oligopoly and duopoly

OLIGOPOLY

GROUP NO. # 10

MEMBERS:Roll Nos.

Abhishek Verma 105

Abhishek Patil 085

Gauri Patil 091

Namrata Verma 065

Ravi Prakash Singh 090

Santosh Nair 084

Vikrant Gole 075

INDEX Introduction Examples of Oligopoly Characteristics of Oligopoly Determinants of Oligopoly Forms of Oligopoly Kinked Demand Curve Why Oligopoly exist? Game Theory Approach Dominant Strategy Prisoner’s Dilemma Price Leadership Strategy Price Discrimination Strategy Characteristics of different types of markets

INTRODUCTION The term ‘Oligopoly’ has been derived from two

Greek words: ‘Oligi’ which means few and ‘Polien’ means

sellers. Thus, Oligopoly is a competition among few big

sellers each of them selling either homogenous or heterogeneous products.

Oligopoly refers to a market situation where there are a few sellers(2-10), selling homogenous or differentiated products in a market.

Oligopoly is often describes as ‘Competition among few’.

INTRODUCTION

An oligopoly is a market dominated by a small number of strategically interdependent firms.

When just a few large firms dominate a market:Actions of each one have an important impact

on the others. In such a market, each firm recognizes its

strategic interdependence with others. When the products of a few sellers are

homogenous, it is known as ‘Pure Oligopoly’. When the products of a few sellers are

differentiated, but close substitutes of each other, it is known as ‘Differentiated Oligopoly’.

EXAMPLES OF OLIGOPOLY

Automobiles Cereals Steel Soup

CHARACTERISTICS OF OLIGOPOLY

Few Sellers An oligopoly market can be characterized by a few

sellers and their number is limited. (usually not more than 10)

Oligopoly is a special type of imperfect market. It has a large number of buyers but a few sellers.

Homogenous or Differentiated Product The Oligopolists produce either homogenous or

differentiated products. Products may be differentiated by way of design ,

trademark or service

CHARACTERISTICS OF OLIGOPOLY Interdependence The most important feature of Oligopoly is the

interdependence in decision making of the few firms which comprise the industry.

The reactions of the rival firms may be difficult to guess. Hence price is indeterminate under Oligopoly.

High Cross Elasticities The cross elasticity of demand for the products

of oligopoly firms is very high. Hence there is always the fear of retaliation by rivals.

Each firm is conscious about the possible action and reaction of competitors while making any change in price or output.

CHARACTERISTICS OF OLIGOPOLY

Competition Competition is unique in an oligopoly market. It

is a constant struggle against rivals. Uncertainty The interdependence of other firms for one’s own

decision creates an atmosphere of uncertainty about price and output

Price Rigidity In an oligopoly market each firm sticks to its own

price to avoid a possible price war. The price remains rigid because of constant

fear of retaliation from rivals.

Market Structure Continuum

PureCompetition

PureMonopoly

MonopolisticCompetition Oligopoly

Oligopoly:•A Few Large Producers•Homogeneous or Differentiated Products

•Control Over Price, But Mutual Interdependence

•Strategic Behavior•Entry Barriers

MARKET STRUCTURE

What determines if market is an Oligopoly?

The concentration ratio can be used as a guide

CONCENTRATION RATIO

Concentration ratios are measures of the total output that is produced in an industry by a given number of firms in the industry.

The most common concentration ratios are the CR4 and the CR8, which means the 4 and the 8 largest firms.

Two Common Ratios Four-Firm Concentration Ratio: It measures the

total market share of the 4 largest firms in an industry.

Eight-Firm Concentration Ratio: It measures the total market share of the 8 largest firms in an industry.

What concentration ratio constitutes an Oligopoly?

There is no magic number, but if a large percentage of the sales are from the 4 largest firms, it’s

an Oligopoly.

What is an example of a high concentration ratio?

In the Mobile Phone Industry the leading 4 constitutes 71% of

total sales.http://www.ft.com/cms/s/0/1c7540a4-d831-11dd-bcc0-000077b07658.html

What determines if market is an Oligopoly?

Herfindahl-Hirschman Index or HHI can also be used.

HERFINDAHL-HIRSCHMAN INDEX (HHI)

It is a measure of the size of firms in relation to the industry and an indicator of the amount of competition among them.

A measure of industry concentration, calculated as the sum of the squares of the market shares held by each firm in the industry.

Calculation of HHI HHI = s1

2 + s22 + …..sn

where Si = the ith firms market share,

n= number of firms in industry

HERFINDAHL-HIRSCHMAN INDEX(HHI)

Examples 1) For an industry with only 1 firm, (monopoly),

what would be the HHI?

2) Suppose the industry has 10 equal size firms, what is the HHI?

3) What if the industry has 100 equal size firms?

HERFINDAHL-HIRSCHMAN INDEX(HHI)

Answers 1) 10,000 2) 1000 3) 100

FORMS OF OLIGOPOLY

Oligopoly can be classified into several forms. Some of the important forms of Oligopoly are as follows:

Balanced & Unbalanced Oligopoly Balanced Oligopoly An oligopoly in which the sales of the leading

firms are distributed fairly evenly among them. Unbalanced Oligopoly An oligopoly in which the sales of the leading

firms are distributed unevenly among them.

FORMS OF OLIGOPOLY

Perfect and Imperfect Oligopolies If the product of the rival firm are

homogenous then it is Perfect Oligopoly, if the product are differentiated it is Imperfect Oligopoly.

Open and Closed Oligopolies If entry is open to new firms it is termed as

Open Oligopoly, and if entry is strictly restricted it is termed as Closed Oligopoly.

FORMS OF OLIGOPOLY

Collusive Oligopoly/Collusion The practice of firms to negotiate price and

market decisions that limit competition. Collusion may take place in the form of a common

agreement or an understanding between the firms.

FORMS OF OLIGOPOLY

Cartel One model of collusion that can be used is the

cartel model. A group of firms that collude to limit competition

in a market by negotiating and accepting agreed-upon price and market shares.

Internationally, some cartels like OPEC exist (public cartel).

http://www.opec.org Cartel is difficult to implement because: 1) Firms want to cheat (to increase profit) 2) Firms want to enter

FORMS OF OLIGOPOLY

Graphs showing Cartel

A CARTEL PICKS THE MONOPOLY PRICE

In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket.

• The firms also split the profit. The firms also split the profit. Each firm earnsEach firm earns$7,500 = [(400-300) x 150]/2.$7,500 = [(400-300) x 150]/2.

FORMS OF OLIGOPOLY

Duopoly Specific type of oligopoly where only two

producers exist in one market. In reality, this definition is generally used where

only two firms have dominant control over a market.

There are two principal duopoly models: Cournot Model: Two firms assume each

others output and treat this as a fixed amount, and produce in their own firm according to this.

Bertrand Model: Both firms assume that the other will not change prices in response to its price cuts. When both firms use this logic, they will reach a Nash Equilibrium.

FORMS OF OLIGOPOLY Nash Equilibrium An equilibrium in which each player takes the best

possible action given the action of the other player.

Set of strategies is in Nash equilibrium if, Holding strategies of all other players (firms)

constant, No player (firm) can obtain a higher payoff (profit)

by choosing a different strategy.

In Nash equilibrium, no firm changes its strategy because each firm is using its:

Best response.Strategy that maximizes its profit given its beliefs

about its rivals' strategies.

STACKELBERG’S MODEL OF OLIGOPOLY

Stackelberg model is an oligopoly model in which firms choose quantities sequentially.

One firm, a follower, takes the output of the other firm , a leader, and adjusts its output accordingly.

COMPETING DUOPOLISTS PICK A LOWER PRICE

When two firms compete against one another, they end up serving 100 passengers each, at a price of $350.

Each firm earns a profit of Each firm earns a profit of $5,000, compared to a $5,000, compared to a profit of $7,500 if they had profit of $7,500 if they had acted as one firm. acted as one firm.

DUOPOLY VERSUS CARTEL PRICING

• The duopoly produces more output and charges a lower The duopoly produces more output and charges a lower price than the cartel.price than the cartel.

THE KINKED DEMAND CURVE

• The The kinked demand modelkinked demand model is a model is a model under which firms in an oligopoly match under which firms in an oligopoly match price reductions by other firms but do not price reductions by other firms but do not match price increases by other firms.match price increases by other firms.

• Hence, each firm faces a “kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals quickly match price cuts.

D1

MR1Quantity

The firm’s demand andmarginal revenue curves

Pri

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THE KINKED DEMAND CURVE

MR2D1

D2

MR1Quantity

The rival’s demand andmarginal revenue curves

Pri

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THE KINKED DEMAND CURVE

MR2D1

D2

MR1Quantity

Pri

ce

Rivals tend tofollow a price cut

THE KINKED DEMAND CURVE

MR2D1

D2

MR1Quantity

Pri

ce

Rivals tend tofollow a price cut

or ignore aprice increase

THE KINKED DEMAND CURVE

MR2D1

D2

MR1Quantity

Effectively creatinga kinked demand curve

Pri

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THE KINKED DEMAND CURVE

D

Quantity

Effectively creatinga kinked demand curve

Pri

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THE KINKED DEMAND CURVE

D

MR1Quantity

Effectively creatinga kinked demand curve

Pri

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MC2

MC1

MR2

THE KINKED DEMAND CURVE

D

Quantity

Profit maximizationMR = MC occurs

at the kink.P

rice

MC2

MC1

MR2

MR1

THE KINKED DEMAND CURVE

THE KINKED DEMAND CURVE (EXAMPLE)

Increase price: the other firms will not change their prices and quantity will decrease by a large amount (elastic)

After the initial price of $6, the firm has two options:

Decrease priceDecrease price: the other : the other firms will decrease their firms will decrease their prices, so quantity will prices, so quantity will increase only by a small increase only by a small amount (amount (inelasticinelastic))

THE KINKED DEMAND CURVE (EXAMPLE)

The demand curve of the typical firm has a kink at the prevailing price. It is relatively flat for higher prices, and relatively steep for lower prices.

There is little evidence, however, that oligopolistic firms really act this way—that firms will not go along with a higher price but only match a lower price.

THE KINKED DEMAND CURVE (EXAMPLE)

•The demand curve of the The demand curve of the typical firm has a typical firm has a kink at the kink at the prevailing priceprevailing price. It is . It is relatively flat for higher relatively flat for higher prices, and relatively steep for prices, and relatively steep for lower priceslower prices..

•There is little evidence, There is little evidence, however, that oligopolistic firms however, that oligopolistic firms really act this way—that really act this way—that firms firms will not go along with a will not go along with a higher price but only match a higher price but only match a lower pricelower price..

Why do Oligopolies exist?

MergersEconomies of Scale

ReputationStrategic Barriers

Government Barriers

WHY DO OLIGOPOLY EXIST?

Mergers Oligopolistic firms perpetually balance

competition against cooperation. One way to pursue cooperation is through merger--legally combining two separate firms into a single firm.

Merger gives the resulting firm greater market control-by giving the emerging oligopolists more monopoly power.

They result in more economies of scale and thereby increase that barrier to new entry.

WHY DO OLIGOPOLY EXIST?

Economies of Scale Cost advantages that a business obtains due to

expansion. They are factors that cause a producer’s

average cost per unit to fall as scale is increased.

This makes it virtually impossible for new firms to enter the industry.

A small firm could not produce at minimum cost and would soon be competed out of the business.

WHY DO OLIGOPOLY EXIST?

Reputation Established oligopolists are likely to have favorable

reputations. Investors decision: enter or not?

Critical thing: is it worthy to take the risk of being a new firm in such market?

If expected profit is greater than the initial loss, enter

If initial loss is too great, stay out.

WHY DO OLIGOPOLY EXIST?

Strategic Barriers Strategies designed to keep out potential

competitors, for example:

Maintain excess production capacity as a signal.Make special deals with distributors to receive

best shelf space in retail stores.Spend large amounts on advertising to make it

difficult for a new entrant to differentiate its product.

WHY DO OLIGOPOLY EXIST?

Government Barriers: The need for government authorization is one

entry barrier that can create oligopoly, especially if entry is limited to only a few firms.

It can also create monopolistic competition if

a larger number are allowed entry.

THE GAME THEORY APPROACH

Game Theory ApproachAn approach to modeling strategic interaction of

oligopolists in terms of moves and countermovesElements

Players Strategies Payoffs

Game treePayoff Matrix

THE GAME THEORY APPROACH

Game Tree

• A A game treegame tree is a graphical is a graphical representation of the representation of the consequences of alternative consequences of alternative strategies. Firms can use it to strategies. Firms can use it to develop pricing strategies.develop pricing strategies.

CARTEL AND DUOPOLYOUTCOMES IN THE GAME TREE

Two firms Two firms coordinating price coordinating price decisions choose decisions choose the high price.the high price.

Two firms acting Two firms acting rationally and rationally and interdependently interdependently choose the low choose the low price.price.

THE OUTCOME OF THE PRICE-FIXING GAME

Jack captures large share of market

Jill captures large share of market

Jill: Low PriceJill: Low Price Jack: High PriceJack: High Price

PricePrice $350$350 $400$400

QuantityQuantity 170170 1010

Average costAverage cost $300$300 $300$300

Profit per passengerProfit per passenger $50$50 $100$100

Total profitTotal profit $8,500$8,500 $1,000$1,000

THE DOMINANT STRATEGY

Irrational for Jack to choose high price

• Jack chooses the Jack chooses the low price when Jill low price when Jill chooses the high chooses the high price.price.

Dominant strategy: An action that is the best choice under all circumstances.

THE DOMINANT STRATEGY

• Jack chooses the Jack chooses the low price when Jill low price when Jill chooses the low chooses the low price.price.

Irrational for Jack to choose high price

• Dominant StrategyDominant Strategy: Jack chooses the low price : Jack chooses the low price regardless of Jill’s choice.regardless of Jill’s choice.

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

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GreatestCombined

Profit

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

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IndependentActions

StimulateResponse

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

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IndependentActions

StimulateResponse

Gravitatingto the

Worst Case

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

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CollusionInvites aDifferentSolution.

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

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Low

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SantoshFreight’s Price Strategy

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$12 $15

$12 $6

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CollusionInvites aDifferentSolution.

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

High

Low

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$12 $15

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But, theincentiveto cheat

is very real.

CollusionInvites aDifferentSolution.

A GAME-THEORY OVERVIEW USING PAYOFF MATRIX

THE DUOPOLISTS’ DILEMMA

• The The duopolists’ dilemmaduopolists’ dilemma is a is a situation in which both firms in a situation in which both firms in a market would be better off if they market would be better off if they chose the high price but each chose the high price but each chooses the low price.chooses the low price.

THE PRISONERS’ DILEMMA

The prisoners’ dilemma is a well-known game that demonstrates the difficulty of cooperative behavior in certain circumstances.

In the prisoner’s dilemma, mutual trust gets each one out of the dilemma, confessing is the rational choice.

The prisoners dilemma has its simplest application when the oligopoly consists of only two firms—a duopoly.

THE PRISONERS’ DILEMMA

The prisoners’ dilemma is the duopolists’ dilemma. Although both criminals would be better off if they both kept quiet, they implicate each other because the police reward them for doing so.

THE PRISONERS’ DILEMMA

PRICE LEADERSHIP IN OLIGOPOLY

Price leadership is an implicit agreement under which firms in a market choose a price leader, observe that firm’s price, and match it.

PRICE LEADERSHIP IN OLIGOPOLY

The problem with an implicit pricing agreement is that price signals sent by the leader may be misinterpreted.

Firms could interpret a price cut in two ways:Firms could interpret a price cut in two ways: A A change in market conditionschange in market conditions, in which , in which

case case firms just match the lower price firms just match the lower price and and price fixing continues.price fixing continues.

Under pricingUnder pricing, in which case a , in which case a price war price war may be triggeredmay be triggered, , destroying the price-destroying the price-fixing agreementfixing agreement..

What is Price Discrimination?

The practice of offering a specific good or service at different prices to different segments of the market

Why would a firm want to price discriminate?

Greater profits possible!!

TYPES OF PRICE DISCRIMINATION

Perfect Price Discrimination Charge each buyer the highest price they are

willing to pay. Groups Separate buyers into groups (based on age, sex,

region of country, etc). Groups should have different elasticities of

demand. Higher price to more inelastic group, lower to more

elastic.

IS OLIGOPOLY EFFICIENT?

In oligopoly, price usually exceeds marginal cost. So the quantity produced is less than the efficient

quantity. Oligopoly suffers from the same source and type of

inefficiency as monopoly. Because oligopoly is inefficient, antitrust laws and

regulations are used to try to reduce market power and move the outcome closer to that of competition and efficiency.

CHARACTERISTICS OFDIFFERENT TYPES OF MARKETS

REFERENCES

http://www.wikipedia.com http://www.ft.com http://www.census.gov http://www.antitrust.org http://www.opec.org Economics Principles & Tools(Prentice Hall

Publication)