11.4 The Characteristics of an Oligopoly

• An oligopoly is a market structure characterized by:– Small Number of firms– Interdependence/agreement– Barriers to entry– Industry Concentration

Interdependence

• A key characteristic of oligopolies is that each firm can affect the market, making each firm’s choices dependent on the choices of the other firms. They are interdependent or, Strategically dependent

Interdependence

• The importance of interdependence is that it leads to strategic behavior.

• Strategic behavior is the behavior that occurs when what is best for A depends upon what B does, and what is best for B depends upon what A does.

• Oligopolistic behavior includes both ruthless competition and cooperation.

Barriers to Entry

• Economies of Scale – larger firms have a cost advantage

• Legal Barriers – patents and government regulation eg CRTC regulation and licenses

• Firm-Created Barriers – eg lowering prices so low that new firms can’t make a profit because their costs are too high

Measuring Industry Concentration• How do identify an oligopoly in the industry?Concentration Ratio: the % of industry sales

contributed by the four largest firms

• The higher the concentration the lower the competition.

11.5 Price Behavior in Oligopoly

• Cannot show the optimal level of production (Q*) or price (P*) for the oligopoly

• When there are few firms competing in the industry like in an oligopoly, each firm REACTS to the price/quantity set by the other firms

• How does the oligopolies determine P*/Q*??– The Best Response Function –

Oligopolists are interdependent, they strategize

Game Theory• Strategic behavior has been analyzed using

the mathematical techniques of game theory.

• Game theory provides a description of oligopolistic behavior as a series of strategic moves and countermoves.

Game Theory

• If firms get together and collude or fix prices that is considered a cooperative game

• When it is too costly to collude and enforce the agreements they are in a non-cooperative game situation

Game Theory• Games can be classified by wether there is a

negative, zero or positive pay-off• Zero Sum Game: one firm’s losses are another

firm’s gain• Negative Sum Game: the group of firms lose

at the end of the game• Positive Sum Game: the group of firms end up

better off at the end of the game

Non-cooperative Price Behavior

• Because each firm competes, strategy (rule) is used to maximize profit

• When a strategy is always successful over competitors, then it is called dominant

Eg. Prisoners Dilemma

Dominant Strategy• In an oligopoly, firms try to achieve a

dominant strategy—a strategy that produces better results no matter what strategy other firms follow.

• The interdependence of oligopolies decisions can often lead to the prisoner’s dilemma.

Game Theory and Strategic Decision Making

• The prisoner’s dilemma is a well-known game that demonstrates the difficulty of cooperative behavior in certain circumstances.

Game Theory and Strategic Decision Making

• In the prisoner’s dilemma, where mutual trust gets each one out of the dilemma, confessing is the rational (selfish) choice.

Prisoner’s Dilemma and a Duopoly Example

• The prisoners dilemma has its simplest application when the oligopoly consists of only two firms—a duopoly.

Prisoner’s Dilemma and a Duopoly Example

• By analyzing the strategies of both firms under all situations, all possibilities are placed in a payoff matrix.

• A payoff matrix is a box that contains the outcomes of a strategic game under various circumstances.

Prisoner’s Dilemma and a Duopoly Example

B Cheats

B Does not cheat

A Does not cheat A Cheats

B gets +$200,000 B gets 0

A gets 0

A gets +$200,000

B gets $75,000

A gets $75,000

A loses – $75,000

B loses – $75,000

The Payoff Matrix of Strategic Pricing Duopoly

Prisoner’s DilemmaPrisoner’s Dilemma

Repeated Games• Eventually, there would be a strong incentive to

“cheat” for either company gaining $200,000 compared to $75,000

• This cheating is called Opportunistic Behavior: where a competing firm cheats for a short period of time to get higher profits

• The other company will respond by cheating also – a Tit-for-tat strategy

• Both companies will now get ZERO profits

So, IN THE LONG RUN IT IS ALWAYS BETTER TO COOPERATE

Cooperative Pricing• If the firms in an oligopoly cooperate, they may earn more

profits than if they act independently.

• Price Fixing or Collusion, which leads to secret cooperative agreements, is illegal in the U.S., although it is legal and acceptable in many other countries.

• Price Leadership: the largest firm posts it’s prices and the rest follow – not illegal

Cartels• A cartel is an organization of

independent firms whose purpose is to control and limit production and maintain or increase prices and profits.

• Like collusion, cartels are illegal in the United States.

Factors Conducive to Cooperative Behavior

• There are few firms in the industry.• There are significant barriers to entry.• An identical product is produced.• There are few opportunities to keep actions secret.• There are no legal barriers to sharing agreements.

OPEC as an Example of a CartelOPEC as an Example of a Cartel• OPEC: Organization of Petroleum Exporting Countries.

• Attempts to set prices high enough to earn member countries significant profits, but not so high as to encourage dramatic increases in oil exploration or the pursuit of alternative energy sources.

• Controls prices by setting production quotas for member countries.

• Such cartels are difficult to sustain because members have large incentives to cheat, exceeding their quotas.

Cartels and Technological Change

• Cartels can be destroyed by an outsider with technological superiority.

• Thus, cartels with high profits will provide incentives for significant technological change.

Pricing to Deter Entry into an Industry

• Predatory Pricing: firms cut the prices below costs to deter entry of new firms

• Price War: firms react to rival’s price out with even larger price cuts

11.6 Nonprice Forms of Competition

• Price wars are costly and collusion can be illegal, so…

• Product differentiation• Physical attributes• Bundling of services• Location and accessibility• Sales promo and adverts

Product differentiation

• Advertising – large, rich companies can spend huge amounts and smaller, newer firms might be discouraged to compete

Mergers

• Firms can increase their share of the industry through combining their business with other similar businesses

• Horizontal Merger: selling similar products• Vertical Merger: buying a firm that sells

similar outputs or buys similar outputs• Conglomerate Merger: joining of firms that

are not related

Exclusive Dealings

• A firms supplies its product to a customer on condition that they not buy similar products from rival firms supplying a similar product

Raising Switching Costs

• If a firm can make it expensive for a consumer to switch to another firms product it can insulate itself from competition

Eg. Windows OS can’t run on Apple or a locked cell phone

Network Effects

• Related to switching costs• Network Effects: represent a shared

understanding among consumers about how to use a particular product, service or brand

eg. Owning a phone or fax machine becomes more useful the more people who own them or if everyone is using WINOS it is easier as a student to exchange files

Innovation

• Large size of oligopolies means that they can undertake expensive R&D

• Can channel their competitive interests into product innovation

11.7 Social Evaluation of Oligopoly

• Because of low number of firms in the industry there is a lack of competition, and nonprice competition resource use leads to productive inefficiency

• Because they can engage in cooperative behavior the industry can limit output and increase prices

• Sometimes because of economies of scale, lower prices might exist because of lower costs, and also innovation