Oligopoly

Learning Objectives:

• What is an oligopoly?

• What are different types of oligopoly?

• What is collusion?

• Are collusions sustainable all the time?

• How does credible signaling transform a firm into a market leader?

• Example: How the Meat Industry Keeps Chicken Prices High

What is an Oligopoly?

• A few firms controlling the entire market

• Products sold by the firms in an oligopolistic market may either be identical or differentiated

• A firm’s strategy will depend on what it thinks about the strategy of other firms in the market

Demand curve for a firm in an oligopolistic market

• A firm’s demand curve will depend upon how its rivals will react to price changes by this firm

• If rivals change prices in response to a price change by the firm, then the demand curve for this firm will be steeper, and vice versa

Types of oligopolistic markets based on response of rivals to price or output changes

• Sweezy

• Cournot

• Stackelberg

• Bertrand

Sweezy Oligopoly

• Only a few producers, and many consumers

• Products are differentiated

• Rivals cut prices following price reduction, but not after a price hike

• There exist barriers to entry

Criticism of Sweezy Model

• How does a firm or industry arrive at the initial price point (point of kinked demand curve)?

Cournot Oligopoly

• Only a few producers, and many consumers

• Products are homogeneous or differentiated

• Each firm’s belief is that the rivals will not change their output following a change in its own output

• There exist barriers to entry

Reaction function or Best response function

• Profit maximizing level of output of one firm given the different output levels of the other firm

• Cournot equilibrium: no firm has an incentive to change its own output given the output level of the other firm

Isoprofit curves

• Traces the combinations of outputs from other firms that will result in the same level of profit for one firm

• If marginal cost for a firm falls, then the firm will be able to produce more output and earn more profit at the cost of other firms

Collusion

• Firms benefit by restricting output, either implicitly or explicitly

• Collusive outcome is difficult to sustain

• Example: De Beers and Beyond: The History of the International Diamond Cartel

• Example: The Envelope Cartel Has Finally, Finally Been Brought To Justice

• Example: OPEC: No cut in oil production and prices keep falling

Stackelberg Oligopoly

• Only a few producers, and many consumers

• Products are homogeneous or differentiated

• The leader (firm making the first move) chooses its output level first

• The followers consider the leader’s output as given and make their output decisions

• There exist barriers to entry

Signalling in Stackelberg oligopoly

• The leader has to provide credible signalling about its output

• If the cost to observe leader’s output is too high, then the leader might have to produce lower output and earn lower profit

Bertrand Oligopoly

• Only a few producers, and many consumers

• Products are identical

• Marginal cost is constant across firms

• There is price competition among firms

• There are perfect information and zero transaction costs in the market

• There exist barriers to entry

• Example: Britannica vs Encarta

Entry Barriers

• There are technological advantages for incumbents

• There are sunk costs in the production

• Incumbents can lower their price successfully to make entrant unprofitable

• Consumers cannot respond to price changes

• Example: Airbus vs Boeing (B), 2006