Oligopoly is a market structure featuring a small number of sellers that together account for a large fraction of market sales.

Oligopoly is derived from the Greek work

“olig” meaning “few” or “a small number.”

Features of oligopoly•Fewness of sellers

•Seller interdependence

•Feasibility of coordinated action among ostensibly independent firms

Measures of seller concentration

The concentration ratio is the percentage of total market sales accounted for by an absolute number of the largest firms in the market.

The four-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top four firms in the market.

The eight-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top eight firms in the market.

Industry or Product CR4 CR8

Refrigerators 94 98Motor vehicles 94 98Soft drinks 94 97Long distance telephone 92 97Laundry machines 91 NABreakfast foods 88 93Vaccuum cleaners 80 96Running shoes 79 97Beer 77 94Aircraft engines 72 83Domestic air flights 68 82Tires 66 86Aluminum 64 88Soap 60 73Pet food 52 71

Concentration Ratios: Very Concentrated Industries

Source: U.S. Bureau of the Census, Census of Manufacturers

Industry or Product CR4 CR8

Fast food 44 57Personal computers 45 63Office furniture 45 59Toys 41 58Bread 34 47Lawn equipment 40 57Machine tools 30 44Paint 24 36Newspapers 22 34Furniture 17 25Boat building 14 22Concrete 8 12Women's dresses 6 10

Concentration Ratios: Less Concentrated Industries

Source: U.S. Bureau of the Census, Census of Manufacturers

Seller interdependence•If Kroger offers deep discounts on soft drinks, will Wal-Mart follow suit?

•Northwest Airlines “perks” miles do not expire—how did United, Delta, et al react?

•AT&T’s “where’s the savings?” ad campaign prompted an effective retaliatory ad strategy by MCI.

•Some ISP’s now pledge not to sell information to database companies—will this affect AOL?

•Alcoa’s decision to add production capacity is conditioned upon the investment plans of rival aluminum producers.

Game Theory and Seller Interdependence

Selecting a course of action in a situation in

which rival players are selecting strategies that suit their interests is the basic problem

of game theory.

A situation of competitive rivalry must involve two or more players whose choice of actions affect each other.

1. Players and their actions

•A “player” can be a firm, an interest group or coalition, a military leader, government official.

•Games generally consider only one kind of action—e.g., number of daily departures, fares, in-flight services, schedules, advertising, choice of hubs, ordering planes, expanding terminals, use of computerized reservations systems, mergers and acquisitions, and human resource decisions.

2. Outcomes and Payoffs

The firm’s action, together with the actions of its rivals, determine its payoff

•In the standard “business” game, the payoff can be in the form of profit, market share, ratings points,

•In war games, the payoff might be measured in enemy killed or territory seized.

•In political games, payoffs may be measured in votes or campaign contributions.

3. Underlying “rules”

The rules of the game define the range of possible outcomes and payoffs

•For example, collusion to fix prices or a merger among direct rivals in a concentrated market structure may be against the rules.

•Another set a rules specifies whether players move sequentially or simultaneously, who moves first, and what does each player know about the other players’ preference and prior to actions?

Prisoner’s dilemma

Ralph and Gertie have been charged with bank robbery. But lacking a confession,

the DA can only get a “recklessendangerment” charge to stick. So the

police play one suspect off against the other.

OK, Ralph. Confess,rat on Gertie, and you get a

reduced sentence of one year in prison.

Let’s make a deal

What will Gertie do?

The payoff matrix

StayMum

Confess

StayMum

2 years, 2 years

8 years, 1 year

Confess 1 year,8 years

5 years,

5 years

Ralph

Gertie

Confess is the dominantstrategy in this case,

since it gives the shortest sentence irrespective of whether the other prisoner

selects the “confess” or “stay mum” strategy

Dominant strategy

A dominant strategy yields the best possible payoff for any strategy selected by the other player(s).

Price wars in a duopoly

The preceding is what we call a “non-cooperative” game.

Cooperation among duopolists is a strategy that maximizes joint profits. So why do price wars

break out?

The payoff matrix for a running shoe duopoly

HighPrice

LowPrice

HighPrice

$10 million, $10 million

$5 million,$12 million

Low Price

$12 million,$5 million

$7 million, $7 million

REEBOK

NIKE

Notice that “low price” is the dominant strategy

Pizza Planet and Luigi’s are rivals in the market for home-delivered pizza. Each rival seeks to gain an advantage through advertising (product differentiation).

Advertising is presumed NOT to affect market demand--only market share.

Market share depends on the intensity of advertising relative to one’s rival.

Advertising rivalry

Let

P = $15

Q = 100 pizzas (market quantity-demanded)

AC (w/o advertising expense) = $5.

Hence:

/Pizza = (TR - TC)/Q = ($1500 - $500)/100 = $10

If neither seller advertises, each will sell 50 pizzas and earn a profit of $500. However, advertising could potentially increase sales to 75 pizzas.

The payoff matrix for a pizza duopoly

LowAdvertising

HighAdvertising

LowAdvertising

$400, $400

$150,$550

HighAdvertising

$550,$150

$300, $300

LUIGI’S

PIZZA PLANET

Notice that “high advertising” is the dominant strategy

Nash Equilibrium A list of strategies, one for each player, is a Nash equilibrium if each player’s strategy maximizes his (or her) payoff given the strategies selected by the other players and if this condition holds for all players simultaneously.

You have Russell Crowe—er, I mean John Nash, to thank for this concept

Nash Equilibrium and the Shoe, Pizza Duopoly Games

•A Nash equilibrium is given by the “low-low” strategy in the running shoe duopoly game

•A Nash equilibrium is given by the “high-high strategy” in the pizza duopoly game.