OLIGOPOLY

QUICK COMPARISON BETWEEN FOUR

MARKETS
Key
characteristics

Perfect
Competition

Monopolistic
Competition

Oligopoly

Monopoly

No. of Sellers

Large number of
sellers

Many sellers

Few sellers

One single seller

Price decision
(Price control)

Price taker
(no control over
P)

Price taker
(little control)

Price maker
(some control)

Price maker
(complete control)

Type of product

Homogenous/
Identical

Slightly
differentiated

Homogenous/
Differentiated

Unique

Barriers to Entry

No barriers/ Easy
entry & exit

No barriers/ Easy
entry & exit

Difficult of entry &

exit

Completely
blocked for entry

Type of SR profit

Supernormal/
normal/
subnormal profi

Supernormal/
normal/
subnormal profit

Supernormal/
normal/
subnormal profit

Supernormal/
normal/
subnormal profit

Type of LR profit

Normal profit

Normal profit

Supernormal
profit

Supernormal
profit

Demand curve

Horizontal DD
curve, perfectly
elastic demand,
D=MR=AR=P

Downward
sloping (elastic)
P=AR=D>MR

Downward
sloping or kinked
DD curve

Downward
sloping (inelastic)2
P=AR=D>MR

OLIGOPOLY

A market structure characterized by few sellers,

either a homogeneous or a differentiated product,
and difficult market entry.

CHARACTERISTICS
a) Few sellers

b)

Homogeneous or differentiated product

c)

Only a few large firms dominate an industry. Share a

large proportion of the industry.
Firms can produce either a homogeneous (oligopolist
firms do not compete each other) or a differentiated
product (if the firms compete each other).

Mutual interdependence

Mutual interdependence is a condition in which an action

by one firm may cause a reaction form other firms.
3

Difficult entry

d)

Barriers to entry exist but these are not as restrictive as

in monopoly. The most significant barrier to entry in an
oligopoly is economies of scale.

Non-price competition

e)

Since the oligopoly firms are mutual interdependence,

price cannot be used to increase revenue. Therefore
all the firms will involve in non-price competition.
Oligopolists may try to capture business away from their
rivals through better advertising campaigns and
improved products. This explains why advertising
expenditures are large in this market and the importance
of R & D function.

new entrant may suffer just from being

new

Lieberman & Hall;

Introduction to Economics,
2005

REPUTATION AS A BARRIER

Established oligopolists are likely to have

favorable reputations

In

some cases, where potential profits are

great, investors may decide it is worth the
risk and accept initial losses in order to
enter industry
In other industries, the initial losses may be
too great and probability of success too low
for investors to risk their money starting a
new firm

 Oligopoly

firms often pursue strategies

designed to keep out potential competitors
Maintain excess production capacity as a signal
to a potential entrant that they could easily
saturate market and leave new entrant with little
or no revenue
Make special deals with distributors to receive
best shelf space in retail stores
Make long-term arrangements with customers to
ensure that their products are not displaced
quickly by those of a new entrant
Spend large amounts on advertising to make it
difficult for a new entrant to differentiate its
product

Lieberman & Hall;

Introduction to Economics,
2005

STRATEGIC BARRIERS

Patents and copyrightswhich can be responsible

for monopolycan also create oligopolies
Like monopolies, oligopolies are not shy about
lobbying government to preserve their market
domination
Government barriers can operate against domestic
entrants, too

Lieberman & Hall;

Introduction to Economics,
2005

LEGAL BARRIERS

MUTUAL INTERDEPENDENCE

When just a few large firms dominate a market

So that actions of each one have an important impact on

the others
Would be foolish for any one firm to ignore its competitors
reactions
In such a market, each firm recognizes its strategic
interdependence with others

An oligopoly is a market dominated by a small

number of strategically interdependent firms
8

ECONOMIES OF SCALE: NATURAL

OLIGOPOLIES

When minimum efficient scale (MES) or total output

efficiently produced for a typical firm is a relatively
large percentage of market

A large firmsupplying a large share of the market

will have lower cost per unit than a small firm
Since small firms cant compete, only a few large firms
survive - Market becomes an oligopoly
Tends to happen on its own unless there is government
intervention - Such a market is often called a natural
oligopolyanalogous to natural monopoly

UNDERSTANDING PRICE DETERMINATION IN

OLIGOPOLY FIRMS

If the few firms in oligopoly markets compete each other :

The firms will face kinked demand curve

Their product usually slightly differentiated
They engage in non-price competition

If they do not compete, they may collude to set the P and

Q
Collusion (tacit collusion vs. explicit collusion)
Duopoly game theory
Products normally homogenous
Normally they set P higher and res

10

KINKED DEMAND OR SWEEZYS MODEL

When oligopolist firms compete against each other, price is

determined via kinked demand curve

A demand curve facing an oligopolist that assumes rivals will match a

price decrease, but ignore a price increase.

Sweezys model is based on 2 assumptions:

If one firm reduce price, rivals follow the cut in price to prevent losing
customers to the first firm.

If one firm increase price, rivals will not follow. So they can gain
customers from the first firm.

11

KINKED DEMAND OR SWEEZYS MODEL

IMPORTANT!!!

If Firm A increases price, rivals will not follow. So they can gain
customers from the first firm. (elastic demand)

If Firm A reduces price, rivals follow the cut in price to prevent losing
customers to the first firm. (inelastic demand)

Thus, each firm in the oligopoly market faces a demand curve that is
kinked at the current price & output.

Above kink: demand is elastic. If price, large sale, since customers

shift to other firms that do not follow the price increase.

Below kink: demand is inelastic. If price, small sale, since customers

do not shift to other firms as their prices also reduced (relative similar)
12

HOW DOES KINKED DEMAND CURVE

HAPPEN?

When Firm A P, others do not

follow, customers shift to other
oligopolist firms = elastic demand
curve

Price

Kinked demand
curve

P0
Gap in MR
curve

When Firm A P, others will

follow, customers would not shift
to other oligopolist firms since the
P similar = inelastic demand
curve

D
Q0

MR

Quantity

13

HOW DOES KINKED DEMAND CURVE

HAPPEN?
Price
Kinked demand
curve

P0
Gap in MR
curve

D
Q0

MR

Quantity

14

HOW DOES KINKED DEMAND CURVE

MC
HAPPEN?
4

MC2

Price

MC1

P2

The model explains

price remains relatively
stable overtime i.e.
price rigidity

P0
P1

MC3

When an oligopolist firm

is facing a kinked
demand curve, as long
as MC cross MR during
the gap (vertical MR), P
and Q will be constant

Q2

Q0 Q1 MR

Quantity

15

HOW DOES KINKED DEMAND CURVE

HAPPEN?
Price

MC

ATC

P0

Profit determination depends

on the location of the ATC

ATC

In SR, oligopolist firm may get

supernormal, normal or
subnormal profits
In LR, they will retain
supernormal profit

Supernormal
profit

D
Q0

MR

Quantity

16

Equilibrium or profit maximization output at Q0 (MR

= MC), P is at P0

If MC change cost change. Output optimum still

at Q0. Thus, price still at P0.

As long as MC cuts MR in (in the gap or vertical

segment of MR).

17

At price P, the oligopolist will sell at output Q.

At prices above P, the demand is elastic. Rival firms

will not match the increase in price because the fall in
quantity demanded will be greater than the increase in
price. (lose of sale)

At prices below P or point A, the demand will be

inelastic, meaning the quantity demanded is not very
responsive to a price drop. Any reduction in the price
of the oligopolist will be matched by reductions by
other firms.
18

The kinked demand curve will lead to price rigidity. This

explains why price usually remains unchanged for a long
period of time.

Because of the unusual AR curve, the MR curve will be a

discontinuous line and even though MC may increase or
decrease, i.e at MC1 or MC2, MC is still equal to MR at the
same level of output.

Thus the kinked demand curve model predicts that price and
quantity will be insensitive to small cost changes but will
respond if cost changes are large enough.

19

PRICE DETERMINATION IF OLIGOPOLIST FIRM DO

NOT COMPETE EACH OTHER
There are several way in which price can be determined:
1. Collusion
This refers to an agreement (formal and informal) among the
producers to decide the price and output level, both of which are
fixed.
Tacit collusion: informal agreement such as Price leadership
smaller firms implicitly follow market leader

Explicit collusion called Cartel: A group of firms that formally

agree to control the price and the output of a product. The goal of
a cartel is to reap monopoly profits by replacing competition with
cooperation. The best-known cartel is OPEC.

20

PRICE LEADERSHIP

Also known as Model of Price Stability.

A pricing strategy in which a dominant firm sets the

price for an industry and the other firms follow. eg;
petroleum industry

Normally a firm, usually the largest or the most

dominant will be the leader.

21

HOW MUCH IS THE OUTPUT PRODUCED OF

FIRMS?
The price leadership would set price, others would
follow and produce the corresponding output at that
price level.
Given the total demand in the market, the price
leader would supply the amount of output not
supplied by the other firms.

22

Simplest form of cooperation is explicit collusion

Most extreme form of explicit collusion is creation of

a cartel

Group of firms that tries to maximize total profits of the

group as a whole

If explicit collusion to raise prices is such a good

thing for oligopolists, why dont they all do it?

Managers meet face-to-face to decide how to set prices

Lieberman & Hall;

Introduction to Economics,
2005

EXPLICIT COLLUSION

Usually illegal
Penalties, if the oligopolists are caught, can be severe

But oligopolists can collude in other, implicit ways

23

CARTELS
Combine to agree on one fixed price to sell their
goods at the market. The market might be willing to
demand more good at lower price. Cartel impose
higher price for higher profit by restricting supply.
Restricting supply to the market. Firms then split
the output between them quota.

24

PRICE LEADERSHIP DIFFER FROM CARTEL.

WHY?

In Price leadership, P is not predetermined through

formal arrangement among the firms.

But it is communicated by the largest firms through

informal way such as interviews, media coverage,
rumours etc. which induces other firms to follow the
price change voluntarily.

Price stable or rigid due to the dominant firm might

not want to price because if other firms dont
price, then it is gonna lose customers.
25

TACIT COLLUSION
Any

time firms cooperate without an explicit

agreement, they are engaging in tacit collusion
Tit for tat

A game-theoretic strategy of doing to another player

this period what he has done to you in previous
period

However,

gentle reminder of tit-for-tat is not

always effective in maintaining tacit collusion

Oligopolist will sometimes go further

Attempting to punish a firm that threatens to destroy tacit

cooperation
26

 Another

form of tacit collusion is price

leadership

Lieberman & Hall;

Introduction to Economics,
2005

TACIT COLLUSION

One firmthe price leadersets its price and

other sellers copy that price

With

price leadership, there is no formal

agreement

Rather the decisions come about because firms

realizewithout formal discussionthat system
benefits all of them
Decisions include
Choice of leader
Criteria it uses to set its price
Willingness of other firms to follow

27

Oligopoly powereven with collusionhas its

limits

Lieberman & Hall;

Introduction to Economics,
2005

THE LIMITS TO COLLUSION

Even colluding firms are constrained by market demand

curve
Collusioneven when it is tacitmay be illegal
Collusion is limited by powerful incentives to cheat on
any agreement

28

 Oligopoly

presents the greatest challenge to

economists
Essence of oligopoly is strategic
interdependence

Lieberman & Hall;

Introduction to Economics,
2005

OLIGOPOLY BEHAVIOR

Wherein each firm anticipates actions of its rivals

when making decisions

In

order to understand and predict behavior

in oligopoly markets

Economists have had to modify the tools used to

analyze other market structures and to develop
entirely new tools as well

One

approachgame theoryhas yielded

rich insights into oligopoly behavior

29

In real world, oligopolists will usually get more than

one chance to choose their prices
The equilibrium in a game with repeated plays may
be very different from equilibrium in a game played
only once

Lieberman & Hall;

Introduction to Economics,
2005

COOPERATIVE BEHAVIOR IN
OLIGOPOLY

Often, firms will evolve some form of cooperation in the

long run

30

 Game

theory

An approach to modeling strategic interaction of

oligopolists in terms of moves and countermoves

Lieberman & Hall;

Introduction to Economics,
2005

THE GAME THEORY APPROACH

In

all gamesexcept those of pure chance,

such as roulettea players strategy must
take account of the strategies followed by
other players
Game theory analyzes oligopoly decisions
as if they were games by

Looking at the rules players must follow

Payoffs they are trying to achieve
Strategies they can use to achieve them
31

SIMPLE OLIGOPOLY GAMES

Duopoly

two oligopoly firms

Oligopoly market with only two sellers

Assume

that Gus and Filip must make their

decisions independently

Without knowing in advance what the other will do

matter what Filip does, Guss best move is

to charge a low pricehis dominant strategy

No

A similar analysis from Filips point of view, would tell

us that his dominant strategy is the same: a low
price

Equilibrium

price in market is the low price

32

Guss Actions
Confess
Dont Confess
Guss profit
= $25,000
Confess

Filips Actions

Dont Confess

Lieberman & Hall;

Introduction to Economics,
2005

FIG. 4: A DUOPOLY GAME

Guss profit
= $10,000

Filips
Profit =
$25,000

Filips
Profit =
$75,000
Guss profit Guss profit
= $75,000
= $50,000

Filips
Profit =
$10,000

Filips
Profit =
$50,000

33

Antitrust enforcement has focused on three types of

actions

Lieberman & Hall;

Introduction to Economics,
2005

ANTITRUST LEGISLATION AND

ENFORCEMENT
Preventing collusive agreements among firms

Such as price-fixing agreements

Breaking up or limiting activities of large firmsoligopolists

and monopolistswhose market dominance harms
consumers
Preventing mergers that would lead to harmful market
domination

Managers of other firms considering anticompetitive

moves have to think long and hard about consequences
of acts that might violate antitrust laws
While thrust of these policies is to preserve competition

Type of competition preservedand zeal with which policies

are appliedcan shift
34

By enlarging markets from national ones to global ones,

international trade can increase the number of firms in a market

Lieberman & Hall;

Introduction to Economics,
2005

THE GLOBALIZATION OF MARKETS

Decreasing market dominance by a few, and increasing competition

Although oligopolists often try to prevent it, they face increasingly

stiff competition from foreign producers
Entry of U.S. producers has helped to increase competition in
foreign markets for movies, television shows, clothing, household
cleaning products, and prepared foods
While consumers in each nation may have access to more firms,
these may be larger and more powerful firms

Creating greater likelihood of strategic interaction and danger of collusion

35

Technological change works to increase

competition by creating new substitute goods
Can reduce barriers to entry in much the same way
that globalization does

By increasing size of market

Technologythe internethas enabled residents in

many smaller towns to choose among a dozen or
more online sellers of the same merchandize

Lieberman & Hall;

Introduction to Economics,
2005

TECHNOLOGICAL CHANGE

Trend can also be seen as encouraging oligopoly

Result could be strategic interaction, or collusion, among
large national players

Finally, some technologies actually increase MES

of typical firm

Thereby encouraging formation of oligopolies

36