Chapter 25

Oligopoly

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Chapter Objectives

• Concentration Ratios

• The Herfindahl-Hirschman index

• The competitive spectrum

• The kinked demand curve

• Administered prices

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Oligopoly Defined

• An oligopoly is an industry with just a few sellers

• How few? So few that at least one firm is large enough to influence price

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• Oligopoly is the prevalent type of industrial competition in the United States as well as in most of the noncommunist industrial west

• In terms of production, the vast majority of our GDP is accounted for by firms in oligopolistic industries

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Oligopoly

• The crucial factor under oligopoly is the small number of firms

• Because there are so few firms, every competitor must think continually about the actions of its rivals– What each does could make or break the others

• Thus, there is a kind of interdependance among oligopolists

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Oligopoly

• When we talk about big business in the United States,we’re talking about oligopolies. Some examples are– GM, Ford, ExxonMobil, IBM, Boeing, CBS,

NBC, Kellog, and General Mills– We can also include all the other industrial

giants that have become household names

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Oligopoly

• The graph of the oligopolist is similar to that of the monopolist– The oligopolist is analyzed in the same manner as

the monopolist with respect to price, output, profit, and efficiency

– Price is higher than the minimum point of the ATC curve, therefore the oligopolist is not as efficient as the perfect competitor

– The oligopolist has a higher price and a lower output than does the perfect competitor

– The oligopolist, like the monopolist, makes a profit

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Oligopoly

Concentration Ratios

• The concentration ration is the percentage share of industry sales of the four leading firms in the industry– Industries with high concentration ratios are

very oligopolistic

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Calculate the Concentration RatioFirm Percent of sales

A 14 %

B 4

C 23

D 5

E 2

F 8

G 17

H 10

I 2

J 15

Total 100 %

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The concentration ratio is

23 + 17 + 15 + 14 = 69

Concentration Ratio Shortcomings• Concentration ratios do not include imports

– This ignores 2 million Japanese imports as well as the hundreds of thousands of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royces the United States imports

• Concentration ratios tell us nothing about the competitive structure of the rest of the industry– Are all the firms relatively large or are they small?

– When the remaining firms are large, they are not as easily dominated by the top four as are dozens of relatively small firms

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Concentration Ratio Shortcomings

• Concentration rations have become less meaningful as imports have increased– The United States gets 80% of its consumer

electronics and 53% of its oil from abroad

• Imports tend to make the automobile industry’s concentration ration less relevant– Transplants reduce this ratio– As a result, the American car buyers have

reaped the benefits of lower prices and much higher quality

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• The HHI is the sum of the squares of the market shares of each firm in the industry– A monopoly has 100 percent of the market

share

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Herfindahl- Hirschman Index (HHI)

100 = (100 X 100) = 10,0002

You can’t get a bigger HHI number than 10,000. Every monopoly would have an HHI of 10,000

• The HHI is the sum of the squares of the market shares of each firm in the industry

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Herfindahl- Hirschman Index (HHI)

Find the HHI in an industry with just two firms

Each firm has 50 percent of the market

50 + 50 = 2,500 + 2,500 = 5,0002 2

• The HHI is the sum of the squares of the market shares of each firm in the industry

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Herfindahl- Hirschman Index (HHI)

Find the HHI in an industry that has four firms

Each firm has 25 percent of the market

25 + 25 + 25 + 25 2 222

625 + 625 + 625 + 6252500

The Competitive Spectrum

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Cutthroatcompetition

Strongcompetition

Weakcompetition

Priceleadership

Covertcollusion

Opencollusion

Cartel

The possible degrees of competition in an oligopolistic market

Cartels

• A cartel is a combination of firms that acts as if it were a monopoly– The leading firms in an industry band together to

restrict output, share out markets and, consequently, increase prices and profits

– If the demand is there, oligopolistic firms can openly collude to control supply and, to a large degree, market price

– OPEC did this in 1973 when the price of oil quadrupled

– A cartel is the most extreme case of oligopoly

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Withholding Supply to Raise Price

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Quantity

P2

P1

S2

S1

D

When supply is lowered from S1 to S2, price rises from P1 to P2

Open Collusion

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• Open collusion operates like the alleged Mafia– This would be some type of territorial

division of the market among the firms in the industry

• This type of arrangement gives each firm in the market a regional monopoly

• The firm may have only 15 or 20% of the market, but under this type of arrangement, its pricing behavior is that of the monopolist

– Open collusion is slightly less extreme than a cartel

The Colluding Oligopolist

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Output

120

105

90

75

60

40

35

30

25

MC

100 200 300 400 500 6000

ATC

D

MR

This graph could also belong to the monopolist or the monopolistic competitor in the short run

Covert Collusion• This usually involves price-fixing

– In the late 1950s General Electric, Westinghouse, Allis-Chalmers and other leading electrical firms conspired to fix the price of electrical transformers, turbines, and other electrical equipment

– They rigged government bids by taking turns making (high) low bids bilking the public of hundreds of millions of dollars

• In 1961 the U.S. Supreme court found 7 high ranking corporate officials guilty of illegal price fixing and market sharing agreements

• Their employers paid their fines• They got short jail sentences• Their employers paid their salaries while in jail, and they

got their old job back after they got out

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Other Cases of Collusion

• In 1996 Archer Daniels Midland Company pleaded guilty and paid a $100 million criminal fine for its role in two international price-fixing conspiracies

• In 1999 an arrangement was uncovered that fixed worldwide vitamin prices as much as 25% above the market level

• A worldwide price-fixing conspiracy led by Swiss and German companies was prosecuted by the U.S Department of Justice

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Price Leadership

• Price leadership is playing follow the leader– One company raises prices and shortly after, the

other companies in the same market do the same

• The prime rate set by the big banks is a form of price leadership

• Collusion is most likely to succeed when there are few firms and high barriers to entry

Cutthroat Competition

• Cutthroat competition is an extreme case• The cutthroat competitor’s actions are based on

assumptions about their rivals behavior• The cutthroat competitor assumes that if I raise

my price my competitors won’t raise their price• The cutthroat competitor assumes that if I

lower my price, my competitors will also lower their price

• Therefore the cutthroat competitor keeps the price just where it is

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The Cutthroat Oligopolist

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48

44

40

36

32

28

24

20

16

12

8

4

0 1 2 3 4 5 6 7Output

MR

ATC

MC

D

No cutthroat oligopolist will raise or lower price. It keeps the price just where it is and that is at the kink in the demand curve

The Cutthroat Oligopolist

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48

44

40

36

32

28

24

20

16

12

8

4

0 1 2 3 4 5 6 7Output

MR

ATC

MC

D

How much is the price and output for this firm?

Price is $27

Output is 4

At an output of 4 MC=MR

The Cutthroat Oligopolist

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48

44

40

36

32

28

24

20

16

12

8

4

0 1 2 3 4 5 6 7Output

MR

ATC

MC

D

Price is $27

Output is 4

At an output of 4 MC=MR

ATC is $24

Total Profit = (Price – ATC) X Output

= ($27 – 24) X 4 = 3 X 4 = 12

Conclusion

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Cutthroatcompetition

Strongcompetition

Weakcompetition

Priceleadership

Covertcollusion

Opencollusion

Cartel

At one of the spectrum we have the cartel, which no longer operates within the American economy, although it may be found in world markets

At the other end of the spectrum, we have the cutthroat competitor, the firm that will stop at nothing to beat out its rivals

Near the middle are the mildly competing oligopolists and the occasionally cooperating oligopolists.

Conclusion

25-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Cutthroatcompetition

Strongcompetition

Weakcompetition

Priceleadership

Covertcollusion

Opencollusion

Cartel

Where is the spectrum in American industry? The answer is that there is no answer.

First, there is no one place where American industry is located because different industries have different competitive situations.

Second, there is widespread disagreement about the degree of competition in any given industry