Oligopoly

  • What determines market power?

  • Concentration measures

  • How do firms in an oligopoly set prices and output?

  • How does an oligopoly maintain price and profit?

Characteristics

  • few firms produce all or most of the market supply of a particular good or service.

  • High barriers to entry.

  • Standard (or differentiated product)

  • Significant potential market power

  • Interdependence of Firms

  • Since there are so few firms in an Oligopoly

  • The output and price of each firm

  • Will strongly affect the rest of the firms in the market  ==> Interdependence

Leads to strategic behavior

  • Because firms affect each other so strongly

  • Outcomes (of choices) will be affected other firms response

  • Firms must consider responses when they act strategic behavior

Options for strategy

  • Cooperation: work together to maximize joint profits

  • Rivalry: create and use market power; block entry (aggressively market; exclusive dealing; control input/output level)

  • Competition: price at MC, no attempt to block entry or use market power

 

Cooperation: Cartel

  • As a group, they do best if they can act like a monopoly

  • Produce the monopoly output

  • Charge the monopoly price

Cartel: group of firms that makes specific agreements to set price, industry output, and market share for each group.

Cartel Outcome

  • Same as a monopoly:

  • Output is too low, price is too high

  • They must have high barriers to entry to maintain profits

  • Unlike a monopoly:

  • They are separate companies that want to maximize their own profits

    Problems in maintaining a Cartel

    • It is illegal under antitrust law

    • Individual companies have an incentive to cheat (lower price or produce more output)

    • Why? Because the MR for a member of the cartel is not the same as for all the firms. When output increases, all firms absorb the lost revenues of the price drop.

    • When firms cheat, lose the gains of the cartel

     

    Cartel Approach

    • Price Fixing

    • Cartel agreement fixing prices and outputs

    • Illegal if firms intend to collude to increase price above competitive level

    • Ex: Airlines; GE

    • Price leadership: more subtle

    • Leader sets signals a price

    • Firms follow:

    • most successful if firms have separate market areas

 

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Rivalry: non-price competition

  • Aggressively seeking market share

  • Advertising, product differentiation, control over inputs or outlets

  • Most common oligopoly strategy

  • avoids price wars -> lead to competitive outcome

  • Often combine "price leadership" with seeking market share with non price compeition

  • Firms must assess How other firms will react to changes in attempts to get market share:

Rivalry behavior of firms

  • Product differentiation

  • Advertising

  • Predatory pricing: Use of pricing to eliminate competition.

  • Response to price changes

  • Cartel like behavior: dividing up markets

Rivalry: problems

  • For business: easy to get caught in "negative sum games": advertising

  • Increase costs in a market share war: can be worse than competitive pricing

  • For economy:

  • Productive inefficiency: waste of resources

  • Allocative: prices will be way too high

 

Difficulty of changing prices:

  • Oligopolists may face a dilemna when firms rival for market share.

  • Who firms react to price changes

  • If Firm O raises price:

  • Other firms will maintain old price to gain market share.

  • The quantity demanded from Firm O will drop considerably

  • Demand becomes flatter - more like a competitive firm

Changing prices in rivalry

  • If firm O lowers price:

  • Other firms match so they wont lose market share

  • => can start a price war

  • Firms can expect to end up with the same share of Demand but a lower price

  • Result: sticky prices

Kinked Demand

  • two demand curves facing firm.

  • Flat: firms react, follow

  • Steep: firms do not follow

  • If firm lowers price, firms will follow

  • Steeper demand applies

Kinked Demand

  • So firms face a "kinked demand curve"

  • This gives them a MR curve that breaks up

 

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Mergers and Acquisitions

  • Merger: two companies become one

  • Acquisition: One company buys another (or major parts of it)

  • Most Concentration attained this way

 

Mergers and Acquisitions

  • How high is too high?

  • Herfindahl of over 1800 must be reviewed "

  • Contestable market :

  • a market that other firms are able and willing to enter if profitable

  • Implies that the existing firms have to produce closer to the competitive price and output.

 

Barriers to entry

            to be added