1. Chapter 27: Oligopoly and Strategic Behavior
ECON 152 – PRINCIPLES OF MICROECONOMICS
Chapter 27: Oligopoly and Strategic Behavior
Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

2. Oligopoly
Oligopoly
A market situation in which there are very few sellers
Each seller knows that the other sellers will react to its changes in prices and quantities

3. Oligopoly Characteristics of oligopoly Small number of firms
Interdependence
Strategic dependence
A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry

4. Oligopoly Why oligopoly occurs Economies of scale Barriers to entry
Mergers
Vertical Merger
The joining of a firm with another to which it sells an output or from which it buys an input
Horizontal Merger
The joining of firms that are producing or selling a similar product

5. Oligopoly Determining the Existence of an Oligopoly
Concentration Ratio
The percentage of all sales contributed by the leading four or leading eight firms in an industry
It is difficult to specify an arbitrary absolute number to demonstrate the existence of an oligopoly, but it is a good indicator.
Verification is usually based on the observed strategies and behavior of the firms of the industry.

6. Computing the Four-Firm Concentration Ratio
Annual Sales
Firm ($ Millions)
1 150
2 100
3 80
4 70
5 through 25 50
Total number
of firms in
Industry = 25
Total 450
Four-firm concentration ratio =
450
400
88.9% =
Table 27-1

7. E-Commerce Example: Concentration in the Search-Engine Industry
Internet search-engines collect revenue through advertisements posted on their websites.
To measure the concentration ratio in this industry, economists count the number of searches conducted on each site.

8. E-Commerce Example: Concentration in the Search-Engine Industry
The four most frequently used search-engines are Google, Yahoo, AOL Time Warner, and MSN.
The four-firm concentration ratio in this industry is 91 percent, indicating that it qualifies as an oligopoly.

9. Oligopoly, Inefficiency, and Resource Allocation
Oligopolistic firms have some degree of market power, which means each one can affect the market price.
This creates some inefficiency in resource allocation.
But to the extent that U.S. oligopolies must compete with firms from other countries, their market power is limited.

10. Strategic Behavior and Game Theory
Explaining the pricing and output behavior of oligopoly markets
Reaction Function
The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry

11. Strategic Behavior and Game Theory
A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly

12. Strategic Behavior and Game Theory
Cooperative Game
A game in which the players explicitly cooperate to make themselves better off
Noncooperative Game
A game in which the players neither negotiate nor cooperate in any way

13. Strategic Behavior and Game Theory
Zero-Sum Game
A game in which any gains within the group are exactly offset by equal losses by the end of the game
Negative-Sum Game
A game in which players as a group lose at the end of the game
Positive-Sum Game
A game in which players as a group are better off at the end of the game

14. Strategic Behavior and Game Theory
Strategies in noncooperative games
Strategy
Any rule that is used to make a choice
Any potential choice that can be made by players in a game
Dominant Strategies
Strategies that always yield the highest benefit

15. Example: The Prisoner’s Dilemma
You and your partner rob a bank and get caught.

16. Prisoner’s Dilemma You are separated and given these options:
Both confess and get five years in jail
Neither confess and get two years
One confess and the other does not
Confessor goes free
One who does not confess gets ten years
Assume you are Sam reacting to the possible actions of Carol.

17. The Prisoners’ Dilemma Payoff Matrix
Figure 27-1

18. The Prisoners’ Dilemma Payoff Matrix
Confessing is better than not confessing.
Figure 27-1

19. The Prisoners’ Dilemma Payoff Matrix
Confessing is better than not confessing.
Confessing is better than not confessing.
Figure 27-1

20. Strategic Behavior and Game Theory
Applying game theory to pricing strategies
Would you choose a high price or a low price?
Remember
No collusion

21. Pricing Dilemma The firms are separated and given these options:
Both charge high price and each gets $6 million
Both charge low price and each gets $4 million
One charges low price and the other high
Lower priced firm gets $8 million
Higher priced firm gets $2 million
Assume you are Firm #2 reacting to the possible actions of Firm #1

22. Strategic Behavior and Game Theory
Figure 27-2

23. Strategic Behavior and Game Theory
Low is better than high.
Figure 27-2

24. Strategic Behavior and Game Theory
Low is better than high.
Low is better than high.
Figure 27-2

25. Strategic Behavior and Game Theory
Opportunistic Behavior
Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains
An example might be writing a check that you know will bounce
Not realistic
Consequences tend to be more obvious
We make repeat transactions

26. Strategic Behavior and Game Theory
Tit-for-Tat Strategic Behavior
In game theory, cooperation that continues so long as the other players continue to cooperate

27. Price Rigidity and the Kinked Demand Curve
Panel (a) d 1 d 1 A q P
Price and Marginal Revenue per Unit
Quantity per Time Period
Figure 27-3, Panel (a)

28. Price Rigidity and the Kinked Demand Curve
Panel (a) d 2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share d 1 d 1 A q P
Price and Marginal Revenue per Unit
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
Quantity per Time Period
Figure 27-3, Panel (a)

29. Price Rigidity and the Kinked Demand Curve
Panel (a) d 2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share d 1 MR 1 d 1 A q P
Price and Marginal Revenue per Unit
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
Quantity per Time Period
Figure 27-3, Panel (a)

30. Price Rigidity and the Kinked Demand Curve
Panel (a) d 2
MR2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share d 1 MR 1 d 1 A q P
Price and Marginal Revenue per Unit
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
Quantity per Time Period
Figure 27-3, Panel (a)

31. Price Rigidity and the Kinked Demand Curve
Panel (b) d 2 1
The kinked demand curve indicates the possibility of price rigidity MR 2 1 A q P
Price and Marginal Revenue per Unit
Quantity per Time Period
Figure 27-3, Panel (b)

32. Price Rigidity and the Kinked Demand Curve2 1 MR 2 1 q P ' MC MC
Price, Marginal Revenue, and
Marginal Cost per Unit
MC"
Changes in cost do
not impact output
and prices as long as
MC remains in the
vertical portion of MR
Quantity per Time Period
Figure 27-4

33. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices
Price leadership behavior is apparent in the overnight package delivery industry

34. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
Price War
A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices

35. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
Markets where price wars are common
Cigarettes
Long-distance telephone companies
Airlines
Diapers
Frozen foods
PC hardware and software

36. Deterring Entry Into an Industry
Entry Deterrence Strategy - Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm
Increasing entry cost
Threat of price wars
Government regulations
Limit-Pricing Strategies – A group of colluding sellers will set the highest common price without new firms seeking to enter the industry
Raising switching costs for customers
Non-compatible software
Non-transferability of college courses

37. Network Effects and Industry Concentration
A network effect is a situation in which a consumer’s inclination to use an item depends on how many others use it.
In an industry selling products subject to network effects, a small number of firms may be able to secure the bulk of the payoffs resulting from positive market feedback.
Oligopoly is likely to emerge as the prevailing market structure.

38. Comparing Market Structures
Long-Run
Number Unrestricted Ability Economic
Market of Entry and to Set Profits Product Nonprice
Structure Sellers Exit Price Possible Differentiation Competition Examples
Perfect Numerous Yes None No None None Agriculture, competition roofing nails
Monopolistic Many Yes Some No Considerable Yes Toothpaste competition toilet paper, soap, retail trade
Oligopoly Few Partial Some Yes Frequent Yes Recorded music, college textbooks
Pure One Not Consider- Yes None Yes Some electric monopoly for entry able (product is companies, unique) some local telephone companies
Table 27-3

39. Chapter 27: Oligopoly and Strategic Behavior
ECON 152 – PRINCIPLES OF MICROECONOMICS
Chapter 27: Oligopoly and Strategic Behavior
Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.