One of the contributions is
the introduction of the
equilibrium notion now
known as Nash equilibrium
1994 Nobel prize winner in
economics with the game
theorists John Harsanyi and
Reinhard Selten An introduction to game theory
by Martin J. Osborne. Oxford
University Press, 2002
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The Prisoners Dilemma
Simple example to explain why a technique
for 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 Dilemma

How to read the matrix? Rose

Players:{Rose, Colin}
Strategies:{C, NC} C NC
Payoffs
What will Rose do?
What will Colin do? C -20, -20 -3, -30
Colin

NC -30, -3 -5, -5

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The Prisoners Dilemma
A dominant strategy: the players best strategy
regardless of the other players strategy
Roses dominant strategy is confess regardless
of Colins choice
So is Colin

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Nash Equilibrium
Outcome of this game is an example of a
Nash equilibrium
Exists when each player is taking the best
actiongiven best actions taken by other
players
Under the Nash Equilibrium, no players want
to deviate

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Figure 3: Working on a joint project

Elements
Players:{you, your Friend
friend}
Strategies:{work hard,
Goof off} W G
Payoffs W
You 2, 2 0, 3
What is the Nash
Equilibrium?
G 3, 0 1, 1

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Figure 4: Battle of Sex

Elements
Players:{Mr. R and Mr. R
Mrs. R}
Strategies:{ go
shopping, watch a S B
baseball game} S
Payoffs Mrs. R 2, 1 0, 0
What is the Nash
Equilibrium? B 0, 0 1, 2

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 Figure 5: Duopoly

Elements
Players:{Firm A, Firm A
Firm B}
Strategies:{ Low
price, High price} L H
Payoffs
What is the Nash Firm B L 10, 10 40, -5
Equilibrium?

H -5, 40 20, 20
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Simple Oligopoly Games - Duopoly

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 Bs dominant strategy
Outcome is a Nash equilibrium (Low, Low)

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Example: 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 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

When neither player has a dominant strategy, we need a

more sophisticated analysis to predict an outcome to the
game

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Oligopoly Games in the Real World
-- Static v.s. Dynamic

Weve limited the players to one play of the

game
In reality, for gas stations and almost all other
oligopolies, 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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Oligopoly Games in the Real World
-- Cooperation in the long run
One possible result of repeated trials is
cooperative behavior
Results may be very different from
equilibrium in a game played only once
Explicit collusion
Simplest
Managers meet face-to-face to decide how to
set prices
Tacit collusion
No formal discussion
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Explicit Collusion
Most extreme form is creation of a cartel
Group of firms that tries to maximize total profits of
the group as a whole
OPEC
However, it is not commonly observed. Why?
Usually illegal in U.S.A., EU & most of developed
countries
Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways

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 Tacit Collusion
Two most common forms
Tit for tat
A game-theoretic strategy of doing to another
player this period what he has done to you in
previous period
Price Leadership
One firmthe price leadersets its price and
other sellers copy that price

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Tacit Collusion - 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 Collusion Price Leadership
No formal agreement
Rather the decisions come about because
firms realizewithout formal
discussionthat system benefits all of
them

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The Limits to Collusion
Oligopoly powereven with collusion
has its limits
demand constraints
collusioneven when it is tacitmay be
illegal
collusion is limited by powerful incentives to
cheat on any agreement

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The Incentive to Cheat
Will firm stick to the collusion?
Maybe, and maybe not
Problemeach player may conclude that he can do even
better by cheating, Figure 5
Two players would be back to non-cooperative outcome
based on their dominant strategies
May be in each players interest to cheat occasionally
Analyzing this sort of behavior requires some rather
sophisticated game theory models
Economists are actively engaged in building them

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When is Cheating Likely?
While no firm wants to completely destroy a
collusive 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 firms prices
Unstable market demand
Large number of sellers

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The Future of Oligopoly
Some people think U.S. and other Western
economies are moving toward oligopoly as
dominant 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 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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The Globalization of Markets
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 Change
Technological change works
To increase competition by creating new
substitute 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 Four Market Structures: A Postscript

Different market structures

Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Market structure models help us organize
and understand apparent chaos of real-
world markets
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Summary on four types of market
Market Structure
Perfect Monopolistic
Competition Competition Oligopoly Monopoly
# of Firms Many Many Few One
Product Identical Differentiated Either No close substitute
Differentiation
Barriers to None None Big Insurmountable
Entry
Control over None Some Considerable Considerable or
Price Regulated
Concentration 0 Low High 100
Ratio
Long Run 0 0 0 0
Economic
Profit
Examples Wheat Processed Automobiles Local
Food, Brand Electricity, Water
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Clothing
Summary
Oligopoly market characteristics
Small number of large strategically interdependent firms
No free entry or exit
Either differentiated or standardized products
Measure of market structure
Barriers to enter the oligopoly market
Favorable reputation / legal / strategy / substantial economy of scale
Game theory approach to duopoly
Dominant strategy
Nash equilibrium
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

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