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Econ 201Lecture 2.2Spring 2009Market Failure:

Oligopolies

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What is an Oligopoly?

• market in which the industry is dominated by a small number of sellers– Derived from the Greek for few sellers. – Since there are few participants, each oligopolist

(firm) is aware of the actions of the others– decisions of one firm influence, and are influenced by

the decisions of other firms • i.e., firms’ behave strategically taking into account the likely

responses of the other market participants (game theory)

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Oligopoly

Perfect Competition Monopoly

Monopolistic Competition

Oligopoly

• Oligopoly markets are more concentrated than monopolistically competitive markets, but less concentrated than monopolies.

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Strategic Behavior• Perfect Competition

– Only strategy is to reduce costs• Price-taker => output decisions do not affect market price

– cross-price elasticity = 1 (perfect substitutes)– Own-price = -∞

• Monopoly– Price-Searcher: output decision determines price

• Cross-price = 0 (no substitutes)• Own-price: >= |1|

• Oligopoly– Cross-price elasticity near -1– Own-price elasticity > |1|– Will have to take into account actions of other similar firms when making

output/pricing decisions– Much more strategy

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Oligopoly Behavior• Cooperative Oligopoly

– Cartels• Agree to collude; act/price like a single firm monoploist

– Price leadership (Stackleberg leader)• Dominant firm establishes the price; other firms react to

“leader”• Non-cooperative Oligopolies

– Sticky prices (kinked demand curve)• Sticky upward

– Nash equilibrium• Characterized by stable prices

– Perfect competition• Completely rivalarous

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Cooperative Oligopolies

• Cartels (highly cooperative)– Firms act as single-firm monopolist

• Stackelberg Price Leader (passive cooperation)

- leader firm moves first and then the follower firms move sequentially

– Stackelberg leader is sometimes referred to as the Market Leader.

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Non-cooperative Oligopolies• Competitive/psuedo-competitive behavior (non-

cooperative)– Perfect Competition (almost): firms undercut each

other’s prices• competition between sellers is fierce, with relatively low

prices and high production– Outcome may be similar to PC or Monopolistic Competition

– Nash equilibrium• Firms avoid “ruinous” price competition by keeping prices

stable and avoiding price competition (undercutting each others prices)

• May lead to product proliferation

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Where We’re Going

• How do we tell if a market is an oligopoly?– Market Concentration

• CR4: market share for the 4 largest firms• Herfindahl Index (HHI): computed from the

squares of the market shares

• Strategic behavior (how do they behave in the market place)– Collusive: act together– Non-collusive: act separately and/or

stratgeicially

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How do we tell?

• Market concentration refers to the size and distribution of firm market shares and the number of firms in the market.

• Economists use two measures of industry concentration:– Four-firm Concentration Ratio – The Herfindahl-Hirschman Index

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Attempts to Measure Market Concentration

• four-firm concentration ratio is often utilized to characterize/determine whether a market is an oligopoly. – market share of the four largest firms in an industry

• Herfindahl index, – also known as Herfindahl-Hirschman Index or HHI,– widely applied in competition law and antitrust. – sum of the squares of the market shares of each

individual firm.– Decreases in the Herfindahl index generally indicate a

loss of pricing power and an increase in competition, whereas increases imply the opposite.

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Four-Firm Concentration Ratio

• The four-firm concentration ratio (CR4) measures market concentration by adding the market shares of the four largest firms in an industry.– If CR4 > 60, then the market is likely to

be oligopolistic.

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ExampleFirm Market Share

Nike 62%

New Balance 15.5%

Asics 10%

Adidas 4.3%

CR 4 = 62 15.5 10 4.3 91.8

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Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in

1997

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The Herfindahl-Hirschman Index

• The Herfindahl-Hirschman index (HHI) is found by summing the squares of the market shares of all firms in an industry.– Advantages over the CR4 measure:

• Captures changes in market shares• Uses data on all firms

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ExampleFirm Market Share

Nike 62%

New Balance 15.5%

Asics 10%

Adidas 4.3%

HHI 622 15.52 102 4.32 4,202.74

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Example (cont’d)

Firm Market ShareNike 22.95%New Balance 22.95%Asics 22.95%Adidas 22.95%

What happens if market shares are evenly distributed?

HHI 22.952 22.952 22.952 22.952 2,106.81CR 4 91.8

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Non-competitive Oligopolies• Non-competitive/collusive behavior (cooperative

oligopolies)– Cartels: firms may collude to raise prices and restrict production

in the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel.

– Dominant Firm/Price Leader:• collude in an attempt to stabilize unstable markets, so as to reduce

the risks inherent in these markets for investment and product development.

• does not require formal agreement – although for the act to be illegal there must be a real communication

between companies– for example, in some industries, there may be an acknowledged market

leader which informally sets prices to which other producers respond, known as price leadership.

– Stackleberg price-leader model

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Cartel Pricing Tactic

• Reduce Qs to monopoly levels in order to: – a) obtain a higher price– b) earn monopoly rents

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Competition Versus Cartel

Price, p,$ per unit

(a) Firm

qc q*qmQuantity, q, Units

per year

S

MR

Market demand

AC

MC

pm

MCm

pc

pmem

ec

MCm

pc

Price, p,$ per unit

(b) Market

Qm Qc Quantity, Q, Units

per year

Source: Jeffrey M. Perloff, Microeconomics, 3rd Ed., 2004, p. 435

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Figure 12.4 Duopoly Equilibrium in a Centralized Cartel

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How do Cartels Operate?

• Firms in the cartel need to agree on:– 1) Market price– 2) Quantity supplied by the Industry– 3) Each firm’s “quota”– 4) “Not to cheat” on either price or quantity

supplied

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Conditions for cartel success• the cartel can significantly raise price • cartel controls market • low organizational costs

– few firms (or a few large ones)– industry association

• many small buyers: no monopsony power• cartel can be maintained

– cheating can be detected and prevented– low expectation of severe government punishment

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An Example of a Cartel• Organization of the Petroleum Exporting Countries (OPEC) is

an international cartel made up of Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.

• Principal aim of the organization, according to its Statute, is the determination of the best means for safeguarding their interests, individually and collectively; devising ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations

• OPEC triggered high inflation across both the developing and developed world using oil embargoes in the 1973 oil crisis.

• OPEC's ability to control the price of oil has diminished due to the subsequent discovery/development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization.

• OPEC nations still account for two-thirds of the world's oil reserves, and, in 2005, 41.7% of the world's oil production,

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Game Theory Modelsof Oligoploy

• Stackelberg's duopoly. In this model the firms move sequentially (see Stackelberg competition).

• Cournot's duopoly. In this model the firms simultaneously choose quantities (see Cournot competition).

• Bertrand's oligopoly. In this model the firms simultaneously choose prices (see Bertrand competition).

• Monopolistic competition. A market structure in which several or many sellers each produce similar, but slightly differentiated products. Each producer can set its price and quantity without affecting the marketplace as a whole.

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Why cartels can raise profits

• if a firm is maximizing its profit, why should joining a cartel increase its profit?– a firm is already choosing output (or price) to

maximize its profit– however, it ignores effect that changing its

output level has on other firms’ profits• cartel takes into account how changes in

one firm's output affect cartel profits

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Firms “cheat”

• luckily for consumers, cartels often fail because each firm in a cartel has an incentive to cheat on the cartel agreement

• cheating firm– produces extra output or lowers its price– ignores the negative effect of its extra output

on other firms’ profits

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Cartel can greatly raise price

• only incur cost of organizing a cartel and enduring risk of prosecution if cartel can raise price substantial

• demand facing cartel cannot be very elastic, which is more likely if the cartel controls the market

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Cartel controls market

• if the cartel does not have a large share of the market, it cannot raise price much

• to control the market– few noncartel firms– no recycling– limited entry

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Entry and cartel success

• barriers to entry limit competition • cartels with large number of firms rare

(except professional associations)

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Cartels• A cartel is a formal (explicit) agreement among firms.

– usually occur in an oligopolistic industry, where there are a small number of sellers – usually involve homogeneous products.

• Cartel members may agree on such matters – as price fixing, – total industry output,– market shares, – allocation of customers, – allocation of territories

• aim of such collusion is to increase individual member's profits by reducing competition.

– Competition laws forbid cartels. • Several economic studies and legal decisions of antitrust authorities have found that

the median price increase achieved by cartels in the last 200 years is around 25%.• Private international cartels (those with participants from two or more nations) had an

average price increase of 28%, whereas domestic cartels averaged 18%. Less than 10% of all cartels in the sample failed to raise market prices

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How do Cartels Operate?

• Firms in the cartel need to agree on:– 1) Market price– 2) Quantity supplied by the Industry– 3) Each firm’s “quota”– 4) “Not to cheat” on either price or quantity

supplied

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Factors that work against a Cartel- in the long run

• Each firm has an incentive to cheat– Price that firm receives is still above MC of

production • Could earn additional profits by slightly expanding

output

• However, when all firms do this– -> back at competitive market outcome

• Qs up to point where MV=MC

• See “prisoners dilemma”

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What market conditions make Cartels more likely?

• Market demand is inelastic– higher prices lead to increase revenues for the cartel

• Homogenous goods– easier to initially set/enforce cartel price

• Small number of firms/high concentration of market share (easier to monitor, collude)– Fringe players could defeat cartel– More equal shares -> increase incentive to cheat

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Price-leadership

• Stackelberg price leadership model– Not explicitly collusive– Requires a dominant firm (large market share and

some market power)– Firms are allowed to change prices within a certain

range • If firm(s) lower price(s) below the “allowed” range, then

dominant firm retaliates with lower price and takes away market share

– Example: AT&T in the LD market after “Divestiture”

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Non-Cooperative Cartels

• Some degree of price competition– Firms engage in highly competitive pricing

• Similar outcome as perfect competition– Firms have some market power

• Resembles monopolistic competition

• Stable prices prevail– Non-collusive– Firms choose not to compete because of

kinked demand curve

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Kinked-Demand Curve• Above the kink, demand is relatively elastic because all other firm’s

prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point

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Nash Equilibrium

• If firm facing kinked demand curve tries to raise price:– Other firms do not– As demand is highly elastic and other firms

are “close” substitutes– Loses market share and revenues

• If firm lowers price– Competitors match price decreases

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Nash Equilibrium

• As a consequence– Best strategy is to neither raise or lower

prices; but to maintain “stable” prices• Nash equilibrium in an oligopolist market

will be characterized by long-term stable prices or “sticky” prices– Non-price competition

• Advertising to create brand name awareness/loyalty

• Product proliferation