Oligopoly

1. Oligopoly Basic Concepts

2. Four market model Oligopoly Pure Competition Monopolistic Competition Pure Monopoly Market Structure Continuum

3. Oligopoly • Definition: • an industry with only a fewsellers selling an identicalor differentiated product. • Product may be identical • aluminum • crude oil • or product may be differentiated • Automobile • cigarettes

4. £ LAC2 LAC3 LAC1 Demand Output possible explanation for the formation of oligopolies • In oligopoly the size of the minimum efficient scale is large relative to market demand. Typical LAC in Oligopoly

5. Characteristics of Oligopoly • A few characteristics of oligopoly: • small number of rival firms (highly concentrated markets) • The actions of any one seller in the market can have a large impact on the profits of all the other sellers. • firms are interdependent • Each seller is large enough to influence price • means each seller faces a downward sloping demand curve • substantial economies of scale • Usually high barriers to entry

6. Economies of scale Long run average cost Unit Cost Quantity per year

7. Barriers to Entry • Structural The cost advantage over entrants because of • Economies of scale • Economies of scope • Control over key input • Government regulations • Strategic The action of incumbents that may deter entry • Over investment in capacity • Limit pricing

8. Price and Output UnderOligopoly • Because of interdependence and diversity No general theoryexists for price and output under oligopoly. • If the firms operated independently, they would drive down the price to the per unit cost of production. • If the firms colluded perfectly, the price would rise to the monopoly price. • The outcome is usually between these two extremes.

9. Price and Output Under Oligopoly • If oligopolists compete with one another, price cutting drives price down to PC, and expands total output to QC. • In contrast, perfect cooperation among firms leads to a higher price PM and a smaller market output of QM. • Due to the difficulty to perfectly collude, when firms try to coordinate their activity, price is typically between PC and PM and output between QM and QC. Profits to oligopolywith perfect collusion. PM PC LRAC = LRMC Demand MR QM QC

10. Incentive to Collude • Firms would be better off cooperating and jointly maximizing their profits However, each firm has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand curve. • This conflict makes collusive agreements difficult to maintain.

11. Gaining from Cheating • Using industry demandDi and marginal revenueMRi, oligopolists maximize their joint profit where MRi=MC– at output Qi and price Pi . • Demand facing each firm df(where no other firms cheat) would be much more elastic than industry demandDi . • The firm maximizes its profit where MRf=MC by expanding output to qf and lowering its price to Pf from Pi Firm Industry Pi Pi Pf MC MC df MRi Di MRf qf Qi

12. Gaining from Cheating Individual firms have an intensive to cheat by cutting price to expand out put • Using industry demandDi and marginal revenueMRi, oligopolists maximize their joint profit where MRi=MC– at output Qi and price Pi . • Demand facing each firm df(where no other firms cheat) would be much more elastic than industry demandDi . • The firm maximizes its profit where MRf=MC by expanding output to qf and lowering its price to Pf from Pi Firm Industry Pi Pi Pf MC MC df MRi Di MRf qf Qi

13. Nash Equilibrium • The Nash equilibrium is a non-cooperative equilibrium - each firm makes the decision that gives it the maximum possible profit, given the actions of its competitors. • As demonstrated, this does not produce a monopoly outcome. • Only if firms can prevent entry by potential new firms and collude with existing firms can they realize a monopoly outcome.

14. Strategic Behavior • Strategic behavior is firm behavior that takes into account the market power and reactions of other firms in the industry

15. Collusive Strategy • Repeated interaction provides opportunities for firms to learn and deploy an array of strategies to enforce collusion. These include: tit-for-tat and trigger strategies • Tit-for-tat strategy: firm colludes in current period only if other firm colluded in previous period; otherwise choose not to collude, e.g. price war. • Trigger strategy: firm colludes if the other firm colludes, but reverts to Nash equilibrium strategy in every future period if the other firm chooses not to collude.

16. Collusive Strategy • Since each firm learns that it makes a larger profit by sticking to collusion, both firms do so and the monopoly outcome prevails. • This outcome results from each firm responding rationally to the credible threat of the other firm to inflict damage if the agreement to collude is broken.

17. Types of Collusive Arrangements • A collusive agreement can be overt or tacit • Overt agreements can take the form of a cartel which are formal arrangements to fix prices, divide up or share the market or limit competition. • Tacit agreements are less formal arrangements and can take the form of a verbal ‘gentleman’s agreement’ to fix prices and output.

18. Obstacles to Collusion • As the number of firms in an oligopolistic market increases, the likelihood of effective collusion declines. • When it is difficult to detect cheating (secret price cuts), effective collusion is less likely. • Low entry barriers also make effective collusion less likely because profit attracts additional rivals. • Unstable demand conditions lead to honest differences among firms about the size of shares and price that maximizes total profit. • Rigorous enforcement of antitrust law makes collusion potentially more costly.