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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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    3

    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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    6

    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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    8

    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.