Oligopoly

Chapter 10

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Market Structure
Most firms possess some market power.

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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.

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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.

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Characteristics of Market Structures

Market Structure
Characteristics Number of firms Barriers to entry Market power (control over price Type of product Perfect Competition Very large number None None Monopolistic Competition Many Low Some Oligopoly Few High Substantial

Standardized Differentiated Standardized or differentiated

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Characteristics of Market Structures

Market Structure
Characteristics Number of firms Barriers to entry Market power (control over price Type of product Perfect Competition Very large number None None Duopoly Two High Substantial Monopoly One High Substantial

Standardized Standardized Unique or differentiated

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Determinants of Market Power

The determinants of market power include:
Number of producers. Size of each firm. Barriers to entry. Availability of substitute goods.

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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.

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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.

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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.

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Concentration Ratio
The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).

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Firm Size
Market power isnt necessarily associated with firm size. A small firm could possess a lot of power in a relatively small market.

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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.

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Oligopoly Behavior
Market structure affects market behavior and outcomes. Assume that the computer market has three oligopolists.

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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.

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Initial Conditions in Computer Market

Price (per computer)

$1000 Market demand

Industry output

20,000 Quantity Demanded (computers per month)

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Initial Market Shares of Microcomputer Producers

Producer Universal Electronics World Computers International Semiconductor Total industry output Output 8,000 6,500 5,500 20,000 Market Share 40.0% 32.5% 27.5% 100.0%

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The Battle for Market Shares

In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms.

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Increased Sales at the Prevailing Market Price

Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists.

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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.

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Retaliation
Oligopolists respond to aggressive marketing by competitors.
Step up marketing efforts. Cut prices on their product(s).

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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.

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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.

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Rivalry for Market Shares

Price (per computer)

$1000 900

F G

Market demand

20,000

25,000

Quantity Demanded (computers per month)

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The Kinked Demand Curve

Close interdependence and the limitations it imposes on price and output decisions is a characteristic of oligopoly.

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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.

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Rivals Response to Price Increases

Rival oligopolists may not match price increases in order to gain market share.

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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.

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The Kinked Demand Curve Confronting an Oligopolist

PRICE (per computer) Demand curve facing oligopolist if rivals match price changes $1100 1000 900

M A D C

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

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

8000 QUANTITY DEMANDED (computers per month)

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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.

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Game Theory
Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.

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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.

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The Payoff Matrix

The payoff to an oligopolists price cut depends on how its rivals respond.

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The Payoff Matrix

The decision to initiate a price cut requires a risk assessment.
Expected ! Probability of v Size of loss value rivals matching from price cuts Probability of Gain from lone  v rivals not matching price cut

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Oligopoly Payoff Matrix

Rivals Actions Universals Options Reduce price Reduce Price Small loss for everyone Huge loss for Universal; rivals gain Dont Reduce Price Huge gain for Universal; rivals lose No change

Dont reduce price

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Oligopoly vs. Competition

Oligopolists may try to coordinate their behavior in a way that maximizes industry profits.

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Price and Output

An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit.

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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.

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Maximizing Oligopoly Profits

Price or Cost (dollars per unit) Industry marginal cost Profitmaximizing price Average cost at profitmaximizing output Industry average cost Market demand

Profits J

Industry marginal revenue

Profit-maximizing output 0
Quantity (units per period)

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Sticky Prices
Prices in oligopoly industries tend to be stable. Like all producers, oligopolists want to maximize profits by producing where MR = MC.

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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.

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Sticky Prices
As a result, modest shifts of the cost curve will have no impact on the production decision of an oligopolists.

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An Oligopolists Marginal Revenue Curve

Price (dollars per computer) S A F
The MR gap The kink in the demand curve

d1 G mr2 mr1

d2

8000 H Quantity Demanded (computers per month)

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The Cost Cushion

Price or Cost (dollars per unit) Marginal revenue MC2 MC1 MC3

Quantity (units per period)

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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.

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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.

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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.

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Examples of Price Fixing

Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators. They were charged again in 1972 for continued price fixing.

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Examples of Price Fixing

School Milk Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states.

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Examples of Price Fixing

Vitamins Seven firms from four nations were accused of fixing global prices on bulk vitamins from 1990 - 1998.

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Examples of Price Fixing

Baby Formula Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula.

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Examples of Price Fixing

Cola The Coca-Cola Bottling Co. of North Carolina agreed to pay a fine and give consumers discount coupons to settle charges of conspiring to fix soft-drink prices from 1982 to 1985.

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Examples of Price Fixing

Music CDs In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the Three Tenors CD.

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Examples of Price Fixing

Laser Eye Surgery The FTC charged VISX and Summit Technology with pricefixing that raised the price of surgery by $500 per eye.

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Examples of Price Fixing

Memory chips In 2004, prosecutors claimed the worlds largest memory-chip (DRAM) makers (Samsung, Micron, and Infineon) fixed prices in the $16 billion-ayear market.

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Price Leadership
Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry.

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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.

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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.

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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.

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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.

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Distribution Control
The control of distribution outlets can be accomplished through selective discounts, long-term supply contracts, or expensive gifts at Christmas.

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Mergers and Acquisition

A firm can limit competition by acquiring competitors through mergers and acquisition.

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Government Regulation
Patents are issued by the federal government. Licensing requirements imposed by government limit competition.

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Nonprice Competition
Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market.

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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.

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Network Economies
The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.

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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.

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Industry Behavior
Antitrust law is government intervention designed to alter market structure or prevent abuse of market power.

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Industry Behavior
There are several problems with the behavioral approach to antitrust law:
Limited government resources. Public apathy. Difficulty of proving collusion.

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Industry Structure
Public efforts to alter market structure have been less frequent than efforts to alter market behavior.

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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.

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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.

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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 2 n 2

share of + share of + y y y share of HHI = firm 1 firm 2 firm n

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The Herfindahl-Hirshman Index

For policy purposes, the Justice Department decided it would draw the line at a value of 1,800.

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Contestability
If entry barriers were low enough, even a highly concentrated industry might be compelled to behave more competitively.

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Behavioral Guidelines: Cost Savings

The FTC now also looks to see if a proposed merger will allow for greater efficiencies and lower costs.

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Oligopoly

End of Chapter 10

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