Module 12: Oligopoly

Oligopoly

Oligopoly Characteristics

Oligopoly firms

  • have a small number of large firms

    • there may be a lot of firms, but there will be 3-4 that dominate the entire market

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

  • engage in interdependent decision making

Interdependence

Oligopoly firms are interdependent on each other.

  • 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

    • one firm will think about what they want to do and then also consider what their competitor will do in response before making a decision

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

  • It does not include imports coming into the US, so it ignores foreign competition

  • They are 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

Most Important Barrier

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

 Other Barriers to Entry

Ownership of a Key Input

  • If a firm controls a key input, it is difficult for others to gain access

  • Limits market entry

  • Examples:

    • DeBeers - diamonds

    • Ocean Spray - cranberries

 Government-Imposed Barriers

  • Government grants exclusive rights to one or a few firms

  • Examples

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

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

    • tariffs/import quotas

Game theory

Game theory is a specialized field of economic study developed in the 1940s

  • General: the study of how people make decisions in situations in which attaining their goals depends on their interactions with others

  • Economics: the study of the decisions of firms in industries where profits depend on interactions with other firms

  • Basically, it is studying the interdependent decision making with oligopolies

Games share three characteristics

  • Rules

    • for a firm: production function, market demand

  • Strategies

    • for a firm: their production decisions

  • Payoffs

    • for a firm: their profits

Price Competition 

Payoff matrix: shows the payoffs resulting from combinations of strategies

Business strategy: a set of actions taken to achieve a goal

  • Dominant strategy: the best strategy, no matter what the other firms do

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

  • this is the most likely outcome (and often the worst combined outcome)

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

    • Number of competitors, intensity of the competition, product differentiation

  • Threat from potential entrants

    • How easy it is for new companies to enter a market and compete with existing firms

  • Competition from substitute goods or services

    • How available are substitutes for the product in question and how close are the substitutes

  • Bargaining power of buyers

    • How much influence do customers have to demand lower prices, higher quality, etc

  • Bargaining power of suppliers

    • How much influence do suppliers have to raise prices, reduce quality, etc