Oligopoly

For a Market to be Described as
Oligopolistic, it must satisfy the
following conditions:
– Few Sellers
– Mutual Interdependence
– The Firm’s products may be
identical or unique (Homogeneous
or Differentiated)
– The are Barriers to Entry (like
monopoly)
– non-price competition
Where Does Oligopoly
“fit in?”
Perfect Competition
Monopolistic
Competition
Monopoly
Oligopoly
Oligopoly Model


Oligopoly is a market in which a small
number of firms supply the entire
market and where natural barriers to
entry prevent other firms from entering
Examples: beer, breakfast cereals,
automobiles, long-distance telephones,
airplanes, database software,...
Concentration Ratios

One Way to Determine Whether a
Market is Oligopolistic is to look at a
Concentration Ratio

A Concentration Ratio Let’s Us
Know if the Whole Industry’s Sales
are Dominated by the Sales of a Few
Firms.
Oligopolies and Collusion
• Overt Collusion
OPEC Cartel
• Covert Collusion
Electrical Equipment
Price Fixing
• Tacit Collusion
• Price Leadership
Models of Oligopoly
No Standard Model due to...
Diversity
Interdependence
1 - Kinked Demand Curve
2 - Collusive Pricing
3 - Price Leadership
Kinked Demand Curve


Each Oligopolist believes that if it
raises its price, other firms will
keep their prices constant, so the
quantity demanded will fall by a
large amount (demand is elastic).
Each firm also believes that if it
cuts its price, other firms will cut
their prices too, so the quantity
demanded will rise by a small
amount (demand is inelastic).
Kinked Demand Curve
Effectively
creating
a kinked
demand
curve
This is an
attempt to
explain the
“sticky
prices” in
oligopoly
industries.
P
P
D2
D1
Quantity Q
The Kinked Demand
Curve Theory


The current
price is P
And at this
price, the firm
is selling the
quantity Q
P
The Kinked Demand
Curve Theory


The marginal
revenue curve
from “b” down.
The marginal
revenue curve
for a price
increase runs
from “a” up.
The Kinked Demand
Curve Theory
• Between a and b,
there is no marginal
revenue curve
• Cost can increase
considerably without
causing the firm to
increase price.
• So long as the MC
curve passes through
the break in the MR
curve, the firms keeps
its price and quantity
constant.
The Kinked Demand
Curve Theory

Summary:
– The demand curve has a kink at the
current price
– The marginal revenue curve is
discontinuous
– Price is sticky and remains at the kink
point unless a large enough change in
marginal cost occurs
– The elasticity of demand indicates a
decrease in TR for any price change.
Cartels and Collusion
Oligopoly is conducive to collusion
If a few firms face identical or
highly similar demand and costs...
They will seek joint profit
maximization...
Collusive Pricing Model




The Cartel Model:
The Oligopolists Get Together (Since
There are So Few of Them) and Act
As If They Were One Monopolist.
Collectively Produce the Monopolistic
Quantity (establish quotas) - Thus
Maximizing Profit as a group.
Example: OPEC
Cartel Model
Collusive agreement --a cartel--is
an agreement between two (or more)
producers to restrict output in order
to raise prices and make bigger
profits (act like a monopoly).
 Strategies for a firm in a cartel

– comply with the agreement
– cheat on the agreement
Problems With Cartels
10 sellers produce oils 150
barrels/day (Total 1,500 b/day)
 If each firm is in perfect
competitive market
 Each firm will get normal profit
 But if they decide to collude as
one monopoly such as OPEC

Maximizing OPEC Profits
Market
Single producer
$
$
MC
MC
AC
2
0
20
MR
D = AR
MR
Q
1,500
Q
Oil (Barrels/Day)
150
Firm
Oil (Barrels/Day)
Maximizing OPEC Profits
Single
If oneproducer
seller cheats
Market
$
$
MC
MC
AC
30
30
22
2
0
a
b
20
MR
D = AR
MR
1,000
Q
1,500 1,800
Q
150
Qcheater
Qquota =100Firm
Oil (Barrels/Day)
= 180
Oil (Barrels/Day)
Problems With Cartels
Generally, They Are Not Legal
(Price Fixing)
 They Are Difficult to Organize
and Monitor
 Can’t Force New Firms to Join
 Usually there is Cheating

The Incentive to Cheat
On A Cartel




If the Cartel Maintains the Monopoly Price,
The Individual Member of the Cartel Can
Act Like a Price Taker (They Can Sell the
Quota amount at the Market Price)
As a Price Taker, They Maximize Profit
Where MC = MR.
This Quantity is Greater Than the Cartel
Wants the Individual Firm to Produce.
All Firms in the Cartel Do This and the
Cartel Falls Apart
Obstacles to Collusion
• Demand & Cost Differences
• Number of Firms
• Cheating
• Recession
• Potential Entry (or new)Entry
• Legal Obstacles: Antitrust
Dominant Firm Price Leadership




One dominant firm (largest or lowest
cost) and several other rival firms
Dominant firm determines price to
maximize profit
Other firms take price and sell what
they can at that price.
All firms watch output to prevent
excess supply and the need to reduce
price.
Dominant Firm Oligopoly
A dominant firm oligopoly may exist
if one firm:
– Has a big cost advantage over the other
firms.
– Sells a large part of the industry output.
– Sets the market price.
• Other firms are price takers.
Dominant Firm Oligopoly
Let’s use Big-G as an example.
Big-G is the dominant
gas station in a city.
Price (dollars per gallon)
Dominant
Firm
Oligopoly
Ten small firms and market demand
Big-G’s price and output decision
S10
1.50
1.00
MC
1.50
a
b
1.00
a
b
D
0.50
0.50
XD
MR
0
10
20
Quantity (thous. of gal./week)
0
10
20
Quantity (thous. of gal./week)
G
A
M
E
T
H
O
E
R
Y
GAME THEORY AND THE
ECONOMICS OF
COOPERATION


Game theory is the study of how
people behave in strategic
situations.
Strategic decisions are those in
which each person, in deciding what
actions to take, must consider how
others might respond to that action.
GAME THEORY AND
THE ECONOMICS OF
COOPERATION


Because the number of firms in an
oligopolistic market is small, each
firm must act strategically.
Each firm knows that its profit
depends not only on how much it
produces but also on how much the
other firms produce.
The Prisoners’ Dilemma


The prisoners’ dilemma provides
insight into the difficulty in
maintaining cooperation.
Often people (firms) fail to cooperate
with one another even when
cooperation would make them better
off.
The Prisoners’ Dilemma

The prisoners’ dilemma is a
particular “game” between two
captured prisoners that illustrates
why cooperation is difficult to
maintain even when it is mutually
beneficial.
The Prisoners’ Dilemma
Nisit’ s Decision
Confess
Nisit gets 8 years
Remain Silent
Nisit gets 20 years
Confess
Dom gets 8 years
Dom’s
Decision
Nisit goes free
Dom goes free
Nisit
Remain
Silent
Dom gets 20 years
Dom gets 1 year
gets 1 year
Oligopolies as a
Prisoners’ Dilemma


The dominant strategy is the best
strategy for a player to follow
regardless of the strategies chosen
by the other players.
Cooperation is difficult to maintain,
because cooperation is not in the
best interest of the individual player.
Figure shows Warm Up and
Monkey Club play Oligopoly
Game
Warm Up
350 person
300 person
WU gets $1,600 profit
WU gets $1,500 profit
350 person
Monkey ‘s
Club
MKC gets $1,600 profit
WU gets $2,000 profit
MKC gets $2,000 profit
WU gets $1,800 profit
300 person
MKC gets $1,500 profit
MKC gets $1,800 profit