chap 010

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Oligopoly

Chapter 10


Market Structure

• Most firms possess some market power.


Degrees of Power

• We classify firms into specific market structures based on the number and relative size of firms in an industry.– Market structure – The number and relative

size of firms in an industry.


Degrees of Power

• In imperfect competition, individual firms have some power in a particular product market.

• Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service.


Characteristics of Market Structures

Market Structure

CharacteristicsPerfect

CompetitionMonopolisticCompetition Oligopoly

Number of firms Very largenumber

Many Few

Barriers to entry None Low High

Market power(control over price

None Some Substantial

Type of product Standardized Differentiated Standardizedordifferentiated


Characteristics of Market Structures

Market Structure

CharacteristicsPerfect

Competition Duopoly Monopoly

Number of firms Very largenumber

Two One

Barriers to entry None High High

Market power(control over price

None Substantial Substantial

Type of product Standardized Standardizedordifferentiated

Unique


Determinants of Market Power• The determinants of market power include:

– Number of producers.– Size of each firm.– Barriers to entry.– Availability of substitute goods.


Determinants of Market Power• Market power increases:

– The fewer the number of firms in the market.– The larger the relative size of the firms in the

market.– The higher the entry barriers.– The fewer the substitutes.


Determinants of Market Power• Barriers to entry determine to what extent

the market is a contestable market.– Contestable market – An imperfectly

competitive industry subject to potential entry if prices or profits increase.


Measuring Market Power

• The standard measure of market power is the concentration ratio.

• The concentration ratio is a measure of market power that relates the size of firms to the size of the market.


Concentration Ratio

• The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).


Firm Size

• Market power isn’t necessarily associated with firm size.

• A small firm could possess a lot of power in a relatively small market.


Measurement Problems

• Many smaller firms acting in unison can achieve market power.

• Concentration ratios 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.

• Assume that the computer market has three oligopolists.


Initial Equilibrium

• Initial conditions and market shares of each firms are described in the following slides.– Market share - The percentage of total

market output produced by a single firm.


Initial Conditions in Computer Market

20,0000

$1000

Market demand

Quantity Demanded (computers per month)

Pri

ce (

per

com

pute

r)

Industry output


Initial Market Shares of Microcomputer Producers

Producer Output Market Share

Universal Electronics 8,000 40.0%

World Computers 6,500 32.5%

International Semiconductor

5,500 27.5%

Total industry output 20,000 100.0%


The Battle for Market Shares

• In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms.


Increased 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• Lowering price may expand total market

sales and increase the sales of an individual firm without affecting the sales of its competitors.

• There simply isn’t any way that a firm can do so without causing alarms to go off in the industry.


Retaliation

• Oligopolists respond to aggressive marketing by competitors.– Step up marketing efforts.– Cut prices on their product(s).


Retaliation

• One way oligopolists market their products is through product differentiation.– Product differentiation – Features that make

one product appear different from competing products in the same market.


Retaliation

• An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price.

• This is why oligopolists avoid price competition and instead pursue nonprice competition.


Rivalry for Market Shares

FG

Marketdemand

$1000900

0 20,000 25,000Quantity Demanded (computers per month)

Pric

e (p

er c

ompu

ter)


The Kinked Demand Curve

• Close interdependence – and the limitations it imposes on price and output decisions – is a characteristic of oligopoly.


Rivals’ Response to 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.


Rivals’ Response to Price Increases• Rival oligopolists may not match price

increases in order to gain market share.


The Kinked Demand Curve Confronting an Oligopolist• The shape of the demand curve facing an

oligopolist depends on how its rivals responded 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.


1000

PR

ICE

(pe

r co

mpu

ter)

QUANTITY DEMANDED (computers per month)0

The Kinked Demand Curve Confronting an Oligopolist

Demand curve facing oligopolist if rivals match price changes

Demand curvefacing oligopolist ifrivals don't matchprice changes

Demand curve facing oligopolist if rivals match price cuts but not price hikes

MA

CD

B$1100

900

8000


Game Theory

• Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies.

• The payoff to an oligopolist’s price cut depends on how its rivals respond.


Game Theory

• Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.


Game Theory

• Each oligopolist is uncertain about its rival’s behavior.– 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.


The Payoff Matrix

• The payoff to an oligopolist’s price cut depends on how its rivals respond.


The Payoff Matrix

• The decision to initiate a price cut requires a risk assessment.

cutsprice from loss ofSize

matchingrivals of Probability

valueExpected

cutprice lonefrom Gain

matching notrivals of Probability


Oligopoly Payoff Matrix

Rivals’ Actions

Universal’s Options Reduce Price Don’t ReducePrice

Reduce price Small loss foreveryone

Huge gain forUniversal; rivalslose

Don’t reduce price Huge loss forUniversal; rivalsgain

No change


Oligopoly vs. Competition

• Oligopolists may try to coordinate their behavior in a way that maximizes industry profits.


Price and Output

• An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit.


Price and Output

• To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.


Pric

e or

Cos

t (d

olla

rs p

er u

nit)

Quantity (units per period)0

Maximizing Oligopoly Profits

Industrymarginal

cost

Industry average

cost

Marketdemand

Industry marginalrevenue

Profits

J

Profit-maximizing

price

Average costat profit-

maximizingoutput

Profit-maximizing output


Sticky Prices

• Prices in oligopoly industries tend to be stable.

• Like all producers, oligopolists want to maximize profits by producing where MR = MC.


Sticky Prices

• The kinked demand curve is really a composite of two separate demand curves.

• There is a gap in an oligopolist’s marginal revenue (MR) curve.– Marginal revenue – The change in total

revenue that results from a one-unit increase in the quantity sold.


Sticky Prices

• As a result, modest shifts of the cost curve will have no impact on the production decision of an oligopolists.


An Oligopolist’s Marginal Revenue Curve

A

G

Hd2

S

0 8000

Pri

ce (

dolla

rs p

er

com

pu

ter)

Quantity Demanded (computers per month)

mr2 mr1

d1

F

The kink in the demand curve

The MR gap


The Cost CushionP

rice

or

Co

st (

do

llars

per

un

it)

MC2MC1MC3

Marginal revenue

0Quantity (units per period)


Coordination Problems

• There is an inherent conflict in the joint and individual interests of oligopolists.– Each oligopolist wants industry profits to be

maximized.– Each oligopolist wants to maximize it’s own

market share.


Coordination Problems

• To avoid self-destructive behavior, each oligopolist must coordinate production decisions so that:– Industry output and price are maintained at

profit-maximizing levels.– Each oligopolistic firm is content with its

market share.


Price Fixing

• The most explicit form of coordination among oligopolists is called price fixing.

• Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold.


Examples of Price Fixing

• Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators.

• They were charged again in 1972 for continued price fixing.



• School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states.



• Vitamins – Seven firms from four nations were accused of fixing global prices on bulk vitamins from 1990 - 1998.



• Baby Formula – Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula.



• Cola – The Coca-Cola Bottling Co. of North Carolina agreed to pay a fine and give consumers discount coupons to settle charges of conspiring to fix soft-drink prices from 1982 to 1985.



• Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD.



• Laser Eye Surgery – The FTC charged VISX and Summit Technology with price-fixing that raised the price of surgery by $500 per eye.



• Memory chips – In 2004, prosecutors claimed the world’s largest memory-chip (DRAM) makers (Samsung, Micron, and Infineon) fixed prices in the $16 billion-a-year market.


Price Leadership

• Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry.


Allocation of Market Shares

• One way to allocate market share is a cartel agreement.

• A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market.


Allocation of Market Shares

• An oligopolist may resort to predatory pricing when market shares are not being divided in a satisfactory manner.– Predatory pricing - temporary price

reductions designed to alter market shares or drive out competition.


Barriers to Entry

• Above-normal profits cannot be maintained over the long-run unless barriers to entry exist.

• Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market.


Patents

• Patents prevent potential competitors from setting up shop.

• They either have to develop an alternative method for producing a product or receive permission from the patent holder to use the patented process.


Distribution Control

• The control of distribution outlets can be accomplished through selective discounts, long-term supply contracts, or expensive gifts at Christmas.


Mergers and Acquisition

• A firm can limit competition by acquiring competitors through mergers and acquisition.


Government Regulation

• Patents are issued by the federal government.

• Licensing requirements imposed by government limit competition.


Nonprice Competition

• Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market.


Training

• Early market entry can create an important barrier to later competition.

• Customers of training-intensive products (such as computer hardware and software) become familiar with a particular system.


Network Economies

• The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.


Antitrust Enforcement

• Market power contributes to market failure when it leads to resource misallocations or greater inequity.

• Market failure is an imperfection in the market mechanism that prevents optimal outcomes.


Industry Behavior

• Antitrust law is government intervention designed to alter market structure or prevent abuse of market power.


Industry Behavior

• There are several problems with the behavioral approach to antitrust law:– Limited government resources.– Public apathy.– Difficulty of proving collusion.


Industry Structure

• Public efforts to alter market structure have been less frequent than efforts to alter market behavior.


Objections to Antitrust

• Some argue that we shouldn’t punish those who achieved monopolies through hard work and innovation.

• Noncompetitive behavior, not industry structure, should be the only concern of antitrust.


The Herfindahl-Hirshman Index• The Herfindahl-Hirshman index (HHI) is

a measure of industry concentration that accounts for number of firms and size of each.


The Herfindahl-Hirshman Index• The Herfindahl-Hirshman Index of market

equals the sum of the squares of the market shares of each firm in an industry.


The Herfindahl-Hirshman Index• For policy purposes, the Justice

Department decided it would draw the line at a value of 1,800.


Contestability

• If entry barriers were low enough, even a highly concentrated industry might be compelled to behave more competitively.


Behavioral Guidelines: Cost Savings• The FTC now also looks to see if a

proposed merger will allow for greater efficiencies and lower costs.


Oligopoly

End of Chapter 10

chap 010

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