Basic Concepts Oligopoly

7/29/2019 Basic Concepts Oligopoly

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OligopolyBasic Concepts


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Oligopoly

Market Structure ContinuumPure

CompetitionPure

MonopolyMonopolisticCompetition

Four market model


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Oligopoly

Definition:

an industry with only a fewsellers selling anidenticalordifferentiated product.

Product may be identical

aluminum

crude oil

or product may be differentiated

Automobile

cigarettes


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Characteristics of Oligopoly

A few characteristics ofoligopoly: small number of rival firms (highly concentrated

markets)

The actions of any one seller in the market can have a

large impact on the profits of all the other sellers.firms are interdependent

Each seller is large enough to influence pricemeans each seller faces a downward sloping

demand curve substantial economies of scale Usually high barriers to entry


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Economies of scale

UnitCost

Long run average cost

Quantity per year


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Barriers to Entry

StructuralThe cost advantage over entrants because of Economies of scale

Economies of scope Control over key input

Government regulations

Strategic

The action of incumbents that may deter entry Over investment in capacity

Limit pricing


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Price and Output UnderOligopoly

Because of interdependence and diversity No

general theoryexists for price and output underoligopoly.

If the firms operated independently, they woulddrive down the price to the per unit cost of

production.

If the firms colluded perfectly, the price would rise

to the monopoly price.

The outcome is usually between these two

extremes.


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Price and Output UnderOligopoly If oligopolists compete with one another, price cutting

drives price down to PC, and expands total output to QC. In contrast, perfect cooperation among firms leads to a

higher price PM and a smaller market output ofQM.

Due to the difficulty to perfectly collude, when firms try tocoordinate their activity, price is typically between PC andPM and output between QM and QC.

LRAC = LRMC

DemandMR

PM

PC

QM QC

Profits to oligopolywith perfectcollusion.


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Incentive to Collude

Firms would be better off cooperating and

jointly maximizing their profits However, each

firm has an incentive to cheat by lowering

price because the demand curve facing each

firm is more elastic than the market demand

curve.

This conflict makes collusive agreementsdifficult to maintain.


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Gaining from Cheating

Using industry demandDi and marginal revenueMRi,oligopolists maximize their joint profit where MRi=MC at output Qi and price P i .

Demand facing each firm df(where no other firms cheat)would be much more elastic than industry demandDi .

The firm maximizes its profit where MRf=MC byexpanding output to qfand lowering its price to Pffrom P i

Di

MC

MRi

Pi

MC

Pi

Qi

dfMRf

Pf

qf

Industry Firm


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Gaining from Cheating Using industry demandDi and marginal revenueMRi,

oligopolists maximize their joint profit where MRi=MC at output Qi and price P i .

Demand facing each firm df(where no other firms cheat)would be much more elastic than industry demandDi .

The firm maximizes its profit where MRf=MC byexpanding output to qfand lowering its price to Pffrom P i

Di

MC

MRi

Pi

MC

Pi

Qi

dfMRf

Pf

qf

Industry Firm

Individual firms havean intensive to cheatby cutting price toexpand out put


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Nash Equilibrium

The Nash equilibrium is a non-cooperative

equilibrium - each firm makes the decision

that gives it the maximum possible profit,

given the actions of its competitors.

As demonstrated, this does not produce a

monopoly outcome.

Only if firms can prevent entry by potentialnew firms and collude with existing firms can

they realize a monopoly outcome.


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Strategic behavior is

firm behavior that takes

into account the market

power and reactions ofother firms in the

industry

Strategic Behavior


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Collusive Strategy

Repeated interaction provides opportunities for firmsto learn and deploy an array of strategies to enforcecollusion. These include: tit-for-tat and triggerstrategies

Tit-for-tat strategy: firm colludes in current periodonly if other firm colluded in previous period;otherwise choose not to collude, e.g. price war.

Trigger strategy: firm colludes if the other firm

colludes, but reverts to Nash equilibrium strategy inevery future period if the other firm chooses not tocollude.


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Collusive Strategy

Since each firm learns that it makes a larger

profit by sticking to collusion, both firms do so

and the monopoly outcome prevails.

This outcome results from each firm

responding rationally to the credible threat of

the other firm to inflict damage if the

agreement to collude is broken.


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Types of Collusive Arrangements

A collusive agreement can be overt or tacit

Overt agreements can take the form of a

cartel which are formal arrangements to fixprices, divide up or share the market or limit

competition.

Tacit agreements are less formal

arrangements and can take the form of averbal gentlemans agreement to fix pricesand output.


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Obstacles to Collusion

As the number of firms in an oligopolistic marketincreases, the likelihood of effective collusiondeclines.

When it is difficult to detect cheating (secret price

cuts), effective collusion is less likely.Low entry barriers also make effective collusion less

likely because profit attracts additional rivals.

Unstable demand conditions lead to honest

differences among firms about the size of sharesand price that maximizes total profit.

Rigorous enforcement of antitrust law makescollusionpotentiallymore costly.

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Basic Concepts Oligopoly

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