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Understanding Oligopoly Markets: Concentration and Strategic Behavior

Explore the concept of oligopoly markets, where a small number of sellers dominate the industry. Learn about market concentration, cartels, and the behavior of firms in these markets.

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Understanding Oligopoly Markets: Concentration and Strategic Behavior

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  1. Econ 100Lecture 6-3 Market Failure: Oligopolies 2-11-09

  2. What is an Oligopoly? • market in which the industry is dominated by a small number of sellers • Derived from the Greek for few sellers. • Since there are few participants, each oligopolist (firm) is aware of the actions of the others • decisions of one firm influence, and are influenced by the decisions of other firms • i.e., firms’ behave strategically taking into account the likely responses of the other market participants (game theory)

  3. Perfect Competition Monopoly Oligopoly • Oligopoly markets are more concentrated than monopolistically competitive markets, but less concentrated than monopolies. Monopolistic Competition Oligopoly

  4. Strategic Behavior • Perfect Competition • Only strategy is to reduce costs • Price-taker => output decisions do not affect market price • cross-price elasticity = -1 (perfect substitutes) • Own-price = -∞ • Monopoly • Price-Searcher: output decision determines price • Cross-price = 0 (no substitutes) • Own-price: >= |1| • Oligopoly • Cross-price elasticity near -1 • Own-price elasticity > |1| • Will have to take into account actions of other similar firms when making output/pricing decisions • Much more strategy

  5. Oligopoly Behavior • Cooperative Oligopoly • Cartels • Agree to collude; act/price like a single firm monoploist • Price leadership (Stackleberg leader) • Dominant firm establishes the price; other firms react to “leader” • Non-cooperative Oligopolies • Sticky prices (kinked demand curve) • Sticky upward • Nash equilibrium • Characterized by stable prices • Perfect competition • Completely rivalarous

  6. How do we tell? • Market concentration refers to the size and distribution of firm market shares and the number of firms in the market. • Economists use two measures of industry concentration: • Four-firm Concentration Ratio • The Herfindahl-Hirschman Index

  7. Attempts to Measure Market Concentration • four-firm concentration ratio is often utilized to characterize/determine whether a market is an oligopoly. • market share of the four largest firms in an industry • Herfindahl index, • also known as Herfindahl-Hirschman Index or HHI, • widely applied in competition law and antitrust. • sum of the squares of the market shares of each individual firm. • Decreases in the Herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite.

  8. Four-Firm Concentration Ratio • The four-firm concentration ratio (CR4) measures market concentration by adding the market shares of the four largest firms in an industry. • If CR4 > 60, then the market is likely to be oligopolistic.

  9. Example

  10. Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in 1997

  11. The Herfindahl-Hirschman Index • The Herfindahl-Hirschman index (HHI) is found by summing the squares of the market shares of all firms in an industry. • Advantages over the CR4 measure: • Captures changes in market shares • Uses data on all firms

  12. Example

  13. Example (cont’d) What happens if market shares are evenly distributed?

  14. Cartel Pricing Tactic • Reduce Qs to monopoly levels in order to: • a) obtain a higher price • b) earn monopoly rents

  15. Figure 12.4 Duopoly Equilibrium in a Centralized Cartel

  16. How do Cartels Operate? • Firms in the cartel need to agree on: • 1) Market price • 2) Quantity supplied by the Industry • 3) Each firm’s “quota” • 4) “Not to cheat” on either price or quantity supplied

  17. Conditions for cartel success • the cartel can significantly raise price • cartel controls market • low organizational costs • few firms (or a few large ones) • industry association • many small buyers: no monopsony power • cartel can be maintained • cheating can be detected and prevented • low expectation of severe government punishment

  18. Cartels • A cartel is a formal (explicit) agreement among firms. • usually occur in an oligopolistic industry, where there are a small number of sellers • usually involve homogeneous products. • Cartel members may agree on such matters • as price fixing, • total industry output, • market shares, • allocation of customers, • allocation of territories • aim of such collusion is to increase individual member's profits by reducing competition. • Competition laws forbid cartels. • Several economic studies and legal decisions of antitrust authorities have found that the median price increase achieved by cartels in the last 200 years is around 25%. • Private international cartels (those with participants from two or more nations) had an average price increase of 28%, whereas domestic cartels averaged 18%. Less than 10% of all cartels in the sample failed to raise market prices

  19. How do Cartels Operate? • Firms in the cartel need to agree on: • 1) Market price • 2) Quantity supplied by the Industry • 3) Each firm’s “quota” • 4) “Not to cheat” on either price or quantity supplied

  20. Factors that work against a Cartel- in the long run • Each firm has an incentive to cheat • Price that firm receives is still above MC of production • Could earn additional profits by slightly expanding output • However, when all firms do this • -> back at competitive market outcome • Qs up to point where MV=MC • See “prisoners dilemma”

  21. What market conditions make Cartels more likely? • Market demand is inelastic • higher prices lead to increase revenues for the cartel • Homogenous goods • easier to initially set/enforce cartel price • Small number of firms/high concentration of market share (easier to monitor, collude) • Fringe players could defeat cartel • More equal shares -> increase incentive to cheat

  22. Non-Cooperative Cartels • Some degree of price competition • Firms engage in highly competitive pricing • Similar outcome as perfect competition • Firms have some market power • Resembles monopolistic competition • Stable prices prevail • Non-collusive • Firms choose not to compete because of kinked demand curve

  23. Kinked-Demand Curve • Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point

  24. Nash Equilibrium • If firm facing kinked demand curve tries to raise price: • Other firms do not • As demand is highly elastic and other firms are “close” substitutes • Loses market share and revenues • If firm lowers price • Competitors match price decreases

  25. Nash Equilibrium • As a consequence • Best strategy is to neither raise or lower prices; but to maintain “stable” prices • Nash equilibrium in an oligopolistic market will be characterized by long-term stable prices or “sticky” prices • Non-price competition • Advertising to create brand name awareness/loyalty • Product proliferation

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