Chapter 12: Oligopoly and Strategic Behaviour (gemini)

Chapter 12: Oligopoly and Strategic Behaviour

Characteristics of Oligopoly

A Few Large Producers: The market is dominated by a few firms, such as Canada’s "Big Five" banks.

Homogeneous or Differentiated Products: Oligopolies can produce standardized products (like steel or cement) or differentiated products (like automobiles or breakfast cereals).

Control over Price, but Mutual Interdependence: Firms have considerable control over price, but because there are so few, each must consider the possible reaction of rivals to its pricing, output, and advertising decisions.

Strategic Behaviour: Self-interested behaviour that takes into account the reactions of others.

Mergers: Some oligopolies result from the merging of two or more formerly competing firms to gain market share and economies of scale.

A Few Large Producers

The market is dominated by a few firms, such as Canada’s "Big Five" banks.

Homogeneous or Differentiated Products

Oligopolies can produce standardized products (like steel or cement) or differentiated products (like automobiles or breakfast cereals).

Control over Price, but Mutual Interdependence

Firms have considerable control over price, but because there are so few, each must consider the possible reaction of rivals to its pricing, output, and advertising decisions.

Strategic Behaviour

Self-interested behaviour that takes into account the reactions of others.

Entry Barriers

Economies of scale, large capital requirements, and control of essential resources create significant obstacles to entry.

Mergers

Some oligopolies result from the merging of two or more formerly competing firms to gain market share and economies of scale.

Concentration Ratio

Reveals the percentage of total industry sales accounted for by the largest firms (usually the four largest).

Herfindahl Index

The sum of the squared percentage market shares of all firms in the industry. It gives much greater weight to larger, and thus more powerful, firms.

Game Theory

The study of how people behave in strategic situations.

Mutual Interdependence

The profit of each firm depends not only on its own price and sales strategies but also on those of the other firms in the industry.

Collusion

Cooperation with rivals can be more profitable than competition.

Incentive to Cheat

Firms may be tempted to cheat on collusive agreements to increase their own profits at the expense of their rivals.

Three Oligopoly Models

1. Kinked-Demand Theory: Non-collusive oligopoly. If a firm raises its price, rivals ignore it (demand is elastic); if a firm lowers its price, rivals follow (demand is inelastic). This leads to price stability.

2. Cartels and Other Collusion:

Cartel: A formal agreement among producers to set the price and the individual output of each member (e.g., OPEC).

Joint-Profit Maximization: Colluding firms act as a single monopoly to maximize total industry profits.

3. Price Leadership: An implicit understanding where the "dominant firm" initiates price changes and all other firms follow.

Kinked-Demand Theory

Non-collusive oligopoly. If a firm raises its price, rivals ignore it (demand is elastic); if a firm lowers its price, rivals follow (demand is inelastic). This leads to price stability

Cartel

2. A formal agreement among producers to set the price and the individual output of each member (e.g., OPEC).

Joint-Profit Maximization: Colluding firms act as a single monopoly to maximize total industry profits.

Price Leadership

An implicit understanding where the "dominant firm" initiates price changes and all other firms follow.

Demand and Cost Differences

It is difficult to agree on a single price when firms have different cost structures.

Number of Firms

The more firms there are, the harder it is to reach an agreement.

Cheating

The temptation to offer "secret" price cuts to select buyers.

Recession

During downturns, excess capacity leads firms to cut prices to maintain sales.

Potential Entry

High prices and profits may attract new entrants.

Oligopoly and Advertising

Positive Effects: Advertising provides information to consumers, reduces search costs, and can enhance competition by introducing new products.

Negative Effects: It can be manipulative, contain misleading claims, and create a barrier to entry by establishing brand loyalty that new firms cannot afford to challenge.

Efficiency of Oligopoly

Productive Efficiency: Not achieved; price is generally greater than minimum Average Total Cost ($P >$ min $ATC$).

Allocative Efficiency: Not achieved; price is greater than Marginal Cost ($P > MC$).

Qualifications: Oligopolies may lead to increased foreign competition, limit-pricing (keeping prices lower to discourage entry), and significant technological advance (R&D).

Oligopoly

A market structure in which a few firms sell either a standardized or a differentiated product, into which entry is difficult, in which the firm has limited control over product price because of mutual interdependence.

Homogeneous Oligopoly 2

An oligopoly in which the firms produce a standardized product.

Differentiated Oligopoly 2

An oligopoly in which the firms produce a differentiated product.

Strategic Behaviour

Self-interested economic actions that take into account the expected reactions of others.

Mutual Interdependence 2

A situation in which a change in price strategy by one firm will affect the sales and profits of another firm.

Interindustry Competition

The competition for sales between the products of one industry and the products of another industry.

Concentration Ratio 2

The percentage of the total sales of an industry made by the four largest sellers in the industry.

Herfindahl Index 2

A measure of the concentration and competitiveness of an industry; calculated as the sum of the squared percentage market shares of the individual firms.

Game Theory 2

A means of analyzing the strategic behaviour of self-interested participants.

Collusion 2

A situation in which firms act together and in agreement to fix prices, divide a market, or otherwise restrict competition.

Cartel 2

A formal agreement among firms in an industry to set the price of a product and establish the outputs of the individual firms or to divide the market for the product geographically.

Price Leadership 2

An informal method that firms in an oligopoly may use to set the price of their product: one firm (the leader) is the first to announce a change in price, and the other firms (the followers) soon announce identical or similar changes.

Nash Equilibrium

An outcome from which neither firm wants to deviate unilaterally.