Oligopoly Kolby Glenn and Jared Mosich

Characteristics A few large producers Homogenous oligopoly- standardized product (Metals, cement, etc…) Differentiated oligopoly- different products (breakfast cereals, cars, etc…) Firms can change prices, but must be aware of the effects on themselves and other firms. Barriers to entry similar to monopoly- Most significant is how hard it is to achieve economies of scale through control of capital. Can emerge through mergers- when 2 or more companies combine to increase market share and influence.

Degree of Industry Concentration To determine how much the largest firms control of an oligopolistic industry, use either: Concentration ratios Herfindahl index

Concentration Ratio Reveals percentage of total output produced and sold by an industries largest firms. If the four largest firms in an industry control 40% or more of that industry, it is considered an oligopoly. 3 shortcomings of concentration ratios: Localized markets- hard to move product around the nation (like cement), so relevant market is limited to a specific area Interindustry competition- aluminum and copper are close rivals, but are considered different industries, and their CR numbers reflect that. World Trade- CR numbers on a national scale don’t reflect foreign producers.

Herfindahl Index A monopoly and a 4-firm oligopoly can have equal CR numbers, but extremely different competition levels. To get HI, (%S1)^2 + (%S2)^2 + …(%Sn)^2 (%S1)= Percentage of market share owned by firm 1 Take the market shares of all firms in the industry and square them, then add them. The larger the HI number, the greater the market power in an industry.

Game-Theory Model and Collusion Game theory refers to the behavior of adapting your business model according to how your opponent runs their business, similar to poker and other “games”. Collusion is simply cooperation with rivals.

If RareAir (RA) decides to go for a high price strategy and Uptown (UP) decides to go for a low-price strategy, UP will make $15 million while RA only makes $6 million. If these companies collude, they can both enact high-price strategies and make $12 million each. Either company could be compelled to cheat on their agreement in order to make a larger profit.

Graphical Representation A. Noncollusive oligopoly B. Cartels and Other collusion C. Price leadership model

Noncollusive oligopoly Demand curve depends on how other firms will react to a price change by one firm Rivals can either match price changes or ignore price changes.

Match Price Change If prices are matched by rivals, the Demand and marginal- revenue lines will be D1 and MR1. This is because the firms won’t lose or take money from their rivals, but other industries.

Ignore Price Change If rivals ignore the price changes, the Demand and Marginal-revenue lines are D2 and MR2. These are more elastic because if they change price, a firm will either gain a lot more business or lose a lot, depending on how they change price.

Kinked Demand Its more likely that rivals follow a price cut and ignore a price change. This can result in a separated MR curve and a “kinked” demand curve.

Cartels and Other Collusion If firms work together to control market pricing, they can reduce uncertainty, increase profits, and maybe prohibit the entry of new rivals. Firms working together will find it best to match prices.

Overt and Covert Collusion OPEC is a cartel, or a group of producers that has a written agreement on how much each member produces and charges. This collusion is “overt,” or open to view. Covert, or “secret,” cartels exist in the US. Cartels are banned in the US, so all cartels operating here are covert, or “secret.” Tacit understandings are secretive verbal agreements mostly between executives made over a round of golf or a cocktail party. These can have corporate consequences if uncovered.

Obstacles to Collusion Demand and cost differences- since different firms have different demand and cost curves, it’s hard for them to agree on a single price. Number of Firms- the more firms that exist, the more difficult it is to collude. Cheating- When a firm cheats, buyers may pit producers against each other in a price war. Oligopolies work best when cheating is easily caught and punished. Recession- bad markets increase ATC, so firms may cut price in order to steal profit from rivals. Potential entry- Profits attract new firms, increasing market supply and lowering profit. Colluding firms must block entry in order to keep order. Legal obstacles- US laws prohibit cartels and price-fixing collusion. Covert means of price control have emerged because of these laws.

Price Leadership Model The dominant or biggest firm will make price changes and other firms will follow. Price only changes with significant change to cost and demand. Price leader communicates price changes by speeches, interviews, and press releases. Price leader may keep price below the short-run profit-maximizing level to prevent new firms entering into the industry. Sometimes firms will battle for control of price leadership which results in firms lowering prices until they realize they are reducing their profits and a firm will become the price leader and raise prices again.

Advertising Firms advertise to increase market share It’s difficult to copy advertising. Other firms can duplicate cut prices but not effective advertising. Product improvements and successful advertising can produce more permanent gains in market share. Oligopolists have an abundance of financial resources to spend on product development and advertising to help increase economic profits. May affect prices, competition, and efficiency both positively and negatively. (Positive) Gains popularity to a firm and draws new consumers. (Negatives) May mislead consumers/ Also could be cancelled out by other firm’s advertising.

Efficiency of Oligopoly Oligopolies are inefficient. Many Oligopolies maintain economic profits year after year. Oligopolist’s production occurs where price exceeds MC and ATC. Neither productive or allocative efficiency are likely to occur. While oligopolies do not face as many government regulations as pure monopolies, they still face informal collusion from other firms. Qualifications- Foreign Competition – More competitive prices Limit Pricing – In an effort to strengthen entry barriers firms keep prices below the short run profit- maximizing level Technological Advances - The short run inefficiencies of oligopolies may be offset by new and improved products, prices, and costs.