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OligopolyOligopoly

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

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OverviewOverview Oligopoly market characteristics

Measure of market structure

Barriers in oligopoly market

Game theory approach to duopoly

Cooperative collusion

Cheating

Future of oligopoly

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OligopolyOligopoly When just a few large firms dominate a

market

In such a market, each firm recognizes its strategicinterdependence with others

So that actions of each one have an important

impact on the others

An oligopoly is a market dominated by a smallnumber ofstrategically interdependentfirms

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Number of Fir

msNumber of Fir

ms

Oligopoly requires that a few firms dominate themarket

How few?

At some point, number of firms is large enoughand interdependence weak enoughthat oligopolybecomes a poor description

Monopolistic competition would fit better

No absolute number at which oligopoly ends and

monopolistic competition begins

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Market Do

mination

Market Do

mination

Strategic interdependence requires that afew 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

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Econo

m

ies

of Sca

le:Na

tu

ra

l OligopoliesEc

onom

ies

of Sca

le:Na

tu

ra

l 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 cantcompete

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

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Figure 1:

Natura

l OligopolyFigure 1:

Natura

l Oligopoly

E

H F

25,000

Units per Month

100,0000

80

$200

Dollars

DMarket

LRATCTypical Firm

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Repu

ta

tionas

a

Ba

rrierR

epu

ta

tionas

a

Ba

rrier 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 great, stay out.

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Strategic BarriersStrategic Barriers

Strategies designed to keep out potentialcompetitors, 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 itsproduct

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Legal Ba

rriers

Legal Ba

rriers

Patents and copyrightswhich can beresponsible for monopolycan also create

oligopolies Like monopolies, oligopolies are not shy

about lobbying government to preservetheir market domination

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Measu

res

ofMa

rket Structure

Measu

res

ofMa

rket Structure

Concentration ratios: Aggregated marketshare of the largest N firms in the industry

Range: 0-100% 4 Firm Concentration ratio: Market share

controlled by the largest 4 firms

Others reported by the U.S. Census: 8 Firm

20 Firm

50 Firm

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Measures ofMarket StructureMeasures ofMarket Structure

Herfindahl-Hirschman Index: summed squares ofall firm market shares in the industry

Si = market share (in percent) of the ith firm

HHI = (Si )2

Range: 0 (perfect competition) to 10,000(monopoly)

i

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Data

on Firm

Numb

ersand SizeD

ata

on Firm

Numb

ersand Size

Compiled by the U.S. Bureau of the Census

Every 5 years

Surveys of domestic firms

Data monitored by Federal Government

Competitive environment Merger advisability

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Databased on the 2002 Economic Census.

http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13

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

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Databased on the 2002 Economic Census.

http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13

Measured Industry Concentration in Manufacturing

D: Not disclosed

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Databased on the 2002 Economic Census.

http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13

Measured Industry Concentration in Manufacturing

D: Not disclosed

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Oligopoly vs. OtherMarket StructuresOligopoly vs. OtherMarket Structures

Oligopoly presents the greatest challenge toeconomists

essence of oligopoly is strategic interdependence economists have had to modify the tools used to

analyze other market structures and to developentirely new tools as well

One approachgame theoryhas yielded richinsights into oligopoly behavior

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The Game Theory ApproachThe Game Theory Approach

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

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Gam

eT

heory ApproachG

ameT

heory Approach

Some situations to which game theory canbe 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

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Gam

eT

heoryGam

eT

heory Short HistoryShort History

John Von Neumann (1903-1957)

Theory of Games and EconomicBehavior with OskarMorgenstern

This book established gametheory as a field

An introduction to gametheoryby Martin J.Osborne. OxfordUniversity Press, 2002

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Gam

eT

heoryGam

eT

heory Short HistoryShort History

John F. Nash, Jr.(1928- )

One of the contributions is

the introduction of theequilibrium notion now

known as Nash equilibrium

1994 Nobel prize winner in

economics with the game

theorists John Harsanyi and

Reinhard SeltenAn introduction to game theory

by Martin J. Osborne. OxfordUniversity Press, 2002

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The Pri

soner

sDile

mmaThe Pri

soner

sDile

mma

Simple example to explain why a techniquefor 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

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Figure 2: The Prisoners DilemmaFigure 2: The Prisoners 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

C -20, -20 -3, -30

NC -30, -3 -5, -5

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The Prisoners DilemmaThe Prisoners Dilemma

A dominant strategy: the players best strategy

regardless of the other players strategy

Roses dominant strategy is

confess

regardlessof Colins choice

So is Colin

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Nash Eq

uilibriumNas

h Equilibrium

Outcome of this game is an example of aNash equilibrium

Exists when each player is taking the bestactiongiven best actions taken by otherplayers

Under the Nash Equilibrium, no players wantto deviate

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Figure 3:Figure 3: Working on a joint project

Elements

Players:{you, your

friend} Strategies:{work hard,

Goof off}

Payoffs

What is the NashEquilibrium?

Friend

You

W G

W2, 2 0, 3

G 3, 0 1, 1

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Figure 4:Figure 4: Battle of Sex

Elements

Players:{Mr. R and

Mrs.