Oligopoly

Dr. Katherine Sauer Principles of Microeconomics ECO 2020

Classifying an industry as an oligopoly Recall the characteristics of an oligopoly market: few firms (more than 1, less than many) identical or differentiated products high barriers to entry

When is an industry an oligopoly? - when the 4-firm concentration ratio is larger than 40% or - when the HHI is greater than 1800

1. The 4-firm concentration ratio is the percent of total output in the industry that is produced by the 4 largest firms.

Here are the market shares for the top 8 firms in two different industries:
Firm 1 2 3 4 5 6 7 8 Industry A 0.10 0.10 0.08 0.08 0.05 0.03 0.02 0.01 Industry B 0.46 0.24 0.10 0.05 0.04 0.03 0.02 0.01

The 4-firm concentration ratio for Industry A is: 0.10+0.10+0.08+0.08= 0.36 The 4-firm concentration ratio for Industry B is: 0.46+0.24+0.10+0.05 = 0.85

2. Herfindahl-Hirshman Index (HHI)

I

HHI ! (marketsharei)
i !1
2

HHI = (market share firm 1) + (market share firm 2) +

HHI greater than 1800: highly concentrated market HHI less than 1000: unconcentrated market

Firm 1 2 3 4 5 6 7 8

Industry A 0.10 0.10 0.08 0.08 0.05 0.03 0.02 0.01

Industry B 0.46 0.24 0.10 0.05 0.04 0.03 0.02 0.01

In Industry A, suppose that the remaining 53% of market share is equally split by 53 firms each have 1% of market. In Industry B, suppose that the remaining 5% of market share is equally split by 5 firms each have 1% of market. 2 2 2 2 2 Industry As HHI = (10) + (10) + (8) + (8) + (5) 2 2 2 2 + (3) + (2) + (1) + (53)(1) = 420

Firm 1 2 3 4 5 6 7 8

Industry A 0.10 0.10 0.08 0.08 0.05 0.03 0.02 0.01

Industry B 0.46 0.24 0.10 0.05 0.04 0.03 0.02 0.01

Industry Bs HHI = (46) + (24) + (10) + (5) + (4) 2 2 2 2 + (3) + (2) + (1) + (5)(1) = 2852

Firm Behavior The group of oligopolists is better off cooperating and acting like a monopolist, producing a small quantity of output and charging a price above marginal cost. Yet, because the oligopolist cares about his own profit, there is an incentive to act on his own. This will limit the ability of the group to act as a monopoly. A key feature of oligopoly is the tension between cooperation and self-interest.

The oligopoly outcome is likely to be in between the competitive market outcome and a monopoly market outcome. Competitive Price < Oligopoly Price < Monopoly Price

Competitive Q > Oligopoly Q > Monopoly Q

Size of an Oligopoly Affects the Market Outcome As the number of firms in an oligopoly increases, the output approaches the competitive output level. The oligopoly output level will converge to n / (n+1) of the competitive output level.

Ex: If the competitive market outcome would be 1000 units of output and there are 5 oligopolists, then the oligopoly level of output would be (5 / 6)1000 = 833.33

If the competitive market outcome would be 800 units of output and there are 2 oligopolists, then the oligopoly level of output would be (2/3) 800 = 533.33

The larger the number of sellers in the industry, the less concerned each seller is about its own impact on market price. - as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. - Price will approach marginal cost. - The quantity of output produced will approach the socially efficient level.

When an oligopolist decides to increase output, two things occur. - Because price is greater than marginal cost, increasing output will increase profit. This is the output effect. - Because increasing output will raise the total quantity sold, the price will fall and will therefore lower profit. This is the price effect.

Because of the strategic nature of an oligopoly industry, a tool called game theory is often used to analyze the firms behavior. game theory: the study of how people behave in strategic situations By strategic, we mean a situation in which each person, in deciding what actions to take, must consider how others might respond to that action.

Each firm in an oligopoly must act strategically, because its profit not only depends on how much output it produces, but also on how much other firms produce as well.

Introduction to Game Theory

A payoff matrix is used for games where decisions are made simultaneously.

Ex: Russia and South Africa both produce diamonds. They are considering entering an agreement where they each reduce production to drive up prices.

Russia abide South Africa abide $18 cheat $20 $15 $16 $18 $15 $16 cheat $20

This outcome is a Nash Equilibrium.

Nash Equilibrium: when each player is doing the best he/she can, given what the other player is doing. Given that Russia has decided to cheat, would South Africa want to change its strategy?
Russia abide South Africa abide $18 cheat $20 $15 $16 $18 $15 $16 cheat $20

No: 15 < 16

Given the South Africa has decided to cheat, would Russia want to change its strategy?
Russia abide South Africa abide $18 cheat $20 $15 $18 $15 $16 $16 * cheat $20

No: 15 < 16 When given what the other players are doing, if no one wants to change strategies, you have found a Nash Equilibrium.

A Nash Equilibrium isnt necessarily the best outcome. Both countries could get the highest payoff if they agreed not to cheat.
Russia abide South Africa abide $18 cheat $20 $15 $16 $18 $15 $16 cheat $20

- But each has an incentive to cheat! - The cheating outcome is not the best for either party.

It is often difficult for oligopolies to form successful cartels. - Antitrust laws prohibit agreements among firms. - Squabbling among cartel members over their shares is also likely to occur. In the absence of a binding agreement, the monopoly outcome is unlikely.

A Prisoners Dilemma is a situation where the actual outcome is not as good as the outcome would be if the firms could enter into a binding agreement with one another to do something else. It illustrates why agreements are hard to maintain even when they are mutually beneficial.

The Classic Prisoners Dilemma example:

Bonnie confess Clyde confess 5years 5years not confess 10years 1year 2years 2years

not confess

1year 10years

Some situations have more than one Nash Equilibrium. Suppose you are on a first date. It is the end of the date and you are both deciding whether to lean in for a kiss.

You

lean in for kiss don't lean in for kiss

Your Date lean in for kiss don't lean in for kiss okay awkward okay * awkward awkward okay * awkward okay