Wednesday, May 11, 2011



An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high. Firms within an oligopoly produce branded products (advertising and marketing is an important feature of competition within such markets) and there are also barriers to entry.
Another important characteristic of an oligopoly is interdependence between firms. This means that each firm must take into account the likely reactions of other firms in the market when making pricing and investment decisions. This creates uncertainty in such markets - which economists seek to model through the use of game theory.
Game theory may be applied in situations in which decision makers must take into account the reasoning of other decision makers. It has been used, for example, to determine the formation of political coalitions or business conglomerates, the optimum price at which to sell products or services, the best site for a manufacturing plant, and even the behaviour of certain species in the struggle for survival.
The ongoing interdependence between businesses can lead to implicit and explicit collusion between the major firms in the market. Collusion occurs when businesses agree to act as if they were in a monopoly position

• While many oligopolies have emerged through the growth of dominant firms in a certain industry, many have also emerged through mergers.
o Ex.steel, airlines, banking, and entertainment industries
• Merging of two or more competing firms is beneficial in that it may increase their market share significantly, and thus achieve greater economies of scale. In this way, competition can also be reduced.
• Firms may also merge hoping to achieve monopoly power.
• The larger firm that results from a merger would have greater control over market supply and price than a few smaller firms.

The Four Firm Concentration Ratio

• Is the scale that determines whether a industry is monopolistic competition or oligopoly. If the combination of market share of the four largest firm in a single industry is equal or greater than 40%, the industry is consider as oligopoly.
• A concentration ratio reveals the percentage of total output produced and sold by the industry's largest firms


Herfindahl Index (Herfindahl-Hirschman Index or HHI,)

• The HHI measures of the number and size of firms in ratio to the industry. It serves as an indicator of the amount of competition within a market. It is defined as the sum of the squares of the market shares of each individual firm

Main Characteristic:
(See the text book for a complete list of features. These are the essential elements.)

Few firms:
1. Each firm is a large enough part of the market that the behaviour of one firm has a large impact on the demand curve of the others.
2. The result is that the firms do not have stable demand curves. If Pepsi changes its price, Coka Cola’s demand curve shifts.
3. As a result the method of finding the profit maximising output by comparing the firm’s costs to the firm’s demand curve is complicated or unworkable. Pepsi can decide on its best price and output, but then Coke will react and change its price or output. That will shift Pepsi’s demand curve, changing its best strategy and so one and so on.

The ordinary model of the firm is less applicable, because the demand curve of one firm depends on the behaviour of other firms. If Pepsi introduces a price cut, the Coke will lose large numbers of customers. The price of a substitute will have changed

If Pepsi raises its price, Coke’s demand curve shifts out. Coke won’t mind, but Pepsi will very likely find the quantity it sells falls very sharply. If Pepsi lowers its price, it will likely win many customers from Coke and have a very large increase in total revenue. Coke’s demand curve will shift in sharply and Coke will be very unhappy.
Coke is very unlike to stand by and let Pepsi undercut its price. If Pepsi insists on reducing its price, Coke will very like have to match the cut. When Coke matches Pepsi’s price, the other things equal assumption doesn’t hold. Pepsi’s price reduction causes an equally large change in price by Coke, and Pepsi’s demand will not increase nearly so much.

Common Behaviours:
1. Fix prices and act like a monopolist.
a. In some nations, can sign a contract and form a cartel that sets a price and assigns an output to each firm.
b. It may be profitable for some firm to ‘cheat’ and try to sell a larger quantity, even at a lower price. So cartels are unstable.
2. Enter into competition which results in relatively low prices. Depending on the nature of the market for the product, expenditures on advertising, packaging and product development may be high.
3. Compete on quality, advertising, packaging or other non-price characteristics.
a. This behaviour avoids the tendency of price competition to reduce profits.
b. It has proved to be a more stable behaviour than cartels.
c. Free trade increased price competition in automobiles and many other commodities.
Game theory:
A method of analysing behaviour in an oligopoly. It plots out the strategies of firms. Each firm plots out its best behaviour, depending on what the other firm does. It’s like two people arrested for a crime. If neither confesses they both go free. But the first one to confess receives a sentence of 3 months. The other receives a sentence of 3 years. Most likely they will each rush to be first to confess. They would be better off if both kept quiet, but that strategy requires a very high degree of trust. – Now if the mafia lurks in the background and promises to shoot whoever confesses, they will keep quiet.

In oligopoly the ‘confess’ strategy may be to cut prices. The first to cut prices will make the big gains in the market. The one who maintains a fixed price will take a large loss. So, if there is no equivalent to the ‘mafia’ both will rush to cut prices. However, there may be something like the ‘mafia’ to prevent price cutting. The biggest, strongest, lowest cost firm may be able to really hurt a smaller, weaker firm by cutting prices in its home market, or by maintaining a low price until the weak firm goes bankrupt. It is costly even for the big firm, but may discourage the small firm from even thinking about cutting prices.
Main Point:

Oligopolistic behaviour is complex – and lots of fun.

Each firm behaviour regarding price, quantity, advertising, or product development influences the other firm’s profitability.

As a result, firms can not make a decision without influencing the demand curve of its rivals. As a result, the rivals most desirable choice changes. They will respond, perhaps retaliate is a better word.

A firm must consider the reaction of its rivals when it chooses its behaviours.

In a static, well established business with good understanding among the firms, they may behave like a monopoly.

In a more dynamic industry, firms are likely to want to make sure they keep their share of the dynamic market growing.

In any case, some young scalawag with a new low cost firm may upset the apple cart. If it has a substantially superior product, or substantially lower costs, then it may be able to cut prices or just expand sales and encroach on other firms and be safe from retaliation.


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