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Oligopoly

Assumptions of the Model

Definition of an oligopoly:

An oligopoly is a market dominated by a few producers, each of which has control over the market. It is an industry where there is a high level of market concentration. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure.

The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. Normally an oligopoly exists when the top five firms in the market account for more than 60% of total market demand/sales.

Characteristics of an oligopoly

There is no single theory of how firms determine price and output under conditions of oligopoly. If a price war breaks out, oligopolists will produce and price much as a perfectly competitive industry would; at other times they act like a pure monopoly. But an oligopoly exhibits the following features:

1. Product branding: Each firm in the market is selling a branded (differentiated) product

2. Entry barriers: Significant entry barriers into the market prevent the dilution of competition in the long run, which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on market prices and output

3. Interdependent decision-making: Interdependence means that firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. In perfect competition and monopoly, the producers did not have to consider a rivals response when choosing output and price.

4. Non-price competition: Non-price competition s a consistent feature of the competitive strategies of oligopolistic firms. Examples of non-price competition includes:

a. Free deliveries and installation

b. Extended warranties for consumers and credit facilities

c. Longer opening hours (e.g. supermarkets and petrol stations)

d. Branding of products and heavy spending on advertising and marketing

e. Extensive after-sales service

f. Expanding into new markets + diversification of the product range

Oligopoly and Measures of Concentration

One method to gauge the extent of market power is the concentration ratio. Concentration ratios give the portion of industry sales held by the 4, 8 or 20 largest firms in the industry. The table below presents the 4, 8 and 20-firm concentration ratios for selected domestic industries in the US for 1982.

Industry

Number of Companies

4-firm ratio (%)

8-firm ratio (%)

20-firm ratio (%)

Petroleum refining

282

28

48

76

Motor vehicles and car bodies

284

92

97

99

Electronic computing equipment

1520

42

64

82

Radio and TV equipment

2083

22

35

57

Aircraft

139

64

81

98

Newspapers

7520

22

34

49

Pharmaceutical preparations

584

26

42

60

Concentration ratios give some idea about market concentration but they say little about the extent of competition or geographical factors. For example, even though the 4-firm concentration ratio for newspapers is 22%, many towns in the US have only one paper. So many local newspapers have virtual monopoly status. Another problem with concentration ratios is that they say nothing about potential competition. Some industries with very high concentration ratios behave much like competitive industries because of the threat of entry into the industry prices are kept low to discourage entry. Finally, the information in the table only represents domestic production. This explains why the 4-firm concentration ratio in motor vehicles is 92% even though imported automobiles would make up approximately 33% of domestic sales.

A more serious problem with concentration ratios is that they do not distinguish between an industry in which one firm dominates and one where a small number of large firms share the market. For example, if one firm had 57% of the market and the other 43 firms in the industry each had 1%, the 4-firm concentration ratio would be 60%. This is the same concentration ratio as an industry with 4 firms having 15% of the market apiece. Industry behaviour might be similar in both cases, but it is also possible that the large firm would dominate the industry in the first case, but it is also possible that the large firm would dominate the industry in the first case, while the four firms in the second case would resort to cutthroat competition.

This problem can be eliminated by using a different measure of market concentration called the Hirschmann-Herfindahl Index. The Hirschmann- Herfindahl Index is calculated by squaring the percentage share of each firm. This puts extra weight on firms with a larger market share.

The formula for computing the Index is:

where Si is the market share of the ith firm. The Herfindahl Index can run from 100 for an industry composed of identically sized firms to 10000 for a pure monopoly. For the two examples above, the index would be:

H = 57 + 1 .. + 1 = 3249 + 43 = 3292

H = 15 + 15 +15 +15 +1 .. + 1 = 900 + 40 = 940

The Hisrchmann-Herfindahl Index is widely considered to be a superior measure of market concentration because it can isolate the presence of a single or few dominant firms. However, the Hirschmann- Herfindahl Index suffers from some of the same problems as concentration ratios: it says nothing about potential competition or geographical concentration.

Price leadership tacit collusion

Another type of oligopolistic behaviour is price leadership. This is when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes prompted by the dominant firm. We see examples of this with the major mortgage lenders and petrol retailers where most suppliers follow the pricing strategies of leading firms. If most of the leading firms in a market are moving prices in the same direction, it can take some time for relative price differences to emerge, which might cause consumers to switch their demand. Firms who market to consumers that they are never knowingly undersold or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion. Does the consumer really benefit from this?

Explicit collusion under oligopoly

It is often observed that when a market is dominated by a few large firms there is always the potential for businesses to seek to reduce market uncertainty and engage in some form of collusive behaviour. When this happens the existing firms decide to engage in price fixing agreements or cartels. The aim of this is to maximize joint profits and act as if the market was a pure monopoly. This behaviour is deemed illegal by the UK and European competition authorities but it is hard to prove that a group of firms have deliberately joined together to raise prices.

What is a cartel?

An organization created from a formal agreement between a group of producers of a good or service, to regulate supply in an effort to regulate or manipulate prices.

A cartel is a collection of businesses or countries that act together as a single producer and agree to influence prices for certain goods and services by controlling production and marketing. The primary goal of a cartel is to limit competition between member firms and to maximize joint profits as if the firms were collectively a monopoly.

A cartel has less command over an industry than a monopoly - a situation where a single group or company owns all or nearly all of a given product or service's market. In the United States, cartels are illegal; however, theOrganization of Petroleum Exporting Countries (OPEC)- the world's largest cartel - is protected by U.S. foreign trade laws.

Source: http://www.investopedia.com/terms/c/cartel.asp#ixzz40CRTsgkp

OPEC

The organization of petroleumexporting countries (OPEC) is perhaps the bestknown example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.

Oligopolistic firms join a cartel to increase their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will charge. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oilproducing firms form a cartel like OPEC to determine their output and price, they will jointly face a downwardsloping market demand curve, just like a monopolist. In fact, the cartel's profitmaximizing decision is the same as that of a monopolist, as Figure reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel's profits are equal to the area of the rectangular box labeled PmBAPc in Figure 1. Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.

Incentives to cheat

Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel's profits. Hence, there is a builtin incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist.

Incentive to Cheat. Diagram A represents the industry and diagram B represents the firms in the industry. There are 20 firms; the competitive quantity produced by each firm is 25 units so the competitive industry quantity is 500 units at $12. After the cartel forms, each firm agree to restrict output to 20 units so the industry quantity reduces to 400 units at $15. When the cartel successfully raises the price, firms in the industry have an incentive to cheat. If a single firm increases output to 30 units while the rest of the firms are producing 20 units, the single firm will earn larger profits. The incentive to cheat is illustrated by the yellow shaded area B in part B of the diagram. Profit is maximized when the cheating firm produces 30 units at point C while receiving the cartel price. Point C is where the marginal cost (MC) curve intersects the new marginal revenue (MR) curve after the cartel successfully raises price. The competitive firms profit is equal to the blue shaded area A.

Collusion in a market or industry is easier to achieve when:

1. There are only a small number of firms in the industry and barriers to entry protect the monopoly power of existing firms in the long run

2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not subject to violent fluctuations which may lead to excess demand or excess supply

3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the total revenue to suppliers in the market this is clearly easier when the product is viewed as a necessity by the majority of final consumers

4. Each firms output can be easily monitored (this is important) this enables the cartel more easily to control total supply and identify firms who are cheating on output quotas.

Possible breakdowns of cartels

Most cartel arrangements experience difficulties and tensions and some producer cartels collapse completely. Several factors can create problems within a collusive agreement between suppliers:

1. Enforcement problems: The cartel aims to restrict total production to maximize total profits of members. But each individual member of the cartel finds it profitable to raise its own production. It may become difficult for the cartel to enforce its output quotas. There may be disputes about how to share out the profits. Other firms not members of the cartel may opt to take a free ride by producing close to but just under the cartel price.

2. Falling market demand during a slowdown or recession creates excess capacity in the industry and puts pressure on individual firms to cut prices to maintain their revenue. There are good recent examples of this in international commodity markets including the collapse of the coffee export cartel and some of the problems that have faced OPEC in recent years

3. The successful entry of non-cartel firms into the industry undermines a cartels control of the market e.g. the emergence of online retailers in the book industry in the mid 1990s.

4. The exposure of illegal price fixing by market regulators e.g. the severe fines imposed on vitamin producers by the European Commission in the autumn of 2001 and recent investigations of price-fixing by the UK Office of Fair Trading.

AN EFFECTIVE cartel requires three things: discipline, a dominant market position and barriers to entry. The Organisation of the Petroleum Exporting Countries lacks all three. Its members cheat on their quotas. It supplies only 30% of the worlds oiltoo little to exercise control. New producers abound.

That is the backdrop to OPECs decision last month to make no attempt to bolster the oil price, sending it below $70 a barrela near 40% drop since June. Saudi Arabia, its most influential member, could have sent the price up single-handedly by deciding to pump less. Unlike cash-strapped oil exporters such as Venezuela, the kingdom can afford self-denial: it has savings of $900 billion.

But Saudi Arabia can also weather a low price: its production costs are $5-$6 a barrelthe lowest in the world. Moreover, history suggests most of the gains from any cut in its output would go to other producers, who would sell their oil for more while increasing their market share. Saudi Arabia did try the tactic in the early 1980s, cutting its output by three-quarters from 10m b/d in 1980 to under 2.5m in 1985-6. The result was higher prices, but also a boom in investment, and then production, in places such as Britain and Norway.

Trying to save OPEC with such tactics could be even more dangerous now. Keeping the price up would be good news for frackers, speeding the spread of that technology from America to other countries. Costly oil spurs thrift too, hastening the shift away from oil in transport. Every hybrid or electric car spells lost business for oil producers. Why encourage them?

Cheap oil also has its consolations. Russia and Iran, two countries with which Saudi Arabia has its differences, are suffering much more. Better still, if low prices stem investment in other sources of oil, such as Canadas tar sands or Americas shale, that means more demand for low-cost Saudi oil in future.

Source: http://www.economist.com/news/finance-and-economics/21635510-what-oil-cartel-up-making-best-low-price

Non-collusive oligopoly

In this case, each firm will embark upon a particular strategy without colluding with its rivals, although there will of course still exist a state of interdependence, as possible reactions of rivals will have to be considered.

There are three broad approaches that might be adopted by firms in a situation of competitive oligopoly:

1. Observe the behaviour of rival firms but make no attempt to predict their possible strategies on the basis that they will not develop counter strategies. This was the essence of the earliest model of oligopoly developed by Cournot as far back as 1838: each firm acts independently on the assumption that its decision will not provoke any response from rivals; this is not generally accepted nowadays as providing a useful framework in which to analyze contemporary oligopoly behaviour.

2. Make the assumption that a given strategy will provoke a response from competitor firms, and assess the nature of the response using past experience. This is the basis of the kinked demand curve model, described below, in which it is assumed that any price cut by one oligopolist will induce all others to do likewise, whilst a similar price increase would not be matched.

3. Formulate a strategy and try to anticipate how rivals are most likely to react, and be prepared with suitable counter measures.

The kinked demand curve model

See: http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/kinkeddcurve.html

The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other firms in the market to a change in its price or another variable. The common assumption of the theory is that firms in an oligopoly are looking to protect and maintain their market share and that rival firms are unlikely to match anothers price increase but may match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm.

If firm A raises price and others leave their prices constant, then we can expect quite a large substitution effect away from firm A making demand relatively price elastic. Firm A would lose market share and expect to see a fall in its total revenue. If firm A reduces price but other firms follow suit, the relative price change is much smaller and demand would be inelastic in respect of the price change. Cutting prices when demand is inelastic also leads to a fall in total revenue with little or no effect on market share.

The kinked demand curve model therefore makes a prediction that a business might reach a stable profit-maximizing equilibrium at price P1 and output Q1 and have little incentive to alter prices. The kinked demand curve model predicts periods of relative price stability under an oligopoly with businesses focusing on non-price competition as a means of reinforcing their market position and increasing their supernormal profits. Short-lived price wars between rival firms can still happen under the kinked demand curve model. During a price war, firms in the market are seeking to snatch a short-term advantage and win over some extra market share.

Change in costs - http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/kinkeddcurvechange.html

Criticisms of the kinked demand curve theory

The theory assumes that oligoplists perceive a kink at the current market price i.e. at point X, but it does not explain how or why the original price was chosen. As a theory, it is therefore incomplete as it does not deal with price determination.

Price stickiness or rigidity in oligopolistic markets might, in practice, be more apparent than real; for example, in the market for new cars, published catalogue prices may remain constant over relatively long periods, but the common practices of offering discounts, and items such as free insurance, cash- back deals and interest -free credit all amount to ways of reducing price. In fact, the theory takes no account of the various forms of non-price competition, which characterize most oligopolistic markets.

There is little empirical evidence from firms operating in oligopolistic markets to substantiate the kinked demand curve hypothesis that a change in price by one firm will always evoke a predictable and uniform response from its rivals. In practice, a very wide range of possible reactions is probable.

Any perceived stability in prices in oligopolistic markets may not be due to the existence of a kinked demand curve, but may occur for other reasons such as the administrative expense and inconvenience of altering prices too regularly.

Cut-price competition (predatory pricing)

Although oligopolistic markets tend to be characterized by relative price stability in the longer term, occasionally short bursts of price warfare break out. This typically occurs when the dominant players attempt to defend and/or raise their market shares because the total level of demand in the market is insufficient to enable all to achieve their intended level of sales, and overcapacity results. Price cutting has the effect of reducing the profits of all the combatants in the short run, with consumers gaining the temporary benefit of lower prices.

However, the likely outcome is that the weakest firms, i.e. those with the highest costs, will be driven into bankruptcy, with a new era of relative price stability eventually emerging. If too many casualties are caused, consumers are likely to face greater monopoly power and possibly higher prices. Price wars have been experienced between supermarket chains in many countries. In the UK such wars have also featured in petrol station forecourts.

Game Theory

The term game theory does not mean that we are really going to be playing games, but it is appropriate because each game involves players, strategies and payoffs. To play a game, each player different firms, labour unions, management or policy-makers must consider the costs and benefits of alternative strategies as well as the possible strategies that might be adopted by other players. The purpose of each game is to win the payoff market share, wages, profits, achievement of policy goals, or whatever. To be successful, a player must adopt a strategy that correctly anticipates the response of its opponent. For example, if a firm in an oligopoly industry is considering the introduction of anew product, it must consider not only the costs of product development and the likely response of consumers, but also whether its rival firms will also introduce new products. If only one firm introduces a new product, it may be able to capture a large market share and pay for development costs, but if all firms introduce new products, the development costs may exceed the increased sales revenue.

The Prisoners Dilemma

Suppose that two criminals, Art and Betty, are held as suspects in a bank robbery. The evidence is convincing, but without a confession, the most that the police can pin on each of them is a one-year jail sentence for a known previous petty crime. If they both confess, each will get a five-year jail term. Thus the best strategy is for both suspects to hold out and spend only a year in jail but the police want a confession to the bank robbery. To coax a confession out of the prisoners, the police can use a simple application of game theory. Put Art and Betty in separate rooms so they cannot communicate, and offer each a suspended sentence (zero years) for confessing and naming the other as an accomplice. The accomplice will then go to jail for 10 years. This offer is made to each suspect. Betty knows that if she and Art both clam up, they get only a year in jail, but if Art confesses and she does not confess, she will go to jail for 10 years. Art knows the same thing. What should the suspects do?

The payoff matrix in the following table illustrates the dilemma faced by the two prisoners.

Art (A)

Betty (B)

Actions

Dont Confess

Confess

Dont Confess

A:1 B: 1

A:0 B: 10

Confess

A: 10 B: 0

A:5 B: 5

Interpreting the payoff matrix is straightforward. The entry (A:1, B:1) in the northwest corner shows what happens if both Art and Betty hold out both go to jail for one year. The entry (A:0, B:10) in the northeast corner shows what happens if Art confesses and Betty holds out Art gets the suspended sentence and Betty goes to jail for 10 years.

What is the most likely outcome of the game? To make the most advantageous decision, each player needs to consider the action of the other. Consider the situation from Arts standpoint. Suppose that Betty confesses. If Art also confesses, he gets 5 years; if he holds out, he will get 10 years. The best strategy is to confess. But what if Betty holds out? If Art also holds out, he will get 1 year. If he confesses, he will get a suspended sentence. Again the right choice is to confess. You get the same situation if you look at it from Bettys standpoint.

Confessing is the dominant strategy because it gives each player the best payoff regardless of the strategy chosen by the other player. A dominant strategy is the only likely outcome of a prisoners dilemma game. When both players adopt their dominant strategies, the game rests in dominant strategy equilibrium. However, it should be noted that in the above example, the equilibrium is not the most beneficial equilibrium to both players.

Cartel Behaviour

The prisoners dilemma has been applied to several areas in economics, most notably, oligopoly behaviour. One can apply it to the classic case of cartel cheating.

Suppose that two firms share a market and must decide whether to produce high quantity (H) or low quantity (L). If the firms form a cartel and agree to restrict production, they can charge high prices and earn $6 million in profits each. This is represented in the northwest corner (A:6, B:6) of the table below :

Firm A

Firm B

Actions

Low Output

High Output

Low Output

A:6 B: 6

A:9 B: 2

High Output

A: 2 B: 9

A:3 B: 3

If there is no cartel agreement and both firms produce high output, price will fall and bring profits down to $3 million per firm. This is represented by the (A:3, B:3) entry in the southeast corner of the table. The other entries in the table show what happens if one firm cheats on the cartel while the other maintains low production. The cheater will increase sales at the expense of the rival, and profits rise to $9 million for the cheater and fall to $2 million for the rival.

What is the most likely outcome to this game? Look at this situation from the perspective of Firm A. If Firm B keeps to the cartel agreement, then Firm A can increase its profits from $6 million to $9 million by cheating. And if Firm B cheats, Firm A should still cheat; otherwise its profits will fall to $2 million. Firm B faces the same choices, so the dominant strategy for both firms is to cheat on the cartel.

Questions

1:

2:

3: The payoff matrix below shows the profit two firms earn if both advertise, neither advertise, or one advertises and the other does not. Profits are reported in millions of dollars. Does either firm have a dominant strategy?

Firm A

Firm B

Actions

Advertise

Dont advertise

Advertise

A:100 B: 20

A:50 B: 70

Dont advertise

A: 0 B: 10

A:20 B: 60

4: Bud and Wise are the only two makers of aniseed beer, a new-age product designed to displace root beer. Bud and Wise are trying to figure out how much of this new beer to produce.

They each know that if they both limit production to 10,000 gallons a day, they will make the maximum attainable joint profit of $200,000 a day - $100,000 a day each.

They also know that if either of them produces 20,000 gallons a day while the other produces 10,000 gallons a day, economic profit will be $150,000 for the one that produces 20,000 gallons and an economic loss of $50,000 for the one that sticks with 10,000 gallons.

They know also that if they both increase production to 20,000 gallons a day, they will both earn zero economic profit.

(a) Construct a payoff matrix for the game that Bud and Wise must play

(b) Find the Nash equilibrium

(c) What is the equilibrium if this game is played repeatedly?

5: The New York Times (Nov 30, 1993) reported that the inability of OPEC to agree last week to cut production has sent the oil market into turmoil leading to the lowest price for domestic crude oil since July 1990

(a) Why were the members of OPEC trying to agree to cut production?

(b) Why do you suppose OPEC was unable to agree on cutting production? Why did the oil market go into turmoil as a result?

(c) The newspaper also noted OPECs view that producing nations outside the organisation, like Britain and Norway, should do their share and cut production. What does the phrase 2do their share suggest about OPECs desired relationship with Norway and Britain?

6: A large share of the world supply of Diamonds comes from Russia and South Africa. Suppose the marginal cost of mining diamonds is constant at 1000 per diamond, and the demand for diamonds is described by the following schedule:

PriceQuantity

80005000

70006000

60007000

50008000

40009000

300010000

200011000

100012000

(a) If there were many suppliers of diamonds, what would be the price and quantity?

(b) If there were only one supplier of diamonds, what would be the price and quantity?

(c) If Russia and South Africa formed a cartel, what would be the price and quantity? If the countries split the market evenly, what would be South Africas production and profit? What would happen to South Africas profit if it increased 1000 units while Russia stuck to the cartel agreement?

7: While there are oligopolies present in goods market, these same companies use the same principles in input markets (factors of production)

(a) If sellers who are oligopolists try to increase the price of goods they sell, what is the goal of buyers who are oligopolists?

(b) Major league baseball team owners in the United States have an oligopoly in the market for baseball players. What is the owners goal regarding players salaries? Why is this goal difficult to achieve?

(c) Baseball players in the United States went on strike in 1994 because they would not accept the salary cap that the owners wanted to impose. If the owners were already colluding over salaries, why did the owners feel the need for a salary cap?

1

Quantity

Price

MR

D

MC

Pc

Pm

Ideal Cartel (B)

A

B

C

D

Competition (C)

Industry

QmQc

Cartel Deadweight

Loss (A)

MC

AC

(25)(20)

Qm'

MR'

D=AR=MR

Pc

Pm

Quantity

Price

Quantity

Price

Competitive

Profit (A)

A

B

Incentive to

Cheat (B)

Cheater (C)

(500)(400)

MR

D

MC

Pc

Pm

Ideal Cartel (E)

D

E

F

Competition (F)

Cartel Deadweight

Loss (D)

Industry

Firm

C

Cheat

Quota

(A)

(B)

Qm

Qc

QmQc

(12)

(15)

(15)

(12)

(30)