1. Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10
Oligopoly
Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10

2. Overview Oligopoly market characteristics Measure of market structure
Barriers in oligopoly market
Game theory approach to duopoly
Cooperative collusion
Cheating
Future of oligopoly

3. Oligopoly When just a few large firms dominate a market
So that actions of each one have an important impact on the others
In such a market, each firm recognizes its strategic interdependence with others
An oligopoly is a market dominated by a small number of strategically interdependent firms
Would be foolish for any one firm to ignore its competitors’ reactions

4. Number of Firms
Oligopoly requires that a few firms dominate the market
How few?
At some point, number of firms is large enough—and interdependence weak enough—that oligopoly becomes a poor description
Monopolistic competition would fit better
No absolute number at which oligopoly ends and monopolistic competition begins

5. Market Domination
Strategic interdependence requires that a few firms dominate the market
Their share of market is large
As combined market share shrinks, strategic interdependence becomes weaker
Oligopoly is a matter of degree
Not an absolute classification

6. Economies of Scale: Natural Oligopolies
When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market
only a few large firms survive since small firms can’t compete
Market becomes an (natural) oligopoly
Remember, MES is defined as the lowest level of output at which it can achieve minimum cost per unit
The output level at which the LRATC first hits bottom

7. Figure 1: Natural Oligopoly
25,000
Units per Month
100,000 80
$200
Dollars
LRATCTypical Firm H F E
DMarket

8. Reputation as a Barrier
Established oligopolists are likely to have favorable reputations
Investors decision: enter or not?
Critical thing: is it worthy to take the risk of being a new firm in such market?
If expected profit is greater than the initial loss, enter
If initial loss is too big, stay out.

9. Strategic Barriers
Strategies designed to keep out potential competitors, for example:
Maintain excess production capacity as a signal
Make special deals with distributors to receive best shelf space in retail stores
Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product
Maintain excess production capacity as a signal to a potential entrant that they could easily saturate market and leave new entrant with little or no revenue

10. Legal Barriers
Patents and copyrights—which can be responsible for monopoly—can also create oligopolies
Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination

11. Measures of Market Structure
Concentration ratios: Aggregated market share of the largest N firms in the industry
Range: 0-100%
4 Firm Concentration ratio: Market share controlled by the largest 4 firms

12. Measured Industry Concentration in Manufacturing
D: Not disclosed
Second and third columns: Percentage in value added in the industry
Last column: Herfindahl index from the 50 largest firms
Data based on the 2002 Economic Census.

13. Measured Industry Concentration in Manufacturing
D: Not disclosed
Data based on the 2002 Economic Census.

14. Oligopoly vs. Other Market Structures
Oligopoly presents the greatest challenge to economists
essence of oligopoly is strategic interdependence
economists have had to modify the tools used to analyze other market structures and to develop entirely new tools as well
One approach—game theory—has yielded rich insights into oligopoly behavior

15. The Game Theory Approach
An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves
Elements
Players
Strategies
Payoffs
Pay off matrix
Game tree

16. Game Theory Approach
Some situations to which game theory can be applied:
firms competing for business
political candidates competing for votes
animals fighting over prey
bidders competing in an auction
legislators' voting behavior under pressure from interest groups
game theory can be used to illuminate economic, political, and biological phenomena.

17. Game Theory – Short History
John Von Neumann ( )
“Theory of Games and Economic Behavior” with Oskar Morgenstern
This book established game theory as a field
“An introduction to game theory” by Martin J. Osborne. Oxford University Press, 2002

18. Game Theory – Short History
John F. Nash, Jr.(1928- )
One of the contributions is the introduction of the equilibrium notion now known as Nash equilibrium
1994 Nobel prize winner in economics with the game theorists John Harsanyi and Reinhard Selten
“An introduction to game theory” by Martin J. Osborne. Oxford University Press, 2002

19. The Prisoner’s Dilemma
Simple example to explain why a technique for obtaining confessions, commonly used by police, is so often successful
Payoff matrix
Players: Rose and Colin
Payoffs: number in the matrix
Strategies: Confess (C) / not confess (NC) for either of the players

20. Figure 2: The Prisoner’s Dilemma
How to read the matrix?
Players:{Rose, Colin}
Strategies:{C, NC}
Payoffs
What will Rose do?
What will Colin do?
Rose
Colin C NC
-20, -20
-3, -30
-30, -3
-5, -5

21. The Prisoner’s Dilemma
A dominant strategy: the player’s best strategy regardless of the other player’s strategy
Rose’s dominant strategy is “confess” regardless of Colin’s choice
So is Colin

22. Nash Equilibrium
Outcome of this game is an example of a Nash equilibrium
Exists when each player is taking the best action—given best actions taken by other players
Under the Nash Equilibrium, no players want to deviate

23. Figure 3: Working on a joint project
Elements
Players:{you, your friend}
Strategies:{work hard, Goof off}
Payoffs
What is the Nash Equilibrium?
Friend
You W G
2, 2
0, 3
3, 0
1, 1

24. Figure 4: Battle of Sex Elements What is the Nash Equilibrium? Mr. R
Players:{Mr. R and Mrs. R}
Strategies:{ go shopping, watch a baseball game}
Payoffs
What is the Nash Equilibrium?
Mr. R
Mrs. R S B
2, 1
0, 0
1, 2

25. Figure 5: Duopoly Elements What is the Nash Equilibrium? Firm A Firm B
Players:{Firm A, Firm B}
Strategies:{ Low price, High price}
Payoffs
What is the Nash Equilibrium?
Firm A
Firm B L H
10, 10
40, -5
-5, 40
20, 20

26. Simple Oligopoly Games - Duopoly
Duopoly - oligopoly market with only two sellers
Assume that Firm A and B must make their decisions independently
Without knowing in advance what the other will do
A’s dominant strategy is to charge a low price
So is B’s dominant strategy
Outcome is a Nash equilibrium (Low, Low)

27. Example: Price Competition for Duopoly
Duopoly firms A & B have the same cost structure, produce the undifferentiated goods.
Suppose the MC and ATC is constant, equal to c.
If the two firms are going to set price to maximize their profit, what is the Nash equilibrium?

28. Oligopoly Games in the Real World
Typically more than two strategies
Usually more than two players
In some games, one or more players may not have a dominant strategy
A game with two players will have a Nash equilibrium as long as at least one player has a dominant strategy
When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

29. Oligopoly Games in the Real World -- Static v.s. Dynamic
We’ve limited the players to one play of the game
In reality, for gas stations and almost all other oligopolies, there is repeated play
Where both players select a strategy
Observe the outcome of the trial
Play the game again and again, as long as they remain rivals

30. Oligopoly Games in the Real World -- Cooperation in the long run
One possible result of repeated trials is cooperative behavior
Results may be very different from equilibrium in a game played only once
Explicit collusion
Simplest
Managers meet face-to-face to decide how to set prices
Tacit collusion
No formal discussion

31. Explicit Collusion Most extreme form is creation of a cartel
Group of firms that tries to maximize total profits of the group as a whole
OPEC
However, it is not commonly observed. Why?
Usually illegal in U.S.A., EU & most of developed countries
Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways

32. Tacit Collusion Two most common forms Tit for tat Price Leadership
A game-theoretic strategy of doing to another player this period what he has done to you in previous period
Price Leadership
One firm—the price leader—sets its price and other sellers copy that price

33. Tacit Collusion - Tit For Tat
Prominent in airline industry
However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion
Oligopolist will sometimes go further
Attempting to punish a firm that threatens to destroy tacit cooperation
Lead to price wars

34. Tacit Collusion – Price Leadership
No formal agreement
Rather the decisions come about because firms realize—without formal discussion—that system benefits all of them

35. The Limits to Collusion
Oligopoly power—even with collusion—has its limits
demand constraints
collusion—even when it is tacit—may be illegal
collusion is limited by powerful incentives to cheat on any agreement

36. The Incentive to Cheat Will firm stick to the collusion?
Maybe, and maybe not
Problem—each player may conclude that he can do even better by cheating, Figure 5
Two players would be back to non-cooperative outcome based on their dominant strategies
May be in each player’s interest to cheat occasionally
Analyzing this sort of behavior requires some rather sophisticated game theory models
Economists are actively engaged in building them

37. When is Cheating Likely?
While no firm wants to completely destroy a collusive agreement by cheating
Since this would mean a return to the noncooperative equilibrium wherein each firm earns lower profit
Some firms may be willing to risk destroying agreement if benefits are great enough
Cheating is most likely to occur when there is
Difficulty observing other firms’ prices
Unstable market demand
Large number of sellers

38. The Future of Oligopoly
Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure
Prediction has not come true
Today, there are hundreds and thousands of ongoing businesses in United States
Possible reasons
Antitrust law
Globalization of markets
Technological change
In 1932, two economists—Adolf Berle and Gardiner Means—noted trend toward big business
Predicted the 200 largest U.S. firms would control nation’s entire economy by 1970
Unless something were done to stop it

39. Antitrust Legislation and Enforcement
Three types of actions
Preventing collusive agreements among firms
Such as price-fixing agreements
Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers
Preventing mergers that would lead to harmful market domination
While thrust of these policies is to preserve competition
Type of competition preserved—and zeal with which policies are applied—can shift
Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws

40. The Globalization of Markets
Globalization introduces competition
By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market
Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods
While consumers in each nation may have access to more firms, these may be larger and more powerful firms
Creating greater likelihood of strategic interaction and danger of collusion
Although oligopolists often try to prevent it, they face increasingly stiff competition from foreign producers

41. Technological Change Technological change works
To increase competition by creating new substitute goods
To reduce barriers to entry
To increase size of market
However, technologies on the other hand
encourage oligopoly by actually increasing MES of typical firm
Result could be strategic interaction, or collusion, among large national players
Thereby encouraging formation of oligopolies

42. The Four Market Structures: A Postscript
Different market structures
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Market structure models help us organize and understand apparent chaos of real-world markets

43. Summary on four types of market

44. Summary Oligopoly market characteristics Measure of market structure
Small number of large strategically interdependent firms
No free entry or exit
Either differentiated or standardized products
Measure of market structure
Barriers to enter the oligopoly market
Favorable reputation / legal / strategy / substantial economy of scale
Game theory approach to duopoly
Dominant strategy
Nash equilibrium
Prisoner’s dilemma
Repeated game: cooperative collusion
Explicit : Cartel
Implicit : Tit – for – Tat ; Price leadership
Cheating
Future of oligopoly depends on
Antitrust legislation / globalization of market / technological change