OLIGOPOLIESOLIGOPOLIES Markets with just a few firms. Markets with just a few firms. CONCENTRATION RATIO Measure of the degree of concentration in a market.Measure

OLIGOPOLIESOLIGOPOLIES

Markets with just a few firms.Markets with just a few firms.

CONCENTRATION RATIOCONCENTRATION RATIO• Measure of the degree of concentration in a market.Measure of the degree of concentration in a market.• Four-Firm Concentration Ratio -Four-Firm Concentration Ratio -

Percentage of output produced by the four largest firms.Percentage of output produced by the four largest firms.

Rule of thumb - If four-firm concentration ratio is greater Rule of thumb - If four-firm concentration ratio is greater than 40%, the market is considered an oligopoly.than 40%, the market is considered an oligopoly.

CONCENTRATION RATIOS IN SELECTED CONCENTRATION RATIOS IN SELECTED MANUFACTURING INDUSTRIESMANUFACTURING INDUSTRIES

IndustryIndustry Four-FirmFour-Firm Eight-FirmEight-Firm Concentration-Concentration-Ratio %Ratio % Concentration-Ratio %Concentration-Ratio %

CigarettesCigarettes 93 93 Not AvailableNot Available

Guided Missiles & Space 93Guided Missiles & Space 93 9999 VehiclesVehicles

Beer and Malt BeverageBeer and Malt Beverage 90 90 9898

BatteriesBatteries 87 87 9595

Electric BulbsElectric Bulbs 86 86 9494

Breakfast CerealsBreakfast Cereals 85 85 9898

Motor Vehicles & CarMotor Vehicles & Car 84 84 9191 BodiesBodies

Greeting CardsGreeting Cards 84 84 8888

Engines and TurbinesEngines and Turbines 79 79 9292

Aircraft and PartsAircraft and Parts 79 79 9393

• Firms act strategically;Firms act strategically;• Firms in an oligopoly are Firms in an oligopoly are

independent because they sell independent because they sell similar products, and consumers similar products, and consumers can easily switch from one firm to can easily switch from one firm to another;another;• Actions of one firm affect the profits Actions of one firm affect the profits

of other firms in the oligopoly.of other firms in the oligopoly.

KEY FEATURE OF OLIGOPOLYKEY FEATURE OF OLIGOPOLY

WHY FIRMS DON’T ENTER A PROFITABLE OLIGOPOLY WHY FIRMS DON’T ENTER A PROFITABLE OLIGOPOLY MARKETMARKET

• ECONOMIES OF SCALE In some cases, scale economies are not ECONOMIES OF SCALE In some cases, scale economies are not large enough to generate a natural monopoly but are large enough to large enough to generate a natural monopoly but are large enough to generate a natural oligopoly, with a few firms serving the entire generate a natural oligopoly, with a few firms serving the entire market.market.

• ARTIFICAL BARRIERS TO ENTRY Government may limit the number ARTIFICAL BARRIERS TO ENTRY Government may limit the number of firms in a market by issuing patents or controlling the number of of firms in a market by issuing patents or controlling the number of business licenses.business licenses.

• ADVERTISING CAMPAIGN For some markets, a firm cannot enter ADVERTISING CAMPAIGN For some markets, a firm cannot enter without a substantial investment in an advertising campaign.without a substantial investment in an advertising campaign.

DollarsDollarsPer TripPer Trip

Market DemandMarket Demand

CARTEL VERSUS DUOPOLYCARTEL VERSUS DUOPOLY

d: d: duopolyduopoly

Long-run Average CostLong-run Average Cost

350350

300300

200200

Passengers Per DayPassengers Per Day

DUOPOLY PROFITDUOPOLY PROFIT• Two-hundred passengers a day (100 Two-hundred passengers a day (100

per airline),per airline),

• Price of $350,Price of $350,

• Average cost of $300,Average cost of $300,

• Per passenger profit $350 - $300 =$50,Per passenger profit $350 - $300 =$50,

• Total profit per airline:Total profit per airline:$50 $50 ** 100 = $5,000 100 = $5,000

CARTELCARTEL A group of firms that A group of firms that

coordinate their pricing coordinate their pricing decisions, often by charging decisions, often by charging the same price.the same price.

This is also known as This is also known as priceprice fixingfixing..

DollarsDollarsPer TripPer Trip


CARTEL VERSUS DUOPOLYCARTEL VERSUS DUOPOLY

m: m: monopoly or cartelmonopoly or cartel

d: d: duopolyduopoly

Long-run Average CostLong-run Average Cost

400400

350350

300300

150150 200200

Passengers Per DayPassengers Per Day

CARTEL PROFITCARTEL PROFIT• One-hundred fifty passengers per day One-hundred fifty passengers per day

(point m), or 75 passengers per airline,(point m), or 75 passengers per airline,

• Price of $400,Price of $400,

• Average cost 0f $300,Average cost 0f $300,

• Per passenger profit $400 - $300 =$100Per passenger profit $400 - $300 =$100

• Total profit per airline: Total profit per airline: $100 $100 ** 75 = $7,500 75 = $7,500

The cartel profit exceeds the profit when The cartel profit exceeds the profit when the two airlines compete. the two airlines compete.

THE GAME TREETHE GAME TREE

• Will firms act independently as duopoly firms, Will firms act independently as duopoly firms, or will they reach a price-fixing agreement ?or will they reach a price-fixing agreement ?

• Game tree: a graphical tool that provides a Game tree: a graphical tool that provides a visual representation of the consequences of visual representation of the consequences of alternative strategies;alternative strategies;

• Each firm can use the game tree to develop a Each firm can use the game tree to develop a pricing strategy, knowing that the other firm is pricing strategy, knowing that the other firm is picking a price too.picking a price too.

JILL:JILL:high high

or lowor lowpriceprice

High PriceHigh Price

Low PriceLow Price

JACK:JACK:high high


JACK:JACK:high high


PROFITSPROFITS11

22

33

44

XX

YY

ZZ

JILLJILL JACK JACK7,5007,500 7,500 7,500





Low PriceLow Price


Low PriceLow Price

PROFITS WHEN FIRMS PICK DIFFERENT PROFITS WHEN FIRMS PICK DIFFERENT PRICESPRICES

Jill: Low PriceJill: Low Price Jack: High PriceJack: High Price

PricePrice $350$350 $400$400

QuantityQuantity 170170 1010

Average CostAverage Cost $300$300 $300$300

Profit Per Profit Per $50$50 $100$100PassengerPassenger

ProfitProfit $8,500$8,500 $1,000$1,000

JILL:JILL:high high



Low PriceLow Price

JACK:JACK:high high


JACK:JACK:high high


PROFITSPROFITS11

22

33

44

XX

YY

ZZ






Low PriceLow Price


Low PriceLow Price

Jill: (10 pass Jill: (10 pass ** $400)-$3000 $400)-$3000

Jack:(170 pass Jack:(170 pass ** $350)-$3000 $350)-$3000

Jill:(170 pass Jill:(170 pass ** $350)-$3000 $350)-$3000Jack: (10 pass Jack: (10 pass ** $400)-$3000 $400)-$3000

THE OUTCOME OF THE PRICE-THE OUTCOME OF THE PRICE-FIXING GAMEFIXING GAME

• If Jill picks the high price, move along upper If Jill picks the high price, move along upper branches of tree, reaching rectangle 1 or 2, branches of tree, reaching rectangle 1 or 2, depending on what Jack does;depending on what Jack does;

Although Jill would like Jack to pick high price too, Although Jill would like Jack to pick high price too, irrational for Jack, since he can make more profit by irrational for Jack, since he can make more profit by picking low price; (eliminate rectangle 1)picking low price; (eliminate rectangle 1)

• If Jill Picks low price, move along lower branches of If Jill Picks low price, move along lower branches of tree, reaching rectangle 3 or 4, depending on Jack’s tree, reaching rectangle 3 or 4, depending on Jack’s choice;choice;

Jack won’t pick high price, because Jill would gain at Jack won’t pick high price, because Jill would gain at his expense; (eliminate rectangle 3) his expense; (eliminate rectangle 3)

JACK’S DOMINANT STRATEGYJACK’S DOMINANT STRATEGY

Jack will pick the low price, regardless of what Jack will pick the low price, regardless of what Jill does.Jill does.

JILL’S DOMINANT STRATEGYJILL’S DOMINANT STRATEGY

Since Jill knows that Jack will always choose the Since Jill knows that Jack will always choose the lower price, it would be irrational for Jill to lower price, it would be irrational for Jill to choose the higher price and allow Jack to gain at choose the higher price and allow Jack to gain at her expense. Jill also chooses the lower price.her expense. Jill also chooses the lower price.

DUOPOLIST’S DILEMMADUOPOLIST’S DILEMMA

Although both firms would Although both firms would be better off if they picked be better off if they picked the high price, each firm the high price, each firm picks the low price.picks the low price.

GUARANTEED PRICE MATCHINGGUARANTEED PRICE MATCHING

To eliminate the incentive for underpricing, one firm can guarantee To eliminate the incentive for underpricing, one firm can guarantee that it will match its competitor’s price.that it will match its competitor’s price.

Jack can respond to Jill’s promise to match price in either of two ways:Jack can respond to Jill’s promise to match price in either of two ways:• Pick the high price, each will earn $7,500;Pick the high price, each will earn $7,500;• Pick the low price, each will earn $5,000;Pick the low price, each will earn $5,000;

Jack won’t have to think long before choosing the high price.Jack won’t have to think long before choosing the high price.

RETALIATION STRATEGIESRETALIATION STRATEGIES

Firms use several strategies to Firms use several strategies to maintain a price-fixing agreement. maintain a price-fixing agreement. Three which involve punishing a firm Three which involve punishing a firm that underprices the other firm are:that underprices the other firm are:

• Duopoly price,Duopoly price,

• Grim trigger,Grim trigger,

• Tit-for-tatTit-for-tat

DUOPOLY PRICEDUOPOLY PRICE• Jill picks high price until Jack Jill picks high price until Jack

underprices her;underprices her;

• Once underpriced, Jill picks duopoly Once underpriced, Jill picks duopoly price for remaining lifetime of firm;price for remaining lifetime of firm;

• Less profitable than cartel outcome, Less profitable than cartel outcome, but more profitable than being but more profitable than being underpriced.underpriced.

GRIM TRIGGERGRIM TRIGGER

• When underpriced, Jill drops When underpriced, Jill drops price to level at which each firm price to level at which each firm earns zero economic profit earns zero economic profit forever.forever.

TIT-FOR-TATTIT-FOR-TAT

• Starting with second month, Jill picks price Starting with second month, Jill picks price Jack picked in the previous month;Jack picked in the previous month;

• The cartel price will persist as long as Jack The cartel price will persist as long as Jack picks cartel price;picks cartel price;

• Cartel breaks down if Jack underprices Jill;Cartel breaks down if Jack underprices Jill;

• To restore cartel outcome, Jack must pick To restore cartel outcome, Jack must pick cartel price, allowing Jill to underprice him cartel price, allowing Jill to underprice him for a month.for a month.

11 22 33 44 55 MonthMonth

OutcomeOutcomeCartelCartel UnderpricingUnderpricingDuopolyDuopoly

UnderpricingUnderpricingCartelCartel

Price in $$Price in $$

400400

350350

JACKJACK

JILLJILL

PRICE-FIXING LAWPRICE-FIXING LAW• Under the Sherman Anti-Trust Act of Under the Sherman Anti-Trust Act of

1890 and subsequent legislation, 1890 and subsequent legislation, explicit price fixing is illegal. explicit price fixing is illegal.

• It is illegal for firms to discuss their It is illegal for firms to discuss their pricing strategies or their methods of pricing strategies or their methods of punishing a firm that underprices punishing a firm that underprices other firms.other firms.

PRICE LEADERSHIPPRICE LEADERSHIP• Under this arrangement, a group of Under this arrangement, a group of

firms selects a firm to serve as a price firms selects a firm to serve as a price leader. leader.

• The other firms in the arrangement will The other firms in the arrangement will match the price of the leader.match the price of the leader.

• Implicit agreements allow firms to Implicit agreements allow firms to cooperate without discussing pricing cooperate without discussing pricing strategies.strategies.

PRICE LEADERSHIPPRICE LEADERSHIP• Implicit pricing relationship relies on indirect Implicit pricing relationship relies on indirect

signals, which may be misinterpreted:signals, which may be misinterpreted:• If one firm suddenly drops price, may be If one firm suddenly drops price, may be

interpreted as:interpreted as:

Change in market conditions -- both firms Change in market conditions -- both firms may benefit from a lower price;may benefit from a lower price;

Underpricing -- first firm is trying to increase Underpricing -- first firm is trying to increase market share at second’s expense: result market share at second’s expense: result could be a price war.could be a price war.

Price $Price $

hh

kk

88

66

44

1010 3030 3333

Quantity sold per dayQuantity sold per day

KINKED-DEMAND CURVE MODELKINKED-DEMAND CURVE MODEL

KINKED-DEMAND MODELKINKED-DEMAND MODEL• This model gets its name from assumptions This model gets its name from assumptions

about how firms in an oligopoly respond when about how firms in an oligopoly respond when one firm changes its price. Assume each firm one firm changes its price. Assume each firm starts with a $6 price:starts with a $6 price:

• If one firm increases price, other firms will not If one firm increases price, other firms will not change their price; the quantity will decrease by change their price; the quantity will decrease by a large amount (from 30 to 10) for this firm.a large amount (from 30 to 10) for this firm.

• If one firm decreases price, other firms will too; If one firm decreases price, other firms will too; the quantity will increase by a small amount (from the quantity will increase by a small amount (from 30 to 33) for this firm. 30 to 33) for this firm.

KINKED-DEMAND MODELKINKED-DEMAND MODELAssumptions: Assumptions: • The demand curve has a kink at the prevailing price;The demand curve has a kink at the prevailing price;• It is relatively flat (elastic) for higher prices because It is relatively flat (elastic) for higher prices because

other firms will not match price;other firms will not match price;• It is relatively steep (inelastic) for lower prices It is relatively steep (inelastic) for lower prices

because other firms will match lower price;because other firms will match lower price;• Once price is established, it tends to persist Once price is established, it tends to persist

because there is a large penalty for increasing price because there is a large penalty for increasing price and a small benefit for decreasing priceand a small benefit for decreasing price

KINKED-DEMAND MODELKINKED-DEMAND MODEL

Starting in 1947, various studies Starting in 1947, various studies of oligopolies have failed to find of oligopolies have failed to find compelling evidence to support compelling evidence to support the kinked-demand model of the kinked-demand model of oligopoly.oligopoly.

ENTRY DETERRENCE GAMEENTRY DETERRENCE GAME

How a monopolist might try to prevent How a monopolist might try to prevent a second firm from entering its market.a second firm from entering its market.

It begins with a secure monopoly It begins with a secure monopoly operating on the marginal principle operating on the marginal principle (marginal revenue = marginal cost(marginal revenue = marginal cost

ENTRY DETERRENCE AND LIMITING PRICEENTRY DETERRENCE AND LIMITING PRICEPrice $Price $


m: secure monopolym: secure monopoly400400

300300

150150

Passengers per dayPassengers per day

ENTRY DETERRENCE AND ENTRY DETERRENCE AND LIMITING PRICELIMITING PRICE

If Jane discovers a second airline is If Jane discovers a second airline is about to enter market, she can:about to enter market, she can:

• Act passively and allow the second Act passively and allow the second airline to enter (create a duopoly),airline to enter (create a duopoly),

• Try to prevent the second airline from Try to prevent the second airline from entering (maintain monopoly).entering (maintain monopoly).



m: secure monopolym: secure monopoly

d: duopolyd: duopoly

400400

350350

300300

150150 180180 200200



If Jane produces a large quantity , and If Jane produces a large quantity , and Dick enters anyway, the total output of Dick enters anyway, the total output of the two firms is very large:the two firms is very large:

• the market moves down along the the market moves down along the demand curve to point h, demand curve to point h,

• a price of $290 and quantity of 260,a price of $290 and quantity of 260,

• price is less than average cost,price is less than average cost,

• each firm would lose $1,300.each firm would lose $1,300.


If Jane produces a large quantity , and Dick If Jane produces a large quantity , and Dick stays out, the total output is substantially stays out, the total output is substantially less:less:

• the market moves down along the demand the market moves down along the demand curve to point i, curve to point i,

• a price of $370 and quantity of 180,a price of $370 and quantity of 180,

• Jane makes $12,600 profit,Jane makes $12,600 profit,

• $70 per passenger profit $70 per passenger profit ** 180 passengers. 180 passengers.



m: secure monopolym: secure monopoly

i: insecure monopolyi: insecure monopoly

d: duopolyd: duopoly

h: largeh: large quantityquantity and twoand two firmsfirms

400400

370370

350350

300300290290

150150 180180 200200 260260


JANE:JANE:small small

quantityquantityor largeor largeoutputoutput

Small QuantitySmall Quantity

Large QuantityLarge Quantity

DICK:DICK:enter orenter or

staystayoutout

PROFITSPROFITS11

22

33

44

XX

YY

ZZ

JANEJANE DICK DICK5,0005,000 5,000 5,000

JANE DICKJANE DICK15,000 015,000 0

JANEJANE DICK DICK-1,300-1,300 -1,300 -1,300

JANEJANE DICK DICK12,600 012,600 0

Enter:Enter:p = $350p = $350

Stay out:Stay out:p = $400p = $400

Enter:Enter:p = $290p = $290

Stay Out:Stay Out:p = $370p = $370

DICK:DICK:enter orenter or

staystayoutout

CONTESTABLE MARKETSCONTESTABLE MARKETS A market in which firms can enter and leave A market in which firms can enter and leave

without incurring large costs.without incurring large costs.

The few firms in a contestable market will be The few firms in a contestable market will be continually threatened by the entry of new continually threatened by the entry of new firms, so prices and profits will be relatively firms, so prices and profits will be relatively low.low.

In a perfectly contestable market, firms can In a perfectly contestable market, firms can enter and exit at zero cost.enter and exit at zero cost.

In this case, the price will be the same as a In this case, the price will be the same as a perfectly-competitive market price.perfectly-competitive market price.

ANTITRUST POLICYANTITRUST POLICY

The government uses antitrust policy The government uses antitrust policy to regulate the business practices of to regulate the business practices of markets dominated by a few firms.markets dominated by a few firms.

The government’s objective is to The government’s objective is to prevent a few firms from dominating prevent a few firms from dominating the market and charging relatively high the market and charging relatively high prices.prices.

THREE WAYS FIRMS CAN INCREASE THREE WAYS FIRMS CAN INCREASE MARKET SHAREMARKET SHARE

SUBJECT TO GOVERNMENT SCRUTINYSUBJECT TO GOVERNMENT SCRUTINY

• Trust,Trust,

• Merger,Merger,

• Predatory PricingPredatory Pricing

TRUSTTRUST The owners of several companies transfer The owners of several companies transfer

their decision-making powers to a small their decision-making powers to a small group of trustees. The trustees then make the group of trustees. The trustees then make the decisions for all of the firms of the trust.decisions for all of the firms of the trust.

The firms in a trust act as a single large firm:The firms in a trust act as a single large firm:

The industry that appears to have many firms The industry that appears to have many firms may in fact be a virtual monopoly.may in fact be a virtual monopoly.

MERGERMERGER

The merging of two firms increases The merging of two firms increases market concentration:market concentration:

• A duopoly becomes a monopoly,A duopoly becomes a monopoly,

• A three-firm market becomes a A three-firm market becomes a duopoly.duopoly.

PREDATORY PRICINGPREDATORY PRICING

Predatory pricing works as follows:Predatory pricing works as follows:

• One firm (the predator) sets its price One firm (the predator) sets its price low enough that the predator and its low enough that the predator and its prey (a second firm) loses money;prey (a second firm) loses money;

• The second firm goes out of business;The second firm goes out of business;

• The first firm (the predator) increases The first firm (the predator) increases its price to restore its profits.its price to restore its profits.

A BRIEF HISTORY OF ANTI-TRUST LEGISLATIONA BRIEF HISTORY OF ANTI-TRUST LEGISLATIONA BRIEF HISTORY OF ANTI-TRUST LEGISLATIONA BRIEF HISTORY OF ANTI-TRUST LEGISLATION

DATEDATE LEGISLATIONLEGISLATION DESCRIPTIONDESCRIPTION

1890 1890 Sherman Act Made it illegal to monopolize a marketSherman Act Made it illegal to monopolize a market or engage in practices which resulted or engage in practices which resulted in “restraint of trade.” in “restraint of trade.”

19141914 Clayton Act Clayton Act Outlawed specific practices that Outlawed specific practices that discourage competition. discourage competition.

19141914 Federal TradeFederal Trade Established to enforce anti-trust laws. Established to enforce anti-trust laws.CommissionCommission

19361936 Robinson-Robinson- Prohibited selling products at Prohibited selling products at Patman ActPatman Act “unreasonably low prices” with the “unreasonably low prices” with the

intent of reducing competition. intent of reducing competition.

19501950 Celler-Kefauver Outlawed asset-purchase mergerCeller-Kefauver Outlawed asset-purchase mergerActAct that would substantially reduce that would substantially reduce

competition. competition.

19801980 Hart-Scott-Rodino Extended anti-trust legislation to Hart-Scott-Rodino Extended anti-trust legislation to

ActAct proprietorships and partnerships. proprietorships and partnerships.

TRADE BARRIERS AND TRADE BARRIERS AND MARKET CONCENTRATIONMARKET CONCENTRATION• Reducing trade barriers, such as Reducing trade barriers, such as

tariffs, increases competition.tariffs, increases competition.

• As competition increases, As competition increases, market concentration decreases.market concentration decreases.

DEREGULATION AND DEREGULATION AND CONCENTRATIONCONCENTRATION

The deregulation of air travel The deregulation of air travel eliminated the government’s eliminated the government’s artificial barriers to entry, but other artificial barriers to entry, but other barriers have led to increased barriers have led to increased concentration in some markets.concentration in some markets.

Documents

OLIGOPOLIESOLIGOPOLIES Markets with just a few firms. Markets with just a few firms. CONCENTRATION RATIO Measure of the degree of concentration in a market.Measure