Oligopoly

1. Oligopoly

2. By the end of this Section, you should be able to: • Describe the characteristics of an oligopoly • Discuss the efficiency of an oligopolist’s actions • Discuss the equilibrium conditions for an oligopoly • Define the 4-firm concentration ratio

3. Definition • An Oligopoly is a market situation in which there exists very few sellers of an identical good. Each seller knows the other sellers will react to its changes in price and quantity output. • Game theory relates to an oligopoly because an oligopoly is a “game” between the participating firms, who interact by deciding how much of an identical product to produce.

4. Characteristics of an Oligopoly • Top few producing firms in the industry account for an overwhelming percentage of the total industry output. • There exists strategic dependence which is a situation in which one firm’s actions with respect to price, quantity, advertising and related changes may be strategically countered by the reactions of one or more other firms in the industry. • Firms in an oligopoly must attempt to predict their rival’s reactions to their actions. • Not the case in a competitive market or a monopoly.

5. Actions for Firms in an Oligopoly • Firms in an oligopoly have two options to choose from when choosing their output and pricing levels. • They can: • Co-operate with the other firms in the Oligopoly • This is like pricing high in the activity. • Firms can co-operate by choosing to charge a high price and limiting output of the product. • This results in monopolist profits spread among the oligopolies. • Act independently of the other firms in the Oligopoly • This is like pricing low in the activity. • Firms can act independently by increasing their output and lowering their price. • This results in competitive market conditions and profits for the firms in the oligopoly.

6. Actions for Firms: Co-operate • Firms in an Oligopoly co-operate with one another by choosing to price high and limit their output. • This results in an equilibrium quantity where MR=MC and P>MR (just like a monopoly). • The firms then split the monopoly level of profits among all the firms in the industry. • When firms in an oligopoly co-operate, they collude. • When firms collude, they form a cartel. • A cartel is a group of firms acting together to limit output, raise price and increase economic profit. • Cartel’s are illegal, but some do operate in some industries. • Cartel’s tend to break down: we saw this in our exercise.

7. Actions for Firms: Co-operate • So in summary: • Firms who co-operate lead to monopolist level prices and quantities in total. • When looking at Oligopolies at a whole, this is the Pareto solution. • When all firms price high, the Oligopoly as a whole will make the highest profit. • However, when looking at society as a whole, Oligopolies who co-operate cause a DWL. • If firms are acting like a monopolist, quantity supplied is too low and price is too high, and there exists a DWL; just like in a monopoly.

8. Actions for Firms: Act Independently • If firms choose not to collude, they must guess and react for how others are going to act. • Example: Suppose there exists 2 gas stations in a small town. You are the owner of one of them. • You decide to decrease your price to increase the amount of gas you sell and your profit. • Then in response the other station decreases their price more to sell more gas than you and capture more of the profit. • Then in response you may choose to retaliate and decrease your price even more. • We saw this in our exercise. • Firms who work independently will continue to decrease their price until they can not decrease their price any more. • This is the point where P=MR=MC (the competitive firm equilibrium). • Or where the firms in an oligopoly are acting like competitive firms.

9. Actions for Firms: Act Independently • So in summary: • Firms who act independently lead to competitive level prices and quantities in total. • This means they price and produce where P=MR=MC. • This means the firm may have short run profits but in the long run, their economic profit = 0. • When looking at Oligopolies at a whole, this is the Nash solution. • Regardless of what the other firms do, each firm has an individual incentive to price low • However, this results in the lowest profits for the oligopoly as a whole.

10. Actions for firms: Act Independently • However, when looking at society as a whole, Oligopolies who act independently maximize social welfare. • If firms are acting like a competitive market, quantity supplied is high and price is low, and there exists no DWL; just like in a competitive market.

11. Nash Equilibrium and Pareto Optimum • The decisions of an Oligopoly can be expressed in a game. • For example, suppose there are two firms. These firms have the option to produce at Monopolistic output or Competitive output. • The profit of each choice can be represented in a game (numbers here are just an example). Nash Equilibrium = (Comp. Output, Comp. Output) Pareto Outcome = (Monop. Output, Monop. Ouput) Firm 2’s Actions Firm 1’s Actions 36, 36 30, 40 40, 30 32, 32

12. Cournot vs. Bertrand Oligopoly • There exists two competing theories on how Oligopolies decide what price to charge and how much quantity to produce. • The difference between these two theories is the order in which they decide price and quantity.

13. Bertrand Oligopoly • A Bertrand Oligopoly exists when firms choose the price to charge. • For example the activity where you decided to price high or low. • Once each firms has picked a price, how much quantity they produce in total is dependent on the industry demand curve.

14. Cournot Oligopoly • A Cournot Oligopoly exists when firms choose the amount of quantity to produce. • For example the game on the previous slide. • Once each firm has picked their quantity they are going to produce, the industry price is determined by the industry demand curve.

15. How to tell what kind of market you have: • The type of market (competitive, monopolist or oligopoly) is dependent on how much market power firms have. • Market power is the ability to set the price of the output above marginal cost. • The higher the market power, the higher the price. • To determine the type of market, we evaluate the market power of firms in the market by evaluating firm’s percentage of market sales.

16. How to tell what kind of market you have: • There exists many types of measuring techniques and ratios to determine market type. • One is the Four Firm Concentration Ratio. • Evaluates the percentage total of sales contributed by the leading four firms in an industry. • The higher the percentage of sales, the more market power a firm has.

17. Four Firm Concentration Ratio = sum of sales of top 4 firms sum of sales in industry • Example: Suppose the sum of sales of an industry for a particular good is 450. Meanwhile the top four firms have the following amount in sales: 150, 100, 80, 70. • 4 firm concentration ratio = 150+100+80+70 = .889 450 • This means almost 90% of total output is produced by the 4 largest firms. • What does this percentage mean?

18. 4 Firm Concentration Ratios by Market Type • All other percentages are indeterminate • Note: the higher the ratio, the more market power exists and the less the efficiency of the market • Note: the lower the ratio, the less market power exists and the more efficient the market • Summary handout comparing market types will be posted.