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Economics
6th edition, Global Edition

Chapter 14
Oligopoly: Firms in Less
Competitive Markets

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Chapter Outline
14.1 Oligopoly and Barriers to Entry
14.2 Game Theory and Oligopoly
14.3 Sequential Games and Business Strategy

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 What is Oligopoly?

The distinguishing features of oligopoly (non-collusive) are:

– A few dominant firms compete (e.g. cigarettes, cereals,

automobiles, airlines, cement, sugar, etc…)
– Products may be homogeneous or differentiated.
– Each firm faces a downward sloping demand curve for its
product (a “kinked” demand curve).
– Barriers to entry for new firms exist (preventing firms from
competing away profits - easy to virtually impossible.
– All kinds of oligopoly have one thing in common: The
behavior of any given oligopolistic firm depends on the
behavior of the other firms in the industry – strategic
interdependence. The actions of one firm affect the profits of
the other firms in the market.
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14.1 Oligopoly and Barriers to Entry

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% tends to indicate

an oligopoly to many economists.

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.

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Table 14.1 Examples of oligopolies in retail trade and

manufacturing

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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.

One example of a 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.

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Figure 14.1 Economies of scale help determine the extent of

competition in an industry

If long-run average
cost is minimized at a
small fraction of
industry output, as on
LRAC1, there is room
in the industry for
many firms.
But if it takes a large
(relative to industry
size) firm to achieve
economies of scale,
the market is more
likely to be an
oligopoly.
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Other Reasons for Oligopolies

Existence (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

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Other Reasons for Oligopolies

Existence (2 of 2)
Government-imposed barriers

• Governments might grant exclusive rights to some

industry to one or a small number of firms.
• Examples: Occupational licensing for dentists
and doctors
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.
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 Oligopoly Interdependency – Kinked
Demand Curve

Non-collusive oligopoly: the kinked D curve

– The kinked D curve theory is the theory where

oligopolists face a D curve that is kinked at the current
price: D being significantly more elastic above the
current price than below

– The effect of this is to create a situation of price

stability/rigidity

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 Oligopoly Interdependency – Kinked
Demand Curve

– If an oligopolist cuts its price, its rivals will follow

suit to prevent losing customers to the first firm

– If an oligopolist raises its price, its rivals will not

follow suit in order to gain customers from the first
firm

– A rise in price will lead to a large fall in sales as

customers switch to the now lower-priced rivals. D
is relatively elastic above the kink. However, a fall
in price will bring only a modest increase in sales
as the rivals lower their prices too and thus
customers do not switch. D is relatively inelastic
below the kink.

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 Kinked demand for a firm under oligopoly
£
Assumption 1
If the firm raises its
price, rivals will not

D Assumption 2
P1 If the firm reduces
its price, rivals will
feel forced to lower
theirs too.

D
O Q1 Q
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 Oligopoly Price Rigidity

Stable price under conditions of a kinked D curve

– At qty < Q1, the MR curve will correspond to the

shallow part of the AR curve

– At qty > Q1, the MR curve will correspond to the

steep part of the AR curve

– There will be a gap between point a and b. Profits

are maximised where MC = MR

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 Oligopoly Price Rigidity

– If the MC curve lies anywhere between MC1 and

MC2 (between point a and b), the profit maximising
price and output will be P1 and Q1

– Thus, prices will remain stable even with a

considerable change in costs

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Stable price under conditions of a kinked demand curve
£

If MC is anywhere
between MC1 and MC2,
MC2 profit is maximised at Q1.

P1 MC1

a
D = AR
b

O Q1 Q
MR
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 Oligopoly and The Consumer

Oligopoly may be more beneficial to the consumer than

other market structures

– Oligopolists can use part of their supernormal profit

for research and development and have more
incentive to do so than monopolists

– Improvement in the product design allow the firm to

capture a larger share of the market whereas
technological improvement will reduce costs and
resulting in higher profits in order to enable the firm
better withstand a price war

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 Oligopoly and The Consumer

– Non-price competition via product differentiation may

result in greater choice for the consumer

– Countervailing power - when powerful buyers who can

prevent the price from being pushed up offset the
power of a monopolistic/oligopolistic seller

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14.2 An Alternative Approach: Using

Game Theory to Analyze Oligopoly

Oligopolists are large relative to the market, and the actions

of one oligopolist make large differences in the profits of
another.

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.

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Game theory
Game theory was developed during the 1940s, and advanced by
mathematicians and social scientists like economists.
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
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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.
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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.
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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.
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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 firms.
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.
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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, but you can see
why firms might be tempted to collude: their profits could be
substantially higher.
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Cooperative equilibrium vs.

noncooperative equilibrium
Nash equilibrium is an example of a noncooperative
equilibrium: an equilibrium in a game in which players do not
cooperate but pursue their own self interest.
• Many game theorists concentrate on noncooperative
equilibrium, particularly because of laws against cooperation
among firms.
If we allowed players to coordinate their actions in a game, by
forming alliances etc., we would be looking for a cooperative
equilibrium: an equilibrium in a game in which players cooperate
to increase their mutual payoff.
• This might make sense for many social interactions: groups of
people often try to cooperate rather than work independently.

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Prisoner’s dilemma

Economists and other social scientists refer 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.
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; but 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.
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Figure 14.3 Changing the payoff matrix in a repeated game

Suppose Domino’s and Pizza

Hut are deciding how to price a
pizza: $12 or $10.
• This game gets played not
once, but every day.
A clever way to avoid the low-
profit Nash equilibrium is to
advertise a price-match
guarantee. Then if either firm
cuts prices, the other has
guaranteed to do so as well.
• Now neither firm will have an
incentive to cut prices.
• Do price-match guarantees
really benefit consumers?
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 Collusive Oligopoly

– Because of interdependency, oligopolistic firms may

choose to cooperate with one another (collusion).

– Firms in oligopoly are price setters as opposed to price

takers. A cartel is a group of firms that collude by
agreeing to restrict output to increase prices and profits.

– The Organization of Petroleum Exporting Countries is the

best known cartel. OPEC colluded to restrict output and
raise prices in the 1970s and 1980s.

– But collusion has proved difficult to maintain over time.

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 Collusive Oligopoly

Equilibrium of industry under collusive oligopoly

– The cartel will maximise profits if it acts like a

monopoly
– The total market D curve is shown with the
corresponding market MR curve
– The cartel's MC curve is the horizontal sum of the
MC curves of its members
– Profits are maximised at Q1 where MC = MR

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 Collusive Oligopoly

– The cartel must set a price of P1 (at which Q1 will

be demanded)
– Having agreed on the cartel price, the members
may compete against each other using non-price
competition
– Alternatively, the cartel members may agree to
divide the market among them (to set quotas at the
level that will minimise overall industry costs - each
firm produce at a level of output that all firms' MC
are the same)

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 Profit-maximising cartel
£
Industry profit
maximised at Industry MC
Q1 and P1.

P1

Members must
agree to restrict
total output to Q1.

Industry D = AR
Industry MR
O Q1 Q
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 Collusive Oligopoly

Limitation: high cost producers would not be

agreed to such quotas

Preferable method: The cartel to divide the

market among the members according to their
current market share

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Other Methods for Avoiding Price

Competition

Another method is price leadership, a form of implicit

collusion in which one firm in an oligopoly announces a
price change and the other firms in the industry match
the change.

• Example: In the 1970s, General Motors would

announce a price change at the beginning of a model
year, and Ford and Chrysler would match GM’s price
change.

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Figure 14.5 The OPEC cartel with unequal memebers

Because Saudi Arabia can produce much more oil than Nigeria, its
output decisions have a much larger effect on the price of oil.
• Saudi Arabia has a dominant strategy to cooperate and
produce a low output.
Nigeria, however, has a dominant strategy not to cooperate and
instead produce a high output.
• In order to punish Nigeria for defecting, Saudi Arabia would
have to hurt itself substantially. Would it be worth it to you?
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 The Breakdown of Collusion Oligopoly

Even if there is collusion, there will always be the

temptation for individual oligopolists to cheat, by cutting
prices or selling more than their allotted quota and
resulting in a price war

Price would then fall and the cartel could break up in

the industry

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14.3 Sequential Games and Business

Strategy (Optional - Student Reading)

The game theory models we have analyzed so far have

been simultaneous: the players have made their decisions at
the same time.
But some games are sequential in nature: one firm makes a
decision, and the other makes its decision having observed
the first firm’s decision.
• We analyze such games using a decision tree, indicating
who gets to make a decision at what point, and what the
consequences of their decision will be.

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Figure 14.6 The decision tree for an entry game

1. Apple decides whether to charge $1,000 or $800 for a new laptop.

2. Then Dell decides to enter the market or not, needing a 15% return.
If Apple charges $1,000, Dell will want to enter; its return exceeds 15%.
If Apple charges the low price, Dell will not want to enter.
So Apple can deter Dell from entering the market by charging $800.
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Figure 14.7 The decision tree for a bargaining game (1 of 2)

1. Dell can offer $20 or $30 per copy for TruImage’s software.
2. Then TruImage can accept or reject the offer.
Dell will look ahead, and realize that TruImage is better off
accepting Dell’s offer, no matter what price Dell offers.
Therefore Dell should offer the low price, anticipating that
TruImage will accept the offer.
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Figure 14.7 The decision tree for a bargaining game (2 of 2)

Notice that TruImage would like to threaten to reject an offer of $20.

• If Dell believed the threat, its best action would be to offer $30.
But Dell shouldn’t believe the threat; it is not credible.
• Only the original outcome is a subgame-perfect equilibrium:
where no player can improve their outcome by changing their
decision at any decision node.
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