Oligopoly Behavior
Oligopoly
  • A market in which a few firms produce all or most of the market supply of a particular good or service.
How Do We Know When an Oligopoly Exists?
  • by measuring market power
  • we use the Concentration Ratio - the proportion of total industry output produced by the largest firms (usually the four largest).
  • the concentration ratio is a measure of market power that relates the size of firms to the size of the market. 
  • Important Note:  market power is not necessarily associated with firm size – in other words, a small firm could possess a lot of power in a relatively small market.
  • potential measurement problems:
    • a high ratio or large firm size is not the only way to achieve market power.  Many smaller firms acting in unison can achieve the same result.
    • measurements do not convey the extent to which market power may be concentrated in a local market.
Oligopoly Behavior
  • Market structure affects market behavior and outcomes.
  • The Battle for Market Share
    1. Market share  - the percentage of total market output produced by a single firm
    2. In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms.
      • Increase Sales at the Prevailing Market Price - Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists.
      • Increased Sales at Reduced Prices – Increases in sales due to lowering the price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. However, there simply isn’t any way that a firm can do so without causing all the alarms to go off in the industry.
  • Retaliation
    1. Oligopolists respond to aggressive marketing by competitors by
      • Stepping up marketing efforts.
      • Cutting prices on their product(s).
    2. Price competition is typically self-defeating in an oligopoly
    3. An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price.
The Kinked Demand Curve 
  • Price Reductions
    • the degree to which sales increase when the price is reduced depends on the response of rival oligopolists.
    • we expect oligopolists to match any price reductions by rival oligopolists.
  • Price Increases
    • rival oligopolists may not match price increases in an attempt to gain market share.
    • the shape of the demand curve facing an oligopolist depends on the responses of its rivals 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.
The Herfindahl-Hirschman Index
  • The Herfindahl-Hirschman Index (HHI) is a measure of industry concentration that accounts for number of firms and size of each.
  • HHI of market concentration  =  the sum of the squares of the market shares of each firm in an industry.
  • For policy purposes, the Justice Department decided it would draw the line at a value of 1,800.
Game Theory
  • Game theory is the study of decision-making in situations where strategic interaction (moves and countermoves) between rivals occurs.
  • each oligopolist has to consider the potential responses of rivals when formulating price or output strategies.
    1. the strategic option each oligopolist confronts are summarized in Table 25.4
    2. the payoff to an oligopolist’s price cut depends on how its rivals respond.
    3. if a firm does not reduce its price, it cannot increase profits.
    4. the collective interests of the oligopoly are protected if no one cuts the market     price, but an individual oligopolist could lose if it holds the line on price when     rivals reduce price.
    5. risk assessment is the foundation of game theory
Oligopoly vs. Competition
  • Price and Output
    • an oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit.
  • Sticky Prices
    • prices in oligopoly industries tend to be stable.
    • oligopolists want to maximize profits by producing where   MR = MC
    • the kinked demand curve is really a composite of two separate demand curves.
    • there is a gap in an oligopolist’s marginal revenue curve.
    • consequently, modest shifts of the cost curve will have no impact on the production decision of an oligopolist.
Coordination Problems
  • There is an inherent conflict in the joint and individual interests of oligopolists.  The two goals that conflict are:
    1. Each oligopolist wants the industry profits to be maximized.
    2. Each oligopolist wants to maximize its own market share.  However, doing so can lower the industry’s profits as other oligopolists match price cuts designed to do just that.
  • Price Fixing.
    • Explicit agreements among producers regarding the price(s) at which a good is to be sold.
  • Price Leadership.
    • An oligopolistic pricing pattern that allows one firm to establish the (market) price for all firms in the industry.
  • Allocation of Market Shares.
    • when a monopolist raises his prices, he can adjust with a decrease in output.  However, when oligopolists raise their prices, they have to deal with how the loss of output will be distributed among them.
    • Cartel - a group of firms with an explicit agreement to fix prices and output shares in a particular market.
    • When market shares are not being divided in a manner satisfactory to an oligopolist, he may take drastic action such as predatory pricing.
      • this is temporary price reductions designed to alter market shares or drive out competition.
Barriers to Entry
  • To keep potential competitors out of their industry, oligopolists must maintain barriers to entry.  
  • WHY?  ==>  because above-normal profits cannot be maintained unless barriers to entry exist
    1. Patents – Prevent potential competitors from setting up shop until they either develop an alternative method for producing a product or receive permission from the patent holder to use the patented process.
    2. Distribution Control - A firm can provide a barrier to entry by taking control of the distribution outlets.
      • Visa and MasterCard prevent banks that issue their credit cards from offering rival cards.
      • Frito-Lay elbows out competing snacks by paying high fees to “rent” shelf space in grocery stores.
    3. Mergers and Acquisition
      • a firm can limit competition by acquiring competitors through mergers and acquisition.
    4. Government Regulation
      • Patents are issued by the federal government.
      • Licensing requirements imposed by government limit competition.
      • Barriers to international trade are another government-imposed barrier to entry.
      • Restrictions on the number of cabs licensed in a city is another form of government restriction to market entry.
    5. Nonprice Competition - Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market.
    6. Training - Early market entry can create an important barrier to later competition. Customers of training-intensive products (e.g. computer hardware and software) become familiar with a particular system.  To switch to a different product may entail significant cost.  This cost is a barrier to entry to any competing product trying to enter the market.
    7. Network Economies – the widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.  For example, software developers prefer to write Windows based programs rather than for rival operating systems.


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this page is maintained by Reed Fisher
last updated January 15, 2011