Module 12: Oligopoly

Oligopoly Characteristics

• have a small number of large firms

• have barriers to entry, will not be easy in the long run

• engage in interdependent decision making

Interdependence

firms know who their competitors are, and consider actions and reactions when making decisions, there is a lot of strategy involved in the decision making

Four-firm concentration ratio

the fraction of industry sales accounted for by the largest four firms

• a ratio over 40% tends to indicate oligopoly

Limitations of the Concentration Ratio

• Ignores foreign competition

• Calculated for a national market

  • it doesn't take into account that a market may be a local market

  • if it is a local market, it may have a high share of sales in an area

• Market definitions are tricky

Economies of Scale

• long-run average costs fall as the quantity of output increases

• makes it difficult for new firms to enter

• new firms would have to start small with higher average costs than the existing firms

Government-Imposed Barriers

• Government grants exclusive rights to one or a few firms

• occupational licensing - medical field, such as doctors and dentists

• patents - gives the right to a product for 20 years

• tariffs/import quotas

Game theory

the study of the decisions of firms in industries where profits depend on interactions with other firms. Studying the interdependent decision making with oligopolies

Games characteristics

• Rules

  • for a firm: production function, market demand

• Strategies

  • for a firm: their production decisions

• Payoffs

  • for a firm: their profits

Nash equilibrium

when each firm chooses the best strategy, given the other firm's strategies

Collusion

an agreement among firms to charge the same price or otherwise not compete

Noncooperative Equilibrium

• equilibrium when players pursue their own self-interest

• no cooperation between firms

• it is the Nash equilibrium

Cooperative Equilibrium

• equilibrium when players cooperate to increase mutual payoff

• ex: collusion

Prisoner's dilemma

game where dominant strategies lead to noncooperation

• generally, everyone ends up worse off

Cartel

a group of firms that collude

• members agree to restrict output

• the restriction increases prices and profits

The Five Competitive Forces Model

This model identifies five competitive forces that help determine the level of competition we have in an industry.

The Five Forces

• Competition from existing firms

• Threat from potential entrants

• Competition from substitute goods or services

• Bargaining power of buyers

• Bargaining power of suppliers