Oligopoly

Chapter 10

In This Chapter…

10.1. Revisit Market Structure and Market Power

• What determines how much market power a firm has?

10.2. Profit Maximization Under Oligopoly (Kinked Demand Curve and Sticky Prices)

• How do firms set prices and outputs?

10.3. Coordination, Problems and the Government• What problems oligopolists have in

maintaining price and output levels?

10.1. Revisiting Market Structure

and Market Power

Market Structure and Market PowerWe 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.

Most firms possess some market power.

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.

Degrees of Power

Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service.

Examples:– Sports Shoes– Cereals Producer– Auto Manufacturers

Characteristics of Market Structures

Market Structure

CharacteristicsPerfect

CompetitionMonopolisticCompetition Oligopoly

Number of firms Very largenumber

Many Few

Barriers to entry None Low High

Market power(control over price

None Some Substantial

Type of product Standardized Differentiated Standardizedordifferentiated

Characteristics of Market Structures

Market Structure

CharacteristicsPerfect

Competition Duopoly Monopoly

Number of firms Very largenumber

Two One

Barriers to entry None High High

Market power(control over price

None Substantial Substantial

Type of product Standardized Standardizedordifferentiated

UniqueUnique

One

Determinants of Market Power

Market power of a firm is a function of:

• The Number of producers• The Size of each firm• The Barriers to entry• The Availability of substitute goods

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.

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.

Measuring Market Power

The standard measure of market power is the concentration ratio.

It relates the size of firms to the size of the market. – What proportion of the market supply is

concentrated in the hands a few firms?

Concentration RatioConcentration Ratio:

– is the proportion of total industry output produced by the largest firms (usually the four largest).

•Market power isn’t necessarily associated with firm size.

•….because a small firm could possess a lot of power in a relatively small market.

The Herfindahl-Hirshman Index

The Herfindahl-Hirshman Index (HHI):

is a measure of the concentration of market only on some of the firms in the market.

equals the sum of the squares of the market shares of each firm in an industry.

The Herfindahl-Hirshman Index

HHI:

Measurement Problems

HHI doesn’t tell it all

Concentration ratios do not convey the extent to which market power may be concentrated in a local market.

That is, many smaller firms acting in unison can achieve market power.

Summary Note

Oligopoly is a market in which a few firms supply significant amount of the market supply

…and thus can have market power ( the ability to alter prices/outputs) to maximize profits

10.2: Profit Maximization Under Oligopoly (Price and Output Decisions under Oligopoly)

Kinked Demand Curve and

Sticky Prices

Oligopoly Behavior

Like all other markets, under Oligopoly as well, the Profit Maximizing Output is the level of output at which MR=MC

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Quantity (units per period)0

Maximizing Oligopoly Profits

MC ATC

Marketdemand

MarginalRevenue

Profits

J

Profit-Max. price

ATCat profit-

Max. Q

Profit-max Q

Oligopoly BehaviorHowever, market structure affects market

behavior (strategic actions) and outcomes (Profit and Utility Max).

As there are only a few firms in the market, Oligopolies Might

•Cut/raise prices even if it is not warranted by Costs of production

•Not respond to changes in Costs of Production

Oligopoly Behavior

Assume that the computer market has three oligopolists:

– Universal Electronics – World Computers – International Semiconductor

Initial Conditions in Computer Market

20,0000

$1000

Market demand

Quantity Demanded (computers per month)

Pri

ce (

per

com

pu

ter)

Industry output

Initial Equilibrium

Market share - The percentage of total market output produced by a single firm.

Consider that the data in the following table describes each firms market share

Initial Market Shares of Microcomputer Producers

Producer Output Market Share

1. Universal Electronics 8,000 40.0%

2. World Computers 6,500 32.5%

3. International Semiconductor

5,500 27.5%

Total industry output 20,000 100.0%

Pri

ce o

r C

ost

(dolla

rs p

er

unit

)

Quantity (units per period)0

Maximizing Oligopoly Profits

Industrymarginal

cost

Industry average

cost

Marketdemand

Industry marginalrevenue

Profits

J

Profit-maximizing

price

Average costat profit-

maximizingoutput

Profit-maximizing output

Battle for Market Shares

Given the above graph:– Will the profit be equally shared among

the three markets?

– If so, which producer will have higher share of the profit?

– What would those with the lower profit share do?

– How?

Increased Sales at Reduced Prices

It is possible that lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors.

There is no way that a firm can do so without causing alarms to go off in the industry.– There are few firms in the market, and

they closely follow each other’s action

Increased Sales at Reduced Prices

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

…because increase in the market share of one oligopolist necessarily reduces the shares of the remaining oligopolists

Retaliation

Oligopolists respond to aggressive marketing by competitors by either of the following methods.

1. Non-Price Competition– Step up marketing efforts

2. Price Competition– Cut prices on their product(s).

Retaliation—Non-Price

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.

– This Could be Virtual (Artificial) or Real

Retaliation-Prices

Price War

However, an attempt by one oligopolist to increase its market share by cutting prices may lead to a general reduction in the market price….

!• This is why oligopolists always want to avoid price competition and thus pursue

nonprice competition.

Rivals’ Response to Price Reductions/IncreasesA typical characteristic of oligopoly is thus

the presence of close interdependence in the activities and decisions of firms in the market.

The presence of such close interdependence imposes limitations on price and output decisions of Oligopoly firms

Rivals’ Response to Price Reductions/Increases

The degree to which sales increase when the price is reduced by one Oligopolist thus depend on the response of the rival oligopolists.

We expect Oligopolists to match any price reductions by the rival oligopolist.

However, rival Oligopolists may not match a price increase ….why?– …..in order to gain market share.

The Kinked Demand Curve Confronting an Oligopolist

The shape of the demand curve facing an oligopolist thus 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.

Pri

ce o

r C

ost

(dolla

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er

unit

)

Quantity (units per period)0

Recall:The Starting Point

Industrymarginal

cost

Industry average

cost

Marketdemand

Industry marginalrevenue

Profits

J

Profit-maximizing

price

Average costat profit-

maximizingoutput

Profit-maximizing output

1000

PR

ICE (

per

com

pute

r)

QUANTITY DEMANDED (computers per month)0

The Demand Curve Confronting an Oligopolist….

Demand curve facing oligopolist if rivals match price changes

Demand curvefacing oligopolist ifrivals don't matchprice changes

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

MA

CD

B$1100

900

8000

1000

PR

ICE

(pe

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QUANTITY DEMANDED (computers per month)0

The Kinked Demand Curve Confronting an Oligopolist

Kinked Demand Curve

B

8000

Game Theory Oligopoly Price and Output Decisions are thus strategic!

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

Each oligopolist considers the potential responses of rivals when formulating price or output strategies.

The payoff to an oligopolist’s price cut/increase depends on how its rivals respond.

The Payoff Matrix

The decision to initiate a price cut requires a risk assessment.

cutsprice from loss ofSize

matchingrivals of Probability

valueExpected

cutprice lonefrom Gain

matching notrivals of Probability

Oligopoly Payoff Matrix

Rivals’ Actions

Universal’s Options Reduce Price Don’t Reduce Price

Reduce price Small loss for everyone

Huge gain for Universal; rivals lose

Don’t reduce price Huge loss for Universal; rivals gain

No change

Oligopoly vs. Competition

Thus oligopolists would want to coordinate their behavior in a way that maximizes industry profits.

– There is a Motive for Coordination

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

Price and Output To maximize industry profit, the firms in

an oligopoly must agree:

1. on a monopoly price and maintain it,2. by limiting production and allocating

market shares.

• Cartel:• is a group of firms with an explicit

agreement to fix prices and output shares in a particular market.

• Example: OPEC

Sticky Prices

Prices in oligopoly industries tend to be stable.

Like all producers, oligopolists want to maximize profits by producing where MR = MC.

Sticky Prices

The kinked demand curve is really a composite of two separate demand curves.

• Creates a gap in an oligopolist’s marginal revenue (MR) curve.

– Marginal revenue – The change in total revenue that results from a one-unit increase in the quantity sold.

Sticky Prices

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

An Oligopolist’s Marginal Revenue Curve

A

G

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S

0 8000

Pri

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dolla

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com

pu

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Quantity Demanded (computers per month)

mr2 mr1

d1

F

The kink in the demand curve

The MR gap

The Cost CushionPri

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ost

(d

olla

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un

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MC2

MC1

MC3

Marginal revenue

0Quantity (units per period)

10.3. Coordination, Problems and the Government

– What problems oligopolists have in maintaining price and output levels?

Some Problems

There is an inherent conflict in the joint and individual interests of oligopolists.

– Each oligopolist wants the industry profits to be maximized.

– Each oligopolist also wants to maximize it’s own market share.

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.

Price Fixing---Collusion

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.

Such an action is however, illegal (stifling competition)

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.

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.

Examples of Price Fixing

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

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.

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.

Examples of Price FixingMusic CDs – In 2001, the FTC charged AOL-

Time Warner and Universal Music with fixing prices on the “Three Tenors” CD.

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

Memory chips – In 2004, prosecutors claimed the world’s largest memory-chip (DRAM) makers (Samsung, Micron, and Infineon) fixed prices in the $16 billion-a-year market

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.

Price Leadership

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

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.

The Role of the Government

Antitrust Enforcement

Market failure is an imperfection in the market mechanism that prevents optimal outcomes.

Market power contributes to market failure when it leads to resource misallocations or greater inequity.

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

Industry Behavior

There are several problems with the behavioral approach to antitrust law:

– Limited government resources.– Public apathy.– Difficulty of proving collusion.

Industry Structure

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

Objections to Antitrust

Some argue that we shouldn’t punish those who achieved monopolies through hard work and innovation.

Noncompetitive behavior, not industry structure, should be the only concern of antitrust.

The Herfindahl-Hirshman Index

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

Contestability

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

Behavioral Guidelines: Cost SavingsThe FTC now also looks to see if a proposed

merger will allow for greater efficiencies and lower costs.