1. Market Failure: Oligopolies 2-11-09
Econ 100 Lecture 6-3
Market Failure:
Oligopolies

2. 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)

3. Oligopoly
Oligopoly markets are more concentrated than monopolistically competitive markets, but less concentrated than monopolies.
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly

4. 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

5. Oligopoly Behavior Cooperative Oligopoly Non-cooperative Oligopolies
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

6. 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

7. 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.

8. 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.

9. Example Firm Market Share Nike 62% New Balance 15.5% Asics 10% Adidas
4.3%

10. Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in 1997

11. 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

12. Example Firm Market Share Nike 62% New Balance 15.5% Asics 10% Adidas
4.3%

13. Example (cont’d) What happens if market shares are evenly distributed?
Firm
Market Share
Nike
22.95%
New Balance
Asics
Adidas

14. Cartel Pricing Tactic Reduce Qs to monopoly levels in order to:
a) obtain a higher price
b) earn monopoly rents

15. Figure 12.4 Duopoly Equilibrium in a Centralized Cartel

16. 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

17. 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

18. 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

19. 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

20. 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”

21. 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

22. 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

23. 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

24. 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

25. Nash Equilibrium As a consequence
Best strategy is to neither raise or lower prices; but to maintain “stable” prices
Nash equilibrium in an oligopolistic market will be characterized by long-term stable prices or “sticky” prices
Non-price competition
Advertising to create brand name awareness/loyalty
Product proliferation