Chapter 14 Notes – Oligopoly: Firms in Less Competitive Markets

14.1 Oligopoly and Barriers to Entry

  • Definition & Core Features

    • Oligopoly = market structure with a small number of large, inter-dependent firms.

    • Two key differences from perfect & monopolistic competition:

    • Firms recognize mutual interdependence; every strategic move affects rivals.

    • Entry barriers prevent the long-run erosion of economic profits.

  • Measuring Industry Concentration

    • Four-firm concentration ratio = share of industry sales accounted for by the four largest firms.

    • Rule of thumb: ratio > 40\% ⇒ oligopoly.

    • Limitations

    • Excludes foreign imports.

    • Computed at national level even when competition is local.

    • Sensitive to how the “market” is defined (e.g., Walmart competes with supermarkets, not just “discount department stores”).

  • Empirical Examples (Table 14.1 highlights)

    • Retail Oligopolies: Home centers 96\%, Couriers 91\%, Passenger airlines 71\%, etc.

    • Manufacturing Oligopolies: Tobacco 91\%, Aircraft 90\%, Breakfast cereal 82\%, Soft drinks 53\%.

  • Sources of Barriers to Entry

    1. Economies of scale

    • LRAC falls as output expands; minimum efficient scale relative to industry demand determines how many firms can profitably coexist.

    • If LRAC minimum occurs at a large fraction of total market output, only a few firms can survive ⇒ oligopoly (Figure 14.1).

    1. Control of key inputs (Alcoa – bauxite, De Beers – diamonds, Ocean Spray – cranberries).

    2. Government-imposed barriers

    • Patents (exclusive right for 20 years), tariffs, quotas.

    • Occupational licensing (dentists, doctors, even yoga instructors) – may protect consumers or limit competition.

  • Applied Ethics Example

    • “Are unlicensed yoga instructors a menace?”

    • Raises question: Where is the balance between consumer safety & anti-competitive protectionism?

14.2 Game Theory and Oligopoly

  • Why Use Game Theory?

    • Graphing a single firm’s MR = MC is inadequate when profits depend on rivals’ choices.

    • Game theory analyzes strategic interdependence.

  • Elements of Any Game

    1. Rules – feasible actions (e.g., production functions, demand curves).

    2. Strategies – complete contingent plan for every possible circumstance.

    3. Payoffs – profits, utilities, etc.

  • Duopoly Pricing Example (Netflix vs. Max)

    • Two prices: \$19.99 or \$15.99.

    • Payoff matrix (millions of profits):

    • If both choose \$15.99 ⇒ Netflix 75, Max 75.

    • Dominant strategy for each firm: lower price \$15.99 (Figures 14.2 1-3).

    • Nash equilibrium: ( \$15.99, \$15.99 ).

    • Collusion (illegal) would yield higher joint payoffs: ( \$19.99, \$19.99 ) gives each 100.

    • Illustrates prisoner’s dilemma: dominant strategies produce a sub-optimal outcome.

  • Cooperative vs. Non-Cooperative Equilibria

    • Non-cooperative (Nash) – no coordination; each pursues self-interest.

    • Cooperative – players can coordinate/commit; illegal for most pricing decisions among firms.

  • Repeated Games & Enforcement Mechanisms

    • Price match guarantee (Domino’s vs. Pizza Hut) changes payoffs, deters under-cutting.

    • Implicit collusion via price leadership: one firm sets price, others follow (e.g., GM in 1970s autos, Anheuser-Busch in beer).

  • Cartels

    • Cartel = explicit agreement to restrict output & raise price (e.g., OPEC).

    • Difficulties: incentive to cheat, unequal member sizes (Saudi Arabia vs. Nigeria, Figure 14.5).

14.3 Sequential Games and Business Strategies

  • Some strategic interactions unfold sequentially → modeled by decision trees.

  • Entry Deterrence Example (Samsung vs. Apple, Figure 14.6)

    1. Samsung chooses price \$1{,}800 or \$1{,}500.

    2. Apple decides to enter if expected return ≥ 15\%.

    • Backward induction: Samsung charges \$1{,}500 to deter entry (creates sub-15\% return for Apple).

  • Bargaining Example (Dell–TruImage, Figure 14.7)

    1. Dell offers \$20 or \$30 per software copy.

    2. TruImage accepts/rejects.

    • Threat to reject \$20 is non-credible; Dell anticipates acceptance, so equilibrium offer is \$20.

    • Outcome is a subgame-perfect equilibrium (optimal at every node).

14.4 The Five Competitive Forces Model

  • Michael Porter’s framework determines profitability/competition intensity.

    1. Competition among existing firms

    • Example: ACT keeps SAT price at \$60, whereas GRE faces no rival at \$220.

    1. Threat of potential entrants

    • Samsung’s low price to deter Apple.

    1. Substitutes

    • Film cameras displaced by digital; digital now displaced by smartphones.

    1. Bargaining power of buyers

    • Walmart’s scale pressures suppliers to lower prices.

    1. Bargaining power of suppliers

    • Microsoft’s pricing power rose as its OS became industry standard.

  • Dynamic Insight

    • Even dominant firms can falter: only 53 of the 1955 Fortune 500 remain today despite initial advantages.

Graphs, Tables & Figures – Conceptual Takeaways

  • Figure 14.1: LRAC shapes market structure; large MES ⇒ oligopoly.

  • Figure 14.2: Payoff matrix visualizes prisoner’s dilemma in duopoly pricing.

  • Figure 14.3: Repeated interaction reshapes incentives (price guarantees).

  • Figure 14.4: Historical oil prices show cartel power & instability.

  • Figure 14.5: Asymmetric cartel members complicate enforcement.

  • Figures 14.6–14.7: Decision trees elucidate entry deterrence & bargaining.

Key Terms & Definitions

  • Four-firm concentration ratio, Oligopoly, Economies of scale, Patent, Game theory, Strategy, Payoff matrix, Dominant strategy, Nash equilibrium, Prisoner’s dilemma, Cooperative/Non-cooperative equilibrium, Price leadership, Cartel, Sequential game, Decision tree, Subgame-perfect equilibrium, Five Competitive Forces.

Ethical, Philosophical & Policy Implications

  • Antitrust laws prohibit explicit collusion but allow ambiguous behaviors (price leadership).

  • Occupational licensing may protect consumers but can also entrench incumbents & raise prices.

  • Price guarantees & implicit collusion raise consumer welfare questions: lower uncertainty vs. potentially higher prices.

  • Cartels (OPEC) highlight global welfare trade-offs: producer gains vs. consumer losses & geopolitical leverage.

Connections to Previous Material & Real-World Relevance

  • Builds on monopoly markup idea: oligopolists can sustain markups due to barriers but must account for rivals.

  • Contrasts with perfectly competitive LR equilibrium (zero profit) & monopolistic competition (zero profit with differentiated products).

  • Streaming wars (Netflix, Disney+, Paramount+) illustrate theory: high fixed costs & network effects create oligopolistic rivalry.

  • COVID-19 restaurant failures emphasize threat of substitutes & buyer power (delivery platforms).

Numerical & Statistical References (Key Values)

  • Concentration benchmark: 40\%.

  • Patent length: 20 years.

  • Netflix/Max duopoly profits: 100–150 million vs. 50–75.

  • Domino’s/Pizza Hut prices: \$12 vs. \$10.

  • Phone prices: \$1{,}800 vs. \$1{,}500.

  • Software offers: \$20 or \$30.

  • Large-firm longevity: only 53/500\approx10.6\% of 1955 cohort still in Fortune 500$$.