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Oligopoly


eStudy.useStudy.usMarket Structure – A classification system for the key traits of a market, including

• the number of firms, • the similarity of the products they sell, and • the ease of entry and exit

Oligopoly

only a few firms (firms have market power, can change price)

offer identical (homogeneous) or similar (differentiated) products

difficult to enter or exit the industry

Oligopoly

Interdependent unlike participants in perfect competition where firms don’t need to consider actions of other producers in the short run, in oligopoly actions of each firm will impact other firms in the market


eStudy.useStudy.us Market StructureEconomists who study industrial organization divide markets into four types: monopoly, oligopoly, monopolistic competition, and perfect competition.

Number of Firms

Monopoly Oligopoly Monopolistic Competition

Perfect Competition

One Firm Few

FirmsProduct Type

Many Firms

DifferentiatedIdentical

½ ton trucksWireless phones

NovelsMovies

WheatCorn

Tap WaterSewer Services

Imperfect Competition


eStudy.usImperfect competition – between perfect competition and monopoly

• Oligopoly• Monopolistic competition

• Produce a quantity where price is greater then marginal cost• Price will be higher than Perfect Competition • Quantity produced will be less can Perfect Competition

Oligopoly

eStudy.us Oligopoly Definition • Homogeneous Oligopoly

– Steel (U.S. Steel, Arcelor Mittal, Nuco)

– Copper (Phelps Dodge, Arasco, Freeport-McMoRan, Southwire)GE or GM both needing Steel and Copper will write specification and no matter which producer wins the business GE and GM will get an identical product.

• Differentiated Oligopoly– ½ Ton Truck Market (Ford, GM, Chrysler, Toyota)

– Commercial Airline Market (America, United, Southwest, Delta, _________, ___________

Even if you don’t know a thing about ½ ton trucks you can identify every truck producer. How? Trucks are different and each one has the brand name on the vehicle.

eStudy.us Markets with Few Sellers

Two types of Oligopoly• Collusive – market participants work together to

greater a better profit outcome• Non-collusive – act as competitors in the market place

A small group of sellers– Tension between cooperation and self-interest– Best to cooperate with other firms to create monopoly profit– However, each firm cares only about its own profit which

creates a powerful incentive not to cooperate

Duopoly – Oligopoly with only two members

eStudy.us Non-collusive

Oligopoly firms participate in non-price completion– Unique product features (iPhone, iPad)– Increase transaction cost of switching

• Contracts (Wireless phones, insurance, etc…)• Lock-in ([email protected])

eStudy.us• Non-collusion results in:

– Higher quantity – lower price– lower profit

• Equilibrium Theory– Game Theory: how people or firms behave in strategic situations

• Choose among alternative courses of action• Must consider how others might respond to the action they take

– Nash equilibrium: economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen

Non-collusive

eStudy.usThe prisoners’ dilemma

– Particular “game” between two captured prisoners– Illustrates why cooperation is difficult to maintain

even when it is mutually beneficial

Dominant strategy– A strategy that is best for a player in a game

regardless of the strategies chosen by the other players

Pay-off Table quantifies the value of each outcome in game theory based on participant choices

Non-collusive

eStudy.usBonnie’s decision

Confess Remain silent

Clyde’sDecision

Confess

Remainsilent

Bonnie gets 8 years Bonnie gets 20 years

Bonnie goes free Bonnie gets 1 year

Clyde gets 20 years

Clyde gets 8 years

Clyde gets 1 year

Clyde goes free

Prisoners’ dilemma

In this game between two criminals suspected of committing a crime, the dominate strategy for each is to confess. Why because no matter what the other does confession is the best choice.

eStudy.usOligopolies as a prisoners’ dilemma

– In trying to reach the monopoly outcome– Firms have self-interest

• and do not cooperate even though cooperation would increase profits

• each firm has incentive to cheat to maximize profit

Example Ford and GM (1/2 ton pick-up trucks)– Differentiated oligopoly– Ford is low cost producer– Discounting vs. Free Features


eStudy.usGM Decision

Free Options No Free Options

FordDecision

Rebate

No Rebate

Ford gets $3million profit




GM earns $4million profit




In the ½ ton truck market, using the above payoff table, Ford will choice to Rebate and GM to offer free options. While each could earn more by cooperating, cooperation is not a sustainable equilibrium in the ½ ton truck market.


eStudy.us• Collusion is an agreement among firms in a

market• Cartel – a group of firms acting in unison• Cartels act as a monopoly to maximize profit

– Produce monopoly quantity– Charge monopoly price– Same impacts to society

• Collusion for self-interest unlikely to work– Difficult to reach & enforce an agreement– Antitrust laws

Collusive Oligopoly

eStudy.us Economics of Cooperation

Why firms sometimes cooperate• Game of repeated prisoners’ dilemma

–Repeat the game–Agree on penalties if one cheats–Both need an incentive to cooperate

Encouraging cooperation• Penalty for not cooperating• Return to cooperative outcome after a

period of noncooperation

eStudy.useStudy.usOrganization of Petroleum Exporting Countries (OPEC)

– Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela– By 1973: Qatar, Indonesia, Libya, the United Arab Emirates,

Algeria, Nigeria, Ecuador, Gabon– Control about three-fourths of the world’s oil reserves– Tries to raise the price of its product

Via a coordinated reduction in quantity produced

Cheating Problem: Each member of the cartel– Tempted to increase its production– Get a larger share of the total profit– Cheat on agreement

Collision Example

eStudy.useStudy.us• OPEC was successful at maintaining cooperation

and high prices from 1973 to 1985: increase in price

• Mid-1980s - member countries began arguing about production levels– OPEC became ineffective at maintaining cooperation– Decrease in price

• 2007 to 2008 – significant increase in price primarily caused by increased world demand

Booming World economy

Collision Example

eStudy.usRestraint of trade and the antitrust laws

– The Sherman Antitrust Act, 1890Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy

– The Clayton Act, 1914Further strengthened the antitrust laws

– The Federal Trade Commission Act, 1914• Created the Federal Trade Commission (FTC)• Can prevent mergers that impede competition• Can prevent oligopolists from colluding

Public Policy

eStudy.useStudy.us

Robert Crandall – president of American AirlinesHoward Putnam – president of Braniff Airways

• CRANDALL: I think it’s dumb as hell . . . to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime.

• PUTNAM: Do you have a suggestion for me?• CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares 20

percent. I’ll raise mine the next morning.• PUTNAM: Robert, we . . .• CRANDALL: You’ll make more money, and I will, too.• PUTNAM: We can’t talk about pricing!• CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we

want to talk about.

An illegal phone call – Collusion Example

Public Policy

eStudy.us

• Require retailers to charge customers a given price

• Might seem anticompetitive– Prevents the retailers from competing on price

• Defenders:– Not aimed at reducing competition– Legitimate goal

• Some retailers offer service

Public PolicyResale price maintenance (fair trade)

eStudy.us

• Charge prices that are too low– Anticompetitive because price cuts are

intended to drive other firms out of the market

• Skeptics– Predatory pricing (not a profitable strategy)– Price war (to drive out a rival)– Pricing below cost

Public PolicyPredatory pricing

eStudy.usTying

Public Policy

• Offer two goods together at a single price– Expands market power

• Skeptics– Cannot increase market power by binding

two goods together• Form of price discrimination

– Tying may increase profit

eStudy.useStudy.usU.S. government case against Microsoft • Central issue: tying

Should Microsoft be allowed to integrate its Internet browser into its Windows operating system

• The government’s claim:– Microsoft was bundling to expand market power into the

market of Internet browsers– Would deter other software companies from entering the

market and offering new products

Public Policy Example

eStudy.useStudy.usMicrosoft responded

– New features into old products - natural part of technological progress

• Cars - include CD players, air conditioners• Cameras - built-in flashes• Operating systems - added many features to Windows

– Previously stand-alone products– Computers - more reliable and easier to use

– Integration of Internet technology,• The next natural next step

Microsoft Case

eStudy.useStudy.usDisagreement about the extent of Microsoft’s market power• The government

– More than 80% of new personal computers• Use a Microsoft operating system• Substantial monopoly power

• Microsoft– Software market is always changing– Competitors: Apple Mac & Linux operating systems– Low price illustrates limited market power

Microsoft Case

eStudy.useStudy.us• November 1999 ruling

Microsoft illegally abused market power

• June 2000Ruling to break Microsoft into two companies

Operating system & Applications software

• 2001 appealOverturned the breakup order

• September 2001Justice Department - wanted to settle the case quickly

• November 2002 settlementMicrosoft accepted some restrictions and the browser remains part of the Windows operating system

Microsoft Case

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