Oligopoly

Rhett SmithJon Michael Brooks

Characteristics• Dominated by a few large producers• Large control over price• Homogeneous or Differentiated products• Mutual Interdependence• Entry barriers:

• Economies of Scale• Legal barriers• Ownership and control of resources• Pricing and strategic barriers

Industry Concentration• % concentration ratio- reveals percentage of total output by an

industry’s largest firms• Considered an oligopoly when the 4 largest firms control more than

40% of the market• Shortcomings:

• Localized market- ratios to nation as a whole, some products have highly localized markets

• Inter-industry competition- competition between two industries with similar products (aluminum and copper)

• World trade- Concentration ratios may overstate %s because they do not account for imported products

• Dominant firms- Ratios do not show the production of each firm in the concentration ratio• Herfindahl index- shows the percentage of market shares by all firms• (%S1)^2+(%S2)^2…..

Game Theory Model

Shows the profit each firm can receive based on its own pricing strategy and the strategy of its rival.

Remember: oligopolies are mutually interdependent so the decision of one firm affects the other.

Collusion• Shows cooperation between rivals• Adopts the strategy which gives the firms the highest profits

There is a strong incentive to cheat from both firms. The price will most likely settle into the lower right corner because both will cheat.

Kinked Demand: Non-collusive Oligopoly

• Firms are rivals, do not cooperate• Work against eachother• Price increase, competitor ignores-Elastic

demand• Price decrease, competitor matches-

Inelastic demand curve

Cartels and other Collusion• If both firms have identical

demand and cost conditions they can collude to set single common price

• Then each firms acts independently like a monopoly.

• This is assuming all firms charge at MR=MC

Types of Collusion• Overt Collusion:

• Forms a cartel- creates a written agreement to divide up how much each producer will produce and charge

• Ex: OPEC

• Covert Collusion:• Cartels are illegal in US but still exists in secret• Consists of under the table collusion that is illegal

Obstacles to Collusion

• Demand and Cost differences- the costs and demands of even homogeneous products are different, causing a dispute on one acceptable price.

• Number of Firms- The more firms involved and the amount of market they control makes it difficult to collude

• Cheating- Firms secretly change prices in order to gain more profit• Recession- firms become more desperate, cut prices and gain sales at the

expense of rivals• Potential Entry- Large profits that result from collusion attracts new firms

which would reduce profits. Successful collusion requires blocking the entry of new firms

• Legal: Anti-trust laws: prohibits cartels and price-fixing

Price Leadership Model

• A implicit understanding by which oligopolist can coordinate prices without engaging in outright collusion based on formal agreements and secret meetings.

• Price adjustments are made infrequently because there is always the risk that rivals will not follow the lead.

• The price leader communicates price adjustments by publicizing the price change, and therefore seeks an agreement among competitors.

• The price leader try's to set prices at certain points so that other firms can not enter the market.

Advertising Positive & Negative

• Firms use advertising because they are less easily duplicated than price cuts.• Positive Effects: Advertising reduces monopolies by putting smaller

brand names out into the public so more people become familiar with them. Causing there to be more choices for a certain product. • Negative Effects: Advertising can cause consumers to be mislead

through false information and therefore buy a product that is sold at a higher price but is a worse product than one not advertised and better and sold at a lower price. If two firms in the same industry advertise equally they will gain little to no customers and they will lose profits.

Efficiency of the Oligopoly

• Productive efficiency- firms produce any good in the most cost efficient way. • Allocated efficiency- firms produce the most popular good.