Oligopoly

Oligopoly: Competition has a
face and a name.
Small number of firms that make
output and price decisions taking into
consideration the competitor’s
reactions.

© 2000, 20001Claudia Garcia-Szekely

Characteristics
Few firms each large enough to
influence market price
Products may be differentiated or
homogeneous
The behavior of each firm depends on
the behavior of the others
Entry barriers exit
© 2000, 20001 Claudia Garcia-Szekely

Examples of Oligopolies
Tennis Balls: Wilson, Penn, Dunlop and
Spalding.
Cars: GM, Ford, DaimlerChrysler
Cereal: Quaker, Ralston Food, Kellogg, Post
and General Mills.
Airlines: American and Delta with US
Airways, Northwest and TWA struggling
along.
Aircraft: Boeing (+McDonnell Douglas) and
Lockheed Martin

OPEC
The Organization of Petroleum Exporting Countries:
•Africa (Algeria, Libya and Nigeria)
•Asia (Indonesia)
•Middle East (Iran, Iraq, Kuwait, Qatar, Saudi Arabia and the United
Arab Emirates)
•Latin America (Venezuela). 20001 Claudia Garcia-Szekely
© 2000,

It is the “fewness” that
distinguishes Oligopoly

But how many firms is “a few firms”?


Measures of Concentration
Four Firm Concentration Ratio
Sum of market shares of the four largest
firms in the industry.
The Herfindahl-Hirschman Index (HHI)
The Sum of the squares of the market
shares of all the firms in the industry.


The weight assigned
Firm Market
to the largest firm is
An Example Share
twice that of the next
largest firm 50%
A
Four Firm Concentration B 25%
Ratio: 84.
C 5%
50 + 25 + 5 + 4 = The weight
HHI :3,230 D assigned to the
4%
largest firm is four
2 2 2 2
50 + 25 + 5 + 5(4 ) = Etimes that 4%the
of
next largest firm
2,500 + 625 + 25 + 5(16) F 4%

The HHI index reflects more G 4%
accurately the true distribution of
H 4%
power in the industry. © 2000, 20001 Claudia Garcia-Szekely

Herfindahl-Hirschman Index (HHI)
The largest index for a monopoly:
2
Market share = 100% 100 = 10,000
For an industry with 2 firms:
2
Market share = 50% /each 2(50 )=5,000
For a competitive industry with 10,000 firms:
Market share = 1/10,000 = 0.01%
2
10,000(0.01 )= 1

The More Concentrated the
Industry,

The larger the Herfindahl-Hirschman
Index (HHI)


Percentage of 1992
Value of Shipments
Industry Largest 4 HHI
Medicinal 76 % 3,000
Chemicals
Cars 84 % 2,676

The Larger the HHI Index
The larger market share
concentrated in a few
Breakfast Cereal 85 % 2,253
Cigarettes 93 % ?
firms

Men/Boy Shirts 28 % 315
Ice Cream 24 % 293

Profit Maximization under
Oligopoly
Much is uncertain: there is NO Single model
for Profit Maximization…
An oligopoly's plan is a contingency or
strategic plan:
As in chess: I plan my strategy based on what I
believe my opponent will do in response to my
moves.
Strategic interactions have a variety of
potential outcomes rather than a single
outcome.

Oligopoly Decision Making

Look for the “winning strategy”:
A set of steps to take, contingent on
the competitor’s behavior.


Two Alternative Oligopoly Models

The Collusion Model (Cartel)
The group behaves as ONE monopoly
The Kinked Demand Model


The Collusion Model: “Let’s Agree
to Behave like a Monopolist”

Firms act together like a monopolist
Restrict output to maximize profit
Assign output quotas to member firms
All firms agree to charge one price.


Illegal but done nonetheless…
Explicit Price Collusion
OPEC

Implicit Price Collusion: Firms just
happen to charge the same price but
did not meet to discuss it.
Airlines, Steel.


The Collusion Model
Suppose there are only two firms
Producing identical products
Face identical demand
Have identical cost structures


The Sum of the Firms’ Demand =
Market Demand Each Firm’s Demand
One= Half Market
Firm’s
DemandDemand

P0

Market Demand

1000 2000

The Sum of the Firms’ Demand =
Market Demand
Sum of demand lines for both firms = Market Demand
The Sum of the MR lines for both firms = deach firm

dA+ dB = Market
Market Demand
Demand
deach firm = MRA+B
deach firm

mreach firm © 2000, 20001 Claudia Garcia-Szekely

Collusion: Agree to behave as
One Monopolist
Together these two firms will sell Qo
each firm selling half.
Po MC

D
MR
Qo © 2000, 20001 Claudia Garcia-Szekely

Oligopoly Collusion Solution is
Inefficient The efficient solution is the perfectly
competitive Price and Output
combination (Ppc, Qpc)
MC
Po
Oligopolies restrict
Ppc output and charge higher
prices (Po, Q o)

D
MR
Qo Qpc © 2000, 20001 Claudia Garcia-Szekely

When firms coordinate their
activities they form a Cartel
Enforcement of Cartel agreements is
difficult for two reasons:
1. Antitrust Laws make collusive
agreements illegal
2. There is a strong incentive to
cheat.© 2000, 20001Claudia Garcia-Szekely

The Incentive to Cheat the Aggreement
MC = 10 Profit Maximizing OutputEach firm at: MC = MR
for Cartel
Q P TR
sellstr units MR
30
0 120 0 0
10 110 1100
and charges 110
550
20 100 2000 Price = $60 90
1000
30 90 2700 1350 70
40 80 3200 1600 50
50 70 3500 1750 30
60 60 3600 1800 10
70 50 3500 1750 -10
80 40 3200 1600 -30
90 30 2700 1350 -50
100 20 2000 1000 -70
110 10 1100 550 -90
120 0 0 0 -110

Each firm should produce 30
units
Total sold = 60 units
Price =$60
Firm’s Total Revenue = $3600/2 =
1,800

If each firm sells
To maximize Profit, both firms will
If one firm sells 30
and the other
30 units, revenue
Total revenues for
for each firm =
cheat.the cheating firm
“cheats” selling 40, for
Total revenues
total units for sale =
the cheated firm
1800
would be 50 x 30 =
Q P Firm A Firm B can sell TR for Firm B
70 and the price will =
would be 50 x 40 1,500
0 120
2,000 30
be $50
10 110 30
20 100 30
30 90 30
40 80 30 10 800
50 70 30 20 1400
60 60 30 30 1800
70 50 30 40 2000
80 40 30 50 2000
90 firm 30
Each can 30 60 1800
increase profits by
100 20 30 70 1400
producing more than
110 10 30 80 800
120 agreed. 0 30 90 0

Both firms will bring 40 units
for sale
Total Sold = 80 units
Price = $40
Firm’s Total Revenue =
$3200/2=1,600

Decision Making in Oligopoly
Each firm must take into account the
other firm’s actions and reactions.
There is uncertainty about what the
competitor will do.

Strategic Decisions Under Uncertainty

Game Theory: a tool developed to analyze strategic
decisions under uncertainty

To set up the oligopoly decision as a
game you need to:
Specify the number of players
firms
Strategies available to each player
Abide by the quota agreement or
Cheat the agreement
Payoffs to each player for each choice made
Revenues = 1,800 for both firms if they cooperate
Revenue Cheating Firm = 2,000
Revenue Cheated 20001 Claudia= 1,800
© 2000,
Firm Garcia-Szekely

Setting Up the Previous
Example as a Game.

We must first build a “payoff matrix”:
a table that contains the outcomes
under all possible scenarios.

Payoff Matrix Firm A’s Strategies
Produce 30 units Cheat (40 units)
40
P = 50
P = 60
50
Firm B’s Strategies

Produce A’s Profit = 1,800 30 A’s A sells = 2,000 B
If both firms sell If Profit 40, and
30 units (30 x $60 =Quantity = (40 x $50 = 2,000)
units, total 1,800) sells 30, total
B’s Profitprice = $60 B’s Profit = 1,500
60 and = 1,800 Quantity = 70 and
price = $50
(30 x $50 = 1,500)
Cheat (40 A’s Profit =30, and B A’sboth firms sell 40
If A sells 1,500 If Profit = 1,600
units) (30 x 40, total Quantity (40 x $40 = 1,600)
sells $50 = 1,500) units, total Quantity
= 70 and price = $50 = 80 and price = $40
B’s Profit = 2,000 B’s Profit = 1,600
(40 x $50 = 2,000)

Most Likely Outcome: Both Cheat
A’s Strategies
Produce 30 units Cheat
Best strategy
If A Sells 30 Units as
Produce If A Cheats1,800
A’s Profit = and sells A’s Profit = 2,000
agreed…
B’s Strategies

30 units If B Cheats and sells 40 units….
40 units,
B’s Profit = 1,800 B’s Profit strategy is
B’s best = 1,500
A’s best strategy is the one that the
B’s best strategy is brings the largest payoff.
the one that brings
one that brings the
the largest payoff.
Cheat A’s Profit =payoff.
largest 1,500 A’s Profit = 1,600
If B Sells 30 Units as agreed…
B’s Profit = 2,000 B’s Profit = 1,600
A’s best strategy is the one that brings the largest payoff.
Best strategy
Following their best self interest, both choose to cheat
Following their best self interest, both choose to cheat

The Kinked Demand Model
Developed to explain why prices in
oligopoly markets tended to be
inflexible.
Changes in costs were only rarely met by
changes in prices
When price changes did occur they were
large in magnitude.
This model explains why prices under monopoly tend to be “sticky”


The Kinked Demand Model of
Oligopoly
We assume that firms follow the following
strategy:
My competition will not increase
If I increase my price their price and I
would lose sales.

My competition will also decrease
If I decrease my price their price and I
would gain very few if any
additional sales.

The Kinked Demand Model Quantity
P1 demanded
If I increase my price drops by 20%
say by 10%, no one
follows and I lose P0
sales D0
Demand is more elastic above P0
Q1 Q0
If I decrease my price
by 10%, everyone Quantity
P0
follows and I gain demanded
little or nothing at all! increases 5%
P1 D0
Demand is less elastic below P0
© 2000, 20001 Claudia Garcia-Szekely Q0 Q1

Above P0 demand looks like this
Above P0 MR looks like this
Below P0 demand looks like this
Below P0 MR looks like this
P0
Ignore the lower part of D0
and MR
Ignore the upper part of D0
Note: this Kink in
demand, translates and MR
into a gap in the MR
line
D0
D0

Q0 MR
MR

The Kinked
Demand is more elastic
Demand Model
For prices above the P0
current price

Marginal Revenue is MR
flatter D
Demand is less elastic
For prices below the
current price

Marginal Revenue is
steeper
Q0
© 2000, 20001 Claudia Garcia-Szekely MR

Why are prices MC2

sticky under MC1
P2 MC0
oligopoly? P 1= P0

Price changes only
MR = MC
when MC shifts out
MR = MC1
D
of the MR gap
MR = MC0
If Costs increase
within the MR gap…
Price does not
change Q1 Q0
© 2000, 20001 Claudia Garcia-Szekely MR

Oligopoly

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