Introduction to Oligopoly Micro: Econ: 28 64 Module Introduction to Oligopoly KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: Why oligopolists have an incentive to act in ways that reduce their combined profit. Why oligopolies can benefit from collusion. The purpose of this module is to develop the oligopoly market structure. Many of the high-profile industries in the U.S. are oligopolies and all share a common characteristic: mutual interdependence. Firms often find that it could be mutually beneficial to collude or not compete as vigorously as possible because competition drives down profits for the industry.

Understanding Oligopoly “Few” producers Remember HHI Interdependence Module 57 describes oligopoly as a market structure with a few large producers. There is no universal definition of how many producers must exist before we call the market an oligopoly, so we use measures like the HHI to quantify the market concentration.   An additional key characteristic of oligopoly is that the firms are interdependent and engage in strategic behavior. Interdependence simply means that the actions of one firm (Honda, for example) have an impact on another large firm (Toyota) and vice versa. If Honda would choose to advertise during the Super Bowl, Toyota would be affected and must decide whether to respond or do nothing.

Collusion and Competition Oligopoly firms can increase their profits by colluding to restrict output or raise price. Maintaining collusive agreements is difficult because there is an incentive to cheat Collusion is illegal Oligopoly firms can collude to restrict output and raise price to increase profits (i.e. behave like a monopoly). It is difficult to maintain the collusive agreement, especially as the number of firms involved increases. Each firm has an incentive to cheat by producing a little more (and it is more difficult to get caught the more firms there are) so firms are likely to cheat. And if all firms cheat, the collusive (or cartel) profits disappear.   And, it should be clearly noted that explicitly agreeing to collude on the basis of price and/or output is illegal and people can, and do, get fined and/or imprisoned for doing so.

Price versus Quantity Competition Bertrand Price competition Competitive outcome Cournot Quantity competition Economic profits Strategies between duopolists have been studied by economist for many years.   Joseph Bertrand (1822-1900) showed that when firms are selling an identical product, oligopolists will repeatedly lower price to undercut the competition. This process ends at the perfectly competitive outcome where P=MC. Augustin Cournot (1801-1877) focused on quantity competition, rather than price competition. Again assuming a homogenous product, duopoly firms choose output to maximize profit, given the output of the rival firm. There exists an equilibrium level of output that allows each firm to earn profits that are below monopoly-level profits, but are above normal profits.