Managerial Economics

Topic 5: Oligopoly
Chapter Outline
14.1 Oligopoly and Barriers to Entry

• Cartels

14.2 Game Theory and Oligopoly

Oligopoly: A Very Different Market Structure
In the previous chapters, we examined perfect and monopolistic
competition.

These two market structures were similar: firms produce until their marginal
cost is equal to marginal revenue, and the low barriers to entry would result
in profit being competed away in the long run.

Oligopoly, a market structure in which a small number of interdependent

firms compete, will require completely different tools to analyze. Why?
1. Oligopolists are large and know that their actions have an effect on one
another.
2. Barriers to entry exist, preventing firms from competing away profits.
14.1 Oligopoly and Barriers to Entry
Show how barriers to entry explain the existence of oligopolies.

Before we analyze how oligopolists behave, it is useful to know which firms/markets we are
discussing.

A useful tool for identifying the type of market structure is the four-firm concentration ratio:
the fraction of an industry’s sales accounted for by its four largest firms.
• A four-firm concentration ratio larger than 40 percent tends to indicate an oligopoly.

Although there are limits to how useful four-firm concentration ratios can be, they are a useful
tool in discussing the concentration of market power within an industry.
Table 14.1 Examples of Oligopolies in Retail Trade and Manufacturing

Retail Trade black Manufacturing black

Four-Firm Concentration
Four-Firm Concentration Ratio
Ratio
Industry Industry
Discount department stores (Walmart and 97% Cigarettes (Phillip 98%
Target) Morris and R.J.
Reynolds)
Warehouse clubs and supercenters (Sam’s 94% Beer (Anheuser- 90%
Club and BJ’s Wholesale Club) Busch and
MillerCoors)
College bookstores (Barnes & Noble and 75% Computers (Hewlett- 87%
Follett) Packard and Dell)

Hobby, toy, and game stores (Toys“R”Us 72% Aircraft (Boeing and 81%
and Michael’s) Lockheed Martin)

Radio, television, and other electronic 70% Breakfast cereal 80%

stores (Best Buy and Apple) (Kellogg’s and
General Mills)
Athletic footwear stores (Footlocker and 68% Dog and cat food 71%
Champs) (Mars and Procter &
Gamble)
Pharmacies and drugstores (Walgreens 63% Automobiles (General 68%
and CVS Caremark) Motors and Ford)
Limitations of Four-Firm Concentration Ratios
Four-firm concentration ratios are a good first look at competition in an
industry; above 40 percent indicates an oligopoly to many economists.

But they have some weaknesses:

1. They do not include the goods and services that foreign firms export to
the United States.
2. They are calculated for national markets, even if the market is really local
(like the college bookstore market).
3. The definition of the market is tricky: Walmart is in the “discount
department store” category, but really also competes against
supermarkets and other stores.
Why Do Oligopolies Exist?
Oligopolies often exist because of barriers to entry: anything that
keeps new firms from entering an industry in which firms are earning
economic profits.

The most important barrier to entry is economies of scale: the

situation when a firm’s long-run average costs fall as the firm increases
output.
• This can make it difficult for new firms to enter a market, because
new firms usually have to start small and will hence have
substantially higher average costs than established firms.
Other Reasons for Oligopolies Existing (1 of 2)
Ownership of a key input
• If control of a key input is held by one or a small number of firms, it
will be difficult for additional firms to enter.

• Examples: Alcoa—bauxite for aluminum production

De Beers—diamonds
Ocean Spray—cranberries
Other Reasons for Oligopolies Existing (2 of 2)
Government-imposed barriers
• Governments might grant exclusive rights to some industry to one or
a small number of firms.

• Examples: licensing or Patents

Tariffs and quotas imposed on foreign companies

Patent: The exclusive right to a product for a period of 20 years from

the date the patent is filed with the government.
Cartels (1 of 2)
Why Cartels Succeed or Fail
• Oligopolistic firms have an incentive to form cartels in which they collude in setting prices or
quantities so as to increase their profits.
• The Organization of Petroleum Exporting Countries (OPEC) is a well-known example of an
international cartel.

• Typically, each member of a cartel agrees to reduce its output from the level it would produce
if it acted independently. As a result, the market price rises, and firms earn higher profits.

• If firms reduce market output to the monopoly level, they achieve the highest possible
collective profit.

• However, each member has an incentive to cheat.

Cartels (2 of 2)
Why Cartels Form
• A cartel forms if members of the cartel believe that they can raise their profits by coordinating their actions.
• A cartel takes into account how changes in any one firm’s output affect the profits of all members of the
cartel.
• Therefore, the aggregate profit of a cartel can exceed the combined profits of the same firms acting
independently.

Why Cartels Fail

• External reasons:
• Cartels are generally illegal in developed countries. High fines and jail terms may prevent collusion.
• Some cartels fail because they do not control enough of the market to significantly raise the price.

Maintaining Cartels
• Cartels use various methods to enforce their agreements.
• Most-favored-customer clause: The seller would not offer a lower price to any other current or
future buyer without offering the same price decrease to the firms that signed these contracts.
14.2 Game Theory and Oligopoly
Use game theory to analyze the strategies of oligopolistic firms.

Unlike perfect and monopolistic competitors, oligopolists are large relative to the market, and the
actions of one oligopolist make large differences in the profits of another.
• So graphical analysis of one firm’s actions will not capture the nuances of an oligopolistic market.

Oligopolies are best analyzed using a specialized field of study called game theory.

Game theory: The study of how people make decisions in situations in which attaining their goals
depends on their interactions with others; in economics, the study of the decisions of firms in industries
where the profits of a firm depend on its interactions with other firms.
Game Theory
Game theory was developed during the 1940s and advanced by
mathematicians and economists and other social scientists.

All “games” share certain characteristics:

1. Rules that determine what actions are allowable
2. Strategies that players employ to attain their objectives in the game
3. Payoffs that are the results of the interactions among the players’ strategies

For example, we can model firm production as a “game”:

• Rules: the production functions and market demand curve
• Strategies: firms’ production decisions
• Payoffs: firms’ profits
Figure 14.2 A Duopoly Game (1 of 5)

Suppose Spotify and Apple are the only two firms selling streaming music service.

Each must choose their business strategy: actions that a firm takes to achieve a goal, such as
maximizing profits.

Assume each firm can charge either $14.99 or $9.99.

The combination of strategies chosen determines profit, shown in the above payoff matrix: a table
that shows the payoffs that each firm earns from every combination of strategies by the firms.
 Figure 14.2 A Duopoly Game (2 of 5)

Suppose you are Spotify in this game. How would you play?

• If Apple charges $14.99, you earn $10m profit by charging $14.99 or $15m profit by charging $9.99.
You prefer $9.99.
• If Apple charges $9.99, you earn $5m profit by charging $14.99 or $7.5m profit by charging $9.99.
You prefer $9.99.

Charging $9.99 is a dominant strategy for Spotify: a strategy that is the best for a firm, no
matter what strategies other firms use.
 Figure 14.2 A Duopoly Game (3 of 5)

Now suppose you are Apple. How would you play?

• If Spotify charges $14.99, you earn $10m profit by charging $14.99 or $15m profit by
charging $9.99. You prefer $9.99.
• If Spotify charges $9.99, you earn $5m profit by charging $14.99 or $7.5m profit by
charging $9.99. You prefer $9.99.

Charging $9.99 is a dominant strategy for Apple also.

 Figure 14.2 A Duopoly Game (4 of 5)

Both firms charging $9.99 is a Nash equilibrium: a situation in which each firm
chooses the best strategy, given the strategies chosen by the other firm.

The firms don’t have to have dominant strategies in order for there to be a Nash
equilibrium; their strategies just have to be best responses to one another’s
strategies.
 Figure 14.2 A Duopoly Game (5 of 5)

Notice that both firms could do better via collusion: an agreement among
firms to charge the same price or otherwise not to compete.
• If both firms charge $14.99, they achieve more profit than by acting independently.

Collusion is against the law in the United States and Europe, but you can see
why firms might be tempted to collude: their profits could be substantially
higher.
Prisoner’s Dilemma
Economists and other social scientists refer to the situation with Spotify and
Apple as a prisoner’s dilemma: a game in which pursuing dominant
strategies results in noncooperation that leaves everyone worse off.

PD shows why two rational individuals might not cooperate even though it is
in their best interest to do so.

The name comes from a problem faced by two suspects the police arrest for
a crime.
• The police offer each suspect a suspended prison sentence in exchange for
confessing to the crime and testifying against the other suspect.
• Each suspect has a dominant strategy to confess. If both confess, they both go to jail
for a long time, while they both could have gone to jail for a short time if they had
both remained silent.
Prisoner’s Dilemma

Player 1 has “confess” as a dominant strategy.

Player 2 has “confess” as a dominant strategy.
Nash equilibrium is confess, confess, even though a “better” outcome is don’t confess, don’t confess
Appendix: Coordination games: Stag-Hare
• NE: stag, stag; and Hare,
Hare (no dominant
strategy)

• Other examples:
• Arriving late vs arriving on
time for a meeting. 2 NE:
both arrive on time, and
both late

• Teamwork: cooperate vs
don’t. NE: both cooperate,
and neither cooperate

• Orange sellers: price 15 vs

14. NE: both set 15, and
both set 14.
Appendix: Anti-Coordination games: Chicken
(Hawk-Dove)

• NE: swerve, straight; and straight, swerve

• Hawk, dove; and dove, hawk

• Difference between Chicken and Prisoner’s

Dilemma is that confess is a dominant
strategy in PD while chicken doesn’t have a
dominant strategy