Oligopoly Notes

Oligopoly

LO13.1 Describe the characteristics of oligopoly.

An oligopoly is a market structure dominated by a few large producers offering homogeneous or differentiated products. Due to the limited number of firms, oligopolists have considerable control over prices but must consider the reactions of their rivals regarding pricing, output, and advertising decisions.

A Few Large Producers

The term "a few large producers" is intentionally broad, as oligopoly encompasses various market situations. Examples include the online advertising industry, dominated by firms like Google, Facebook, and Amazon, and smaller auto-parts stores in a medium-sized town with roughly equal market shares. Terms like "Big Three," "Big Four," and "Big Six" are commonly used to describe oligopolistic industries.

Homogeneous or Differentiated Products

Oligopolies can be either homogeneous or differentiated. Homogeneous oligopolies produce standardized products like steel, zinc, copper, lead, and cement. Differentiated oligopolies produce differentiated products, such as automobiles, household appliances, electronics equipment, breakfast cereals, and sporting goods. Differentiated oligopolies often engage in nonprice competition, heavily supported by advertising.

Control over Price, but Mutual Interdependence

Oligopolistic firms are "pricemakers" and can set prices to maximize profit, similar to a monopolist. However, unlike a monopolist, oligopolists must consider how rivals will react to changes in price, output, product characteristics, or advertising. This leads to strategic behavior and mutual interdependence.

Strategic Behavior

Strategic behavior refers to self-interested actions that consider the reactions of others. Firms develop strategies for price, quality, location, service, and advertising to grow their business and expand profits.

Mutual Interdependence

Mutual interdependence means that each firm's profit depends on its own strategies and those of other firms in the concentrated industry. Oligopolistic firms base decisions on anticipated reactions from rivals.

Examples:

• L'Oreal predicting Clinique's response to a price increase in cosmetics.

• Burger King considering McDonald's reaction to an advertising strategy.

Entry Barriers

Barriers to entry that create monopolies also contribute to oligopolies.

Economies of Scale

Economies of scale are significant entry barriers in industries like aircraft, rubber, and copper. Existing firms have sufficient sales to achieve economies of scale, while new firms would have small market shares and higher production costs, making survival difficult.

Capital Expenditure

High capital requirements for plant and equipment are barriers in industries like jet engines, automobiles, commercial aircraft, and petroleum refining.

Ownership and Control of Raw Materials

The ownership and control of raw materials explain oligopolies in mining industries such as gold, silver, and copper.

Patents

Patents act as entry barriers in the computer, chemicals, and pharmaceutical industries.

Preemptive and Retaliatory Strategies

Oligopolists can prevent entry through preemptive and retaliatory pricing and advertising strategies.

Network Effects

Social networking apps and Internet businesses often experience network effects. Startups and small rivals struggle to compete with dominant firms like Facebook or Twitter, which have many users.

Mergers

Oligopolies emerge through the growth of dominant firms or through mergers.

Merging for Market Share and Economies of Scale

The merging of competing firms increases market share and helps achieve greater economies of scale.

Desire for Monopoly Power

Mergers can lead to larger firms with greater control over market supply and prices, as well as the ability to demand lower input prices.

Oligopolistic Industries

Industries are considered oligopolistic when the largest four firms control 40 percent or more of the market. About one-half of all U.S. manufacturing industries are oligopolies.

Shortcomings of Concentration Ratios

Concentration ratios have limitations:

• Apply to the nation as a whole, while markets may be localized.

• Based on arbitrary industry definitions, disguising interindustry competition.

• Do not account for import competition from foreign suppliers.

The Herfindahl Index

The Herfindahl index is used to address the problem of concentration ratios.

Herfindahl index = (%S1)^2 + (%S2)^2 + (%S3)^2 + … + (%Sn)^2

Where:

• %S₁ is the percentage market share of firm 1

• %S₂ is the percentage market share of firm 2

• %S_n is the percentage market share of firm n

The Herfindahl index gives greater weight to larger firms. A higher Herfindahl index indicates greater market power within an industry.

Oligopoly Behavior: A Game-Theory Overview

LO13.2 Discuss how game theory relates to oligopoly.

Oligopoly pricing behavior is similar to strategic games where outcomes depend on the actions of all players. Firms must consider their rivals' actions and expected reactions.

Game Theory

Game theory studies how people behave in strategic situations. The prisoner's dilemma is a classic example.

Prisoner's Dilemma

Two suspects, Betty and Al, are offered a deal: confess and receive a short sentence if the partner remains silent, or remain silent and receive a long sentence if the partner confesses. Both confess out of fear, even though they would be better off staying silent.

Payoff Matrix

Game theory is illustrated using a payoff matrix. Consider RareAir and Uptown, two firms in a duopoly producing athletic shoes. Each can choose to price high or low.

• Cell A: Both firms price high, each earns 12 million.

• Cell B: RareAir prices low, Uptown prices high, RareAir earns 15 million, Uptown earns 6 million.

• Cell C: Uptown prices low, RareAir prices high, Uptown earns 15 million, RareAir earns 6 million.

• Cell D: Both firms price low, each earns 8 million.

Mutual Interdependence Revisited

Oligopolistic firms can increase their profits and influence rivals' profits by changing pricing strategies. Each firm's profit depends on its own strategy and that of its rivals. If Uptown adopts a high-price strategy, its profit will be 12 million only if RareAir also prices high. If RareAir prices low, it can boost profit to 15 million but reduce Uptown's profit to 6 million.

Collusion

Oligopolists can benefit from collusion (cooperation). The best outcome for both firms is cell A, with each earning 12 million. Without collusion, profit incentives lead to cell D, where each firm makes only 8 million.

A firm can increase its own profit by switching to a low-price strategy. Oligopolists can avoid low-profit outcomes by colluding and maintaining a high-price policy, increasing each firm's profit from 8 million to 12 million.

Impact on Consumers

Collusion is bad for consumers because higher prices translate into higher costs and deadweight efficiency losses. Without collusion, competitive low-price strategies lead to higher output and improved efficiency, benefiting consumers but decreasing profits for the oligopolists.

Incentive to Cheat

Oligopolists are tempted to cheat on collusive agreements to increase their profit to 15 million by lowering prices. Collusive agreements are often fragile, leading to substantial low-price, competitive behavior in oligopolistic industries.

QUICK REVIEW 13.1

• Oligopolies consist of few firms producing homogeneous or differentiated products that are mutually interdependent.

• Entry barriers include scale economies, control of patents or resources, retaliatory pricing, and network effects.

• Oligopolies result from internal growth, mergers, or both.

• Game theory demonstrates mutual interdependence, collusion to enhance profits, and the temptation to cheat on agreements.

Oligopoly and Advertising

LO13.4 Contrast the potential positive and negative effects of advertising.

Oligopolists avoid price competition, which results in market share being determined by product development and advertising.

• Product development and advertising are harder to duplicate than price cuts.

• Oligopolists have the financial resources for product development and advertising.

In 2021, firms spent an estimated 243 billion on advertising in the United States and 613 billion worldwide.

Advertising can affect prices, competition, and efficiency both positively and negatively.

Positive Effects of Advertising

Consumers need information about product characteristics and prices for rational decisions. Advertising provides this information at a low cost, reducing the direct and indirect costs of searching for products.

Advertising reduces monopoly power by introducing new products to compete with existing brands. It enhances competition, results in greater economic efficiency, speeds up technological progress, and helps firms obtain economies of scale by increasing sales and output.

Potential Negative Effects of Advertising

Advertising can manipulate consumers, mislead with extravagant claims, and persuade consumers to pay high prices for inferior products. It helps firms establish brand-name loyalty, achieving monopoly power and increasing sales, market shares, and profits. This creates barriers to entry for new firms due to high advertising costs.

Advertising can be self-canceling when campaigns offset each other, resulting in higher costs and little change in market share or profits. This leads to economic inefficiency.

Oligopoly and Efficiency

LO13.5 Discuss the efficiency of oligopoly.

Oligopoly does not meet the triple equality of pure competition: P = MC = \text{minimum ATC}. Oligopolists often sustain sizable economic profits, producing where P > MC and P > ATC, with production below the output at which ATC is minimized. This results in neither productive nor allocative efficiency.

Government regulation is more likely with pure monopoly than an oligopoly.

Qualifications to this View:

• Increased foreign competition has spurred more competitive pricing.

• Limit pricing: Oligopolists keep prices below profit-maximizing levels to deter entry.

• Technological advance: Economic inefficiencies may be offset by contributions to better products, lower prices, and lower costs over time through R&D.

QUICK REVIEW 13.3

• Oligopolists emphasize nonprice competition because advertising and product variations are harder to match and they have ample resources.

• Advertising can reduce monopoly power by providing useful information and introducing new products.

• Advertising can hurt consumers and competition by promoting monopoly power and creating entry barriers.

Game Theory and Strategic Behavior

LO13.6 Use additional game-theory terminology and demonstrate how to find a Nash equilibrium.

Game theory explains mutual interdependence and strategic behavior by oligopolists.

A One-Time Game: Strategies and Equilibrium

Chipco and Dramco, fictitious producers of computer memory chips, have two strategies: international (competing in both countries) and national (selling only in their home country).

This is a one-time, simultaneous, positive-sum game. Both firms have a dominant strategy: an option better than any alternative, regardless of what the other firm does. The Nash equilibrium is an outcome from which neither rival wants to deviate.

Credible and Empty Threats

Chipco and Dramco could increase their profit by jointly pursuing national strategies. A credible threat is a believable statement of coercion. A strong enforcer can help prevent cheating and maintain the group discipline needed for cartels, price-fixing conspiracies, and territorial understandings to successfully generate high profits.

Repeated Games and Reciprocity Strategies

In a repeated game, the optimal strategy is cooperation and restraint, so long as the other firm reciprocates. This can take place without formal collusion and the risk of anti-trust penalties.

First-Mover Advantages and Preemption of Entry

In a sequential game, firms apply strategies sequentially, with one firm moving first and committing to a strategy. The final outcome depends on which firm moves first, as the first mover may establish an equilibrium that works in its favor. First mover tends to get a bigger piece of the pie than the follower.

Brick and Mortar Examples

Many retail businesses that rely on physical stores have used variations of the first-mover strategy to preempt major rivals. Example firm: Walmart.

Digital Examples

Internet startups often argue for the first-mover advantage by attracting many users and hoping to get a bigger market share by building a digital community.

QUICK REVIEW 13.4

• Positive-sum, zero-sum, and negative-sum games have combined payoffs that sum to positive, zero, and negative values.

• A dominant strategy leads to better outcomes for a firm, no matter what the other firm does.

• A Nash equilibrium occurs when both firms are playing dominant strategies, so neither has an incentive to alter its behavior.

• Reciprocity can improve outcomes in repeated games, and there may be first-mover advantages in sequential games.