section 12: market structures module 58: introduction to oligopoly€¦ · •oligopoly acts like a...

Section 12: Market StructuresModule 64:

Introduction to Oligopoly

FOUR MARKET MODELS

Characteristics of Oligopolies:•A Few Large Producers (Less than 10)• Identical or Differentiated Products•High Barriers to Entry •Control Over Price (Price Maker)•Mutual Interdependence•Firms use Strategic Pricing

Examples: OPEC, Cereal Companies, Car Producers

Perfect

Competition

Pure

MonopolyMonopolistic

Competition Oligopoly

Interdependence

• Oligopoly is characterized by interdependence• Outcome (Profit) if each firm is in

relation to the actions of another

• Firms must observe and predict the actions of other firms in the market

Oligopolies occur when only a few large

firms start to control an industry.

High barriers to entry keep others from

entering.

Types of Barriers to Entry1. Economies of Scale

•Ex: The car industry is difficult to enter

because only large firms can make cars

at the lowest cost

2. High Start-up Costs

3. Ownership of Raw Materials

HOW DO OLIGOPOLIES OCCUR?

Duopoly

• All business will produce where MC=MR.• An Oligopoly really does not do

this

• To understand how they operate economists look at the concept of duopoly• Oligopoly consisting of two firms

Demand Schedule for Meat (Fixed Cost is 0)

• If this were Perfectly Competitive, each firm would produce as long as price was above marginal cost• Because fixed cost is 0, they will

produce all the way until total revenue hits zero

• Oligopoly acts like a Monopoly and will keep production lower to maximize profit• They would get involved in

collusion

Collusion/Cartel

• They will engage in collusion activity by cooperating to raise their joint profits• The strongest form of collusion is a

cartel

• They work together to limit output and increase price• Raising profit

• In this case, they will regulate the output to 60 million pounds• But…would they keep their word?

Collusion and Competition

• If they agree to make 60 million pounds, they will split it• 30 million and 30 million • This maximizes their combined efforts

but gives them both the incentive to cheat

• If one firm raises production, the market price lowers• It will make more profit while the

other loses profit

• If both raise production, the market price will lower• Both companies will lose profits

Non-cooperative behavior

• Firms may not act together but on their own in non-cooperating behavior• Based upon self-interest even though

it hurts everyone else

• Collusion is more profitable for all rather than non-cooperative behavior• They may sign a contract (usually

illegal in the U.S.)• Contract would keep prices high and

thus make the agreement illegal


Game Theory

Game theory helps predict human

behavior

THE ICE CREAM MAN SIMULATION1. You are a ice cream salesmen at the beach2. You have identical prices as another salesmen.3. Beachgoers will purchase from the closest

salesmen4. People are evenly distributed along the beach.5. Each morning the two firms pick locations on

the beach

Where is the best location?

Game Theory

An understanding of game theory helps firms in an oligopoly maximize profit.

The study of how people behave in strategic situations

Payoff Matrix

• When there are only two players, their interaction is displayed in a payoff matrix• Each row corresponds to an

action of each player

• Each column represents an action by the other party

Game Theory MatrixYou and your partner are competing firms. You

have one of two choices: Price High or Price Low.

Firm 2

Firm 1

Both High =

$20 Each

Both Low=

$10 each

High Low

High

LowHigh = 0

Low = $30

Low = $30

High = 0

Without talking, write down your choice

Game Theory Matrix

Notice that you have an incentive to collude but also an incentive to cheat on your agreement

Firm 2

Firm 1

Both High =

$20 Each

Both Low=

$10 each

High Low

High

LowHigh = 0

Low = $30

Low = $30

High = 0

Prisoner’s Dilemma

• Each player has the ability to choose themselves over the other party

• When both act this way, neither party benefits

The Prisoner’s DilemmaCharged with a crime, each

prisoner has one of two choices: Deny or Confess

Prisoner 2

Prisoner 1

Both Deny = 5

Years in jail each

Both Confess= 10

Years in jail each

Deny Confess

Deny

ConfessConfess = Free

Deny = 20 Years

Confess = Free

Deny =20 Years

Dominant Strategy

• An action that is the dominate strategy regardless of the other player• Works if you do not have the

ability to communicate with the other party

• It exists as the best alternative strategy

• Not all games have a dominant strategy• Depends of the payoffs in the

game

Dominant StrategyThe dominant strategy is the best move to make

regardless of what your opponent doesWhat is each firm’s dominate strategy?

Firm 2

Fir

m 1 $100, $50

High Low

High

Low

$60, $90

$50, $40 $20, $10

Firm #1-Dominant strategy is high since they should always go high: Same choice twice!!Firm #2- Doesn’t have a dominate strategy:

Different choices!!

Nash Equilibrium

• If both players confess, then they have reached an equilibrium of the game

• Non-cooperative equilibrium (Nash Equilibrium)• Each player in the game chooses the

action that maximizes their payoff given the actions of the other player

• They do not take the effect of their actions on others

• It is the equilibrium of two dominate strategies• It can exist when there is no

dominate strategy

Dominant StrategyNash Equilibrium- The optimal outcome that

will occur when both firms make decisions simultaneously and have no incentive to change

Firm 2

Fir

m 1 $100, $50

High Low

High

Low

$60, $90

$50, $40 $20, $10

The Nash Equilibrium- Firm 1 High, Firm 2 LowSince Firm 1 will always go high, Firm 2 will

decided to go low

What did we learn?1. Oligopolies must use strategic

pricing (they have to worry about the other guy)

2. Oligopolies have a tendency to collude to gain profit.(Collusion is the act of cooperating with

rivals in order to “rig” a situation)3. Collusion results in the incentive to

cheat.4. Firms make informed decisions

based on their dominant strategies

Strategic Behavior

• Not all games are a one-shot game

• Oligopolies will play many games over a period of time• What decision they make now will

affect a game in the future

• They use strategic behavior to play the game in the future

• This type of behavior can be looked at as a formal agreement to collude

Tit for Tat

• Involves playing cooperatively at first• Then follow what the other player

does

• Offers reward to the cooperative player

• Provides punishment for those who do not

Firm 2 makes $180 million profit each year


Firm 2 makes $200 million profit 1st year, $160 million profit each later year






Tit for Tat

Tit

for

Tat

Always Cheat

Alw

ays

Ch

eat

Firm 2

Firm

Tacit Collusion• Firms limit production and raise prices in a way to raise each other’s profit

• It is not a formal agreement

• It is an unspoken agreement between firms• Not technically illegal


Oligopoly in Practice

Tacit Collusion

• This is a common practice of modern oligopolies• Obviously because real collusion is

illegal

• Price are high, but never to the level of a monopoly• Coordinating these high prices is

very hard• Large numbers• Complex products and pricing• Differences in interests• Bargaining power of buyers

Large Numbers

• More firms in the oligopoly means less loss in the future• Fewer units are produced on

which to feel the price effect

• The more firms in the oligopoly the less incentive there is to behave

• More firms make it difficult to regulate the oligopoly and therefore lower the barrier to entry

Complex Products and Pricing Schemes

• In reality, oligopolists sell numerous products• Walmart sells over 100,000 items

• This makes it hard to monitor production and pricing• It is difficult to tell if a firm is

cheating on the tacit agreement

Differences in Interests

• In reality, splitting the market in half is not always an option• Many disagreements occur in the

perception of what is fair and what are the interests of each firm

• Older firms feel entitled compared to newer firms

• Newer firms have lower costs than older firms

Bargaining Power of Buyers

• Often oligopolists sell not to individual consumers, but to other large businesses• These businesses can bargain for

lower prices

• They can usually ask for a discount and go to a competitor if they don’t get one.

• These large firms will offer lower prices to consumers than small retailers because they can extract lower prices from their suppliers

Problems with Tacit Collusion

• Tacit collusion is often hard to achieve• Prices are usually lower than what

would be charged in a monopoly or if they truly colluded

• When it breaks down, an aggressive price competition begins• This is a price war• Price fall to their non-cooperative

level• Sellers try to put each other out of

businesses as punishment for breaking the collusion

Product Differentiation

• Oligopolists welcome extra market power by having slightly different products• It may alter what it produces or adds

extras• Advertising can be used to alter

people’s minds

• Often in tacit collusion, the firms will reach an agreement not to compete on price with differentiated products• Non-price competition does happen

Because firms are interdependent

There are 3 types of Oligopolies

1. Price Leadership (no graph)

2. Colluding Oligopoly

3. Non Colluding Oligopoly

#1. Price Leadership

Price Leadership

• Usually with differentiation, the largest firm will set the price of the product• They will announce their price and

others will follow suit

• This is called price leadership

Example: Small Town Gas Stations

To maximize profit what will they do?

OPEC does this with OIL

Price Leadership

•Collusion is ILLEGAL.

•Firms CANNOT set prices.

•Price leadership is a strategy used by

firms to coordinate prices without

outright collusion

General Process:

1. “Dominant firm” initiates a price change

2. Other firms follow the leader

Breakdowns in Price Leadership

•Temporary Price Wars may occur if

other firms don’t follow price

increases of dominant firm.

•Each firm tries to undercut each

other.

Example: Employee Pricing for Ford

Price Leadership

#2. Colluding Oligopolies

A cartel is a group of producers that

create an agreement to fix prices high.

1. Cartels set price and output at an

agreed upon level

2. Firms require identical or highly

similar demand and costs

3. Cartel must have a way to punish

cheaters

4. Together they act as a monopoly

Cartel = Colluding Oligopoly

Firms in a colluding oligopoly act as a

monopoly and share the profit

D

MCATC

Q

P

MR

#3. Non-Colluding Oligopolies

1. Match price-If one firm cuts it’s prices, then

the other firms follow suit causing inelastic

demand

2. Ignore change-If one firm raises prices,

others maintain same price causing elastic

demand

Kinked Demand Curve Model

If firms are NOT colluding they are likely to

react to competitor’s pricing in two ways:

The kinked demand curve model shows how

noncollusive firms are interdependent

D

Q

If this firm increases it’s price, other firms

will ignore it and keep prices the same

P

Pe

Qe

As the only firm with high prices, Qd for this firm

will decrease a lot

P1

Q1

D

Q

If this firm decreases it’s price, other firms

will match it and lower their prices

P

Pe

Qe

Since all firms have lower prices, Qd for this firm

will increase only a little

P2

Q2

P1

Q1

D

Q

Where is Marginal Revenue?

P

Pe

Q

MR has a vertical gap at the kink. The result is that

MC can move and Qe won’t change. Price is sticky.

MC

MR


Introduction to Monopolistic Competition

Characteristics of Monopolistic

Competition:

•Relatively Large Number of Sellers

•Differentiated Products

•Some control over price

•Easy Entry and Exit (Low Barriers)

•A lot of non-price competition

(Advertising)

Perfect

Competition

Pure



Pure



Monopolistic Competition• This market structure has many

features of a monopoly and perfect competition• Distinct products are like a

monopoly• Downward sloping demand curve

and some market power

• They face competition like perfect competition• The amount of product sold depends

on the prices and products sold by its competition

• Unlike an Oligopoly, the large number of firms will stop collusion

Monopolistic Qualities• Control over price of own good due

to differentiated product• D greater than MR • Plenty of Advertising• Not efficient

“Monopoly” + ”Competition”

Perfect Competition Qualities• Large number of smaller firms• Relatively easy entry and exit• Zero Economic Profit in Long-Run

since firms can enter

•Goods are NOT identical.•Firms seek to capture a piece of the

market by making unique goods.•Since these products have substitutes,

firms use NON-PRICE Competition. Examples of NON-PRICE Competition• Brand Names and Packaging• Product Attributes • Service• Location• Advertising (Two Goals)

1. Increase Demand2. Make demand more INELASTIC

Differentiated Products

Differentiated Products

http://www.myjourneytomillions.com/wp-content/uploads/2013/05/Product-matrix.jpg

http://www.myjourneytomillions.com/wp-content/uploads/2013/05/Product-matrix.jpg

D

MR

MCATC

Q

Monopolistic Competition is made up of

prices makers so MR is less than Demand

In the short-run, it is the same graph as a monopoly making profit

In the long-run, new firms will enter,

driving down the DEMAND for firms

already in the market.

P

Q1

P1

Monopolistic Competition Profit (Short-Run)

• In the short-run, it behaves like a monopoly• Downward sloping demand curve

and downward sloping marginal revenue

• To maximize profits, its sets marginal revenue to marginal cost• It sets prices and output just like a

monopoly

D

MR

MC

Q

P

Firms enter so demand falls until there is no

economic profit

ATC

Q1

P1

D

MR

MC

Q

P

Firms enter so demand falls until there is no

economic profit

ATC

QLR

PLR

Price and quantity falls and TR=TC

D

MR

MC

Q

P

LONG-RUN EQUILIBRIUM

ATC

QLR

PLR

Quantity where MR =MC up to Price = ATC

Why does DEMAND shift?When short-run profits are made…

• New firms enter.• New firms mean more close substitutes and

less market shares for each existing firm.• Demand for each firm falls.

When short-run losses are made…• Firms exit. • Result is less substitutes and more market

shares for remaining firms.• Demand for each firm rises.

D

MR

MC

ATC

Q

What happens when there is a loss?

In the long-run, firms will leave, driving

up the DEMAND for firms already in the

market.

P

Q1

P1

In the short-run, the graph is the same as a monopoly making a loss

Monopolistic Competition Loss (Short-Run)

• However positive profits are not guaranteed.

• If demand is too weak, or if costs are too high, losses could be incurred in the short run.

D

MR

MC

ATC

Q

Firms leave so demand increases until there

is no economic profit

P

Q1

P1

D

MR

MC

ATC

Q

Firms leave so demand increases until there

is no economic profit

P

QLR

PLR

Price and quantity increase and TR=TC

Are Monopolistically Competitive Firms Efficient?

D

MR

MC

Q

P

Long- Run Equilibrium

ATC

QLR

PLR

Not Allocatively Efficient because P MC

Not Productively Efficient because not producing at Minimum ATC

QSocially Optimal

D

MR

MC

Q

P

ATC

QLR

PLR

This firm also has EXCESS CAPACITY

QSocially Optimal


• Given current resources, the firm

can produce at the lowest costs

(minimum ATC) but they decide not

to.

• The gap between the minimum ATC

output and the profit maximizing

output.

• Not the amount underproduced

Excess Capacity

D

MR

MC

Q

P

ATC

QLR

PLR

The firm can produce at a lower cost but it holds back production to maximize profit

QProd Efficient

Excess

Capacity



Product Differentiation and Advertising

Differentiated Product

• Firms have some control over their selling price because they can differentiate• Distinguish their goods from other products in the market

• Firms profit by selling their differences

Nonprice Competition

• It is a way to attract customers through:• Style• Service• Location• but not a lower price

• 1. Characteristics of Goods

• 2. Location of Sale

• 3. Service Level

• 4. Advertising Image

• 5. Brand Names

section 12: market structures module 58: introduction to oligopoly€¦ · •oligopoly acts like a...

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