Unit 5: Monopoly, Monopolistic Competition,
and Oligopoly
Lecture #3, Oligopoly
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Oligopoly
• A few large producers
• Homogeneous or differentiated products
• Limited control over price
• Mutual interdependence
• Strategic behavior
• Collusion possible
• Entry barriers
• Mergers keep # of firms low
LO3
11-2
Measuring Oligopolies
• Four-firm Concentration Ratio
• % output shared by 4 largest firms
• 40% or more to be oligopoly
• Data shows about one-half of U.S.
manufacturing industries are oligopolies
• Cars
• Cereal
• Athletic shoes
LO3
11-3
Measuring Oligopolies
• Shortcomings of concentration ratios:
• Localized markets: ratios measure market share
for the entire U.S., but some industries can only
produce locally
• Inter-industry competition: some products are
produced in completely different industries, but
compete
• World trade: ratios can be inaccurate if there is a
lot of foreign competition (Toyota and Honda compete
in the same market as Ford and Chevy)
LO3
11-4
Measuring Oligopolies
• Herfindahl Index
• HI = ∑ (market sharen)2
• Solves the problem of one dominant
•
•
LO1
industry
Ranges from 0 to 10,000
The larger the index, the higher the market
power
11-5
High Concentration Industries
(1)
Industry
Primary copper
(2)
4-Firm
Concentration
Ratio
(3)
Herfindahl
Index
99
ND
(1)
Industry
(2)
4-Firm
Concentration
Ratio
(3)
Herfindahl
Index
Petrochemicals
85
2662
83
1901
Cane sugar refining
99
ND
Small arms
ammunition
Cigarettes
95
ND
Motor vehicles
81
2321
80
2515
Household laundry
equipment
93
ND
Men’s slacks and
jeans
Beer
91
ND
Aircraft
81
ND
Electric light bulbs
89
2582
Breakfast cereals
78
2521
78
2096
Glass containers
88
2582
Household vacuum
cleaners
Turbines and
generators
88
ND
Phosphate fertilizers
78
1853
Tires
77
1807
Electronic
computers
76
Alcohol distilleries
71
Household
refrigerators and
freezers
85
1986
Primary aluminum
85
ND
LO1
2662
1609
11-6
Oligopoly Pricing Strategy
• Game-Theory Model
• Used to measure pricing behavior of firms
• Profit potential from pricing is dependent upon
•
•
LO4
what the other firm does
Can be analyzed using a payoff matrix that
shows the profits that result from different
combinations of pricing strategies
Prisoners’ Dilemma is a great way to
remember!
11-7
Game Theory Overview
RareAir’s Price Strategy
LO4
High
Uptown’s Price Strategy
• 2 competitors
• 2 price
strategies
• Each strategy
has a payoff
matrix
• Greatest
combined
profit
• Independent
actions
stimulate a
response
A
$12
Low
B
$15
High
$12
C
$6
$6
D
$8
Low
$15
$8
11-8
Game Theory Overview
RareAir’s Price Strategy
LO4
High
Uptown’s Price Strategy
• Independently
lowered prices in
expectation of
greater profit
leads to worst
combined
outcome
• Eventually low
outcomes make
firms return to
higher prices.
A
$12
Low
B
$15
High
$12
C
$6
$6
D
$8
Low
$15
$8
11-9
Oligopoly Pricing Strategy
• Oligopolies display strategic pricing
behavior
• Mutual interdependence
• Collusion
• Incentive to cheat
• Prisoner’s dilemma
LO4
11-10
Game Theory: Economics of Cooperation
• Game theory is the study behavior in
situations of interdependence.
• Payoff (reward) depends on own actions
along with actions of other “players”
• Payoff Matrix illustrates the interdependence
LO5
11-11
Game Theory: Economics of Cooperation
• Prisoners’ Dilemma
• Each player has incentive to cheat
• If both players cheat, both are worse off
• Both are affected by the price and quantity
produced by the other
• Illustrates how cooperation is hard even when
both would be better off
LO5
11-12
Game Theory: Economics of Cooperation
• Effects of interdependence
• Dominant Strategy develops when it is the
•
•
LO5
player’s best action regardless of the other’s
Nash Equilibrium occurs when the strategies
of both players reinforce one another
Tacit Collusion results when firms limit
production and raise prices in a way that
raises each other’s profits without a formal
agreement
11-13
Game Theory: Closing Thoughts
• Price Leadership (one changes and the
other follows) develops
• Firms have a greater incentive to
cooperate in long-run situations
LO5
11-14
Three Pricing Models for Oligopolies
• Kinked Demand Curve
• Collusive Pricing
• Price Leadership
• Reasons for 3 models:
• Diversity of oligopolies
• Complications of interdependence
LO5
11-15
Kinked-Demand Theory
• Non-collusive oligopoly
• Uncertainty about reactions of rival
• Rivals match any price change
• Rivals ignore any price change
• Assume combined strategy
• Match price reductions
• Ignore price increases
LO5
11-16
Kinked Demand Curve
e
P0
f
D2
Rivals Match g
Price Decrease
0
LO5
Q0
MR1
Quantity
MR2
Price and Costs
Price
Rivals Ignore
Price Increase
MC1
D2
P0
e
MR2
f
MC2
g
D1
D1
0
Q0
MR1
Quantity
11-17
Kinked Demand Curve
• Criticisms of the model:
• Explains why prices are inflexible, but not how
the original price was determined
• Ignores how changes in the larger economy
may cause price changes
• Ex. Price wars result from continued lowering of
prices
LO6
11-18
Collusive Pricing
• Collusion allows firms to limit uncertainty
•
to maximize profits
Cartels form when a group of firms or
nations overtly collude
• Formally agreeing to the price (P)
• Sets output levels for members (Q)
• Ex. OPEC
• Covert collusion and cartels are illegal in
the United States
LO6
11-19
Collusive Pricing
Price and Costs
MC
P0
ATC
A0
MR=MC
Economic
Profit
Q0
LO6
D
MR
Quantity
11-20
Global Perspective
LO6
11-21
Obstacles to Collusion
•
•
•
•
•
•
LO6
Each firm bears different costs, making it hard to
agree on a price
The larger # of firms, the more difficult it is
There is still an incentive for firms to cheat
Recession in the economy leaves firms
scrambling for market share
New entrants could hurt profit, so oligopolists try
to block their entry
Anti-trust laws prohibit price-fixing
11-22
Price Leadership Model
• Price Leadership
• Dominant firm initiates price changes
• Other firms follow the leader
• Price changes are infrequent
• Problems
• Limit Pricing occurs when prices are
•
LO6
intentionally set low to limit short-run profit
and block entry of new firms
Possible price wars when “followers” lower
prices ahead of leaders
11-23
Why Advertise?
• It is non-price competition, so it is harder
•
•
•
LO7
than a price change for competitors to
duplicate
Desire for new products speeds up
technological progress and efficiency
Low-cost way of providing information to
consumers
Can help firms obtain economies of scale
11-24
Oligopoly and Advertising
The Largest U.S. Advertisers, 2008
Company
Advertising Spending
Millions of $
Procter & Gamble
$4831
Verizon
$3700
AT&T
$3073
General Motors
$2901
Johnson & Johnson
$2529
Unilever
$2423
Walt Disney
$2218
Time Warner
$2208
General Electric
$2019
Sears
$1865
Source: Advertising Age http://www.adage.com
LO7
11-25
Global Perspective
LO7
11-26
Oligopoly and Efficiency
• Oligopolies are also inefficient
• Productively inefficient P > minATC
• Allocatively inefficient P > MC
LO7
11-27