Oligopoly - uwcmaastricht-econ

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• Competition between the few
– May be a large number of firms in the
industry but the industry is dominated
by a small number of very large
• Concentration Ratio – the proportion
of total market sales (share) held by
the top 3,4,5, etc firms:
– A 4 firm concentration ratio of 75% means
the top 4 firms account for 75% of all
the sales in the industry
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• Several models of oligopolistic behaviour.
• Features of an oligopolistic market structure:
– The market is dominated by a small number of large firms
– High barriers to entry
– Behaviour of firms affected by what they believe their
rivals might do – interdependence of firms. This leads
to strategic behaviour
– Goods could be homogenous or highly differentiated
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Some other features
– Potential for collusion. Oligopolistic firms face the
incentive to collude (cooperate) with other firms to reduce
competition: this reduces uncertainties and increases total
– Branding and brand loyalty may be a potent source of
competitive advantage
– Non-price competition may be prevalent
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• Example:
• Music sales –
The music industry has
a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore
may have many firms
in the industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
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Oligopoly (Barriers to entry)
• Economies of scale
• Product differentiation and brand loyalty
• Ownership of or control over key factors of
• Legal protection
• Threat of mergers or takeovers
• Aggressive tactics, keeping a loss
• Intimidation
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Oligopoly (Collusion)
• Two types of oligopoly (collusive and noncollusive
• Collusive oligopoly : - formal collusion (cartel)
often illegal
- tacit collusion
(dominant firm price
leadership and
barometric firm price
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Collusive oligopoly: cartels
• A cartel is a formal agreement between firms
in an industry to take actions to limit
competition in order to increase profits.
Limiting the quantity to be produced
Restrictions on non-price competition
Dividing the market
Agreeing to set up barriers to entry
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Collusive oligopoly: cartels
• The goal is to maximize industry profits: the
cartel behaves as a monopoly.
• The OPEC (13 oil-producing countries) assigns
an output level to each member
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Collusive oligopoly: Cartels
Obstacles to forming and maintaining cartels:
• Incentive to cheat. If a firm secretly lowers
the price, can increase its profits at the
expense of other firms.
• Cost differences. Since firms have different
cost curves, some will have larger profits than
others. Agreeing on a price and allocating the
output among the firms becomes more
• Firms face different demand curves, due to
product differentiation and market shares.
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• Number of firms.
• Possibility of a price war, when a firm’s price
cat is matched by other firms’ price cuts.
• Recessions: firms have stronger incentives to
reduce prices.
• Potential entry may drive the price down
and lower cartel’s profits. The creation of high
barriers is essential for the long-run survival
of the cartel.
• Lack of a dominant firm. Its presence
facilitates reaching agreement (Saudi Arabia is
the dominant member of the OPEC).
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Collusive oligopoly: tacit
• Cooperation that is implicit or understood,
without formal agreement.
• One type is price leadership: a dominant
firm in the industry sets the price and initiates
any price changes. The remaining firms
become price-takers and accept the price set
by the leader.
• Price changes tend to be infrequent and they
are initiated by the leader when major
demand or cost changes occur.
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• Obstacles:
1. Cost differences
2. Not following the leader, which might imply losing
sales and market share if the leader initiates a price
3. Incentive to cheat
4. Potential entrants
5. It may or may not be illegal
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• Another example are informal agreements
where firms agree to a rule for co-ordinating
prices, such as limit pricing: firms agree to
set a price lower than the profit-maximizing
price. Firms may sacrifice some profit in order
to avoid attracting new firms into the industry.
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Oligopoly: Game Theory
• Temptation to cheat
• Game theory illustrates the characteristics of mutual
interdependence, strategic behaviour and conflicting
incentives (incentive to cheat once firms agree to
• It is not a branch of mathematics, but a discipline in
itself. It is used as a tool in microeconomics but also in
computer science, artificial intelligence, biology and
• The concept of Nash equilibrium (developed by John
Nash, who received the Nobel Prize in economics
together with two other game theorists), although very
popular is not very realistic.
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• The prisoner's dilemma is the story of two
criminals who have been arrested for a heinous
crime and are being interrogated separately. Each
knows that if neither of them talks, the case
against them is weak and they will be convicted
and punished for lesser charges. If this happens,
each will get one year in prison. If both confess,
each will get 20 years in prison. If only one
confesses and testifies against the other, the one
who did not cooperate with the police will get a life
sentence and the one who did cooperate will get
parole. The table below illustrates the structure of
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Prisoner’s dilemma
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• If they agree to not confess, they get one year
in prison.
• But each prisoner, knowing that the other one
will not confess, has the incentive to cheat, ie,
confess and get parole.
• The Nash equilibrium is both confess, as they
then face no incentive to deviate. However,
they become worse off!
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Incentive to cheat: OPEC
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• Player A realises that by breaking the
agreement (and charge a lower price, it can
earn 4 while B earns only 1). It also knows
that player B can break the agreement so it
will end up making 1 instead of 3.
• Player B thinks along the same lines.
• They are both likely to break the agreement,
ending up making 2 both. This is the Nash
equilibrium, in which both become worse off
but none has any incentive to deviate.
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Non-collusive oligopoly: The
Kinked demand curve
• The Kinked demand curve is a model
developed to explain price rigidities of
oligopolistic firms that do not collude.
• Firms do not make any agreements with each
other on how to fix prices. Their price behavior
is influenced by the expectations of how rival
firms will react to a price change.
• Consider three firms, each producing 100 units
and selling at 5.
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Assume the firm is charging a price of
£5 and producing an output of 100.
If it chose to raise price above £5, its
rivals would not follow suit and the firm
effectively faces an elastic demand
curve for its product (consumers would
buy from the cheaper rivals). The %
change in demand would be greater
than the % change in price and TR
would fall.
If the firm seeks to lower its price to
gain a competitive advantage, its rivals
will follow suit. Any gains it makes will
quickly be lost and the % change in
demand will be smaller than the %
reduction in price – total revenue
would again fall as the firm now faces
a relatively inelastic demand curve.
Revenue B
Total Revenue A
Total Revenue B
Kinked D Curve
D = elastic
D = Inelastic
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• The firm therefore, effectively faces
a ‘kinked demand curve’ forcing it to maintain
a stable or rigid pricing structure. Oligopolistic
firms may overcome this by engaging in nonprice competition.
• The principle of the kinked demand curve rests
on the principle that:
a. If a firm raises its price, its rivals will not
follow suit
b. If a firm lowers its price, its rivals will all do
the same
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This model illustrates:
• Firms that do not collude are forced to take
into account the actions of their rivals.
• Even though firms do not collude, there is still
price stability. Firms are reluctant to change
prices because of the likely actions of their
• Firms do not compete with each other on the
basis of price.
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Non-price competition
• Oligopolistic firms try to avoid price
competition, as this may trigger price wars,
which result in lower profits for all firms.
• They do engage in intense non-price
competition, in order to increase market share
by methods such as product development,
advertising and branding. This may also
increase barriers to entry.
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Non-price competition is very important in
oligopoly because:
1. Availability of financial resources that firms
can devote to R&D and advertising and
2. New products do not only may increase sales
and profits but they also increase monopoly
power and make demand less elastic.
3. Product differentiation may increase profits
without creating risks for immediate
retaliation by rivals, as it takes time and
resources to develop a new product.
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• http://www.youtube.com/watch?v=U_e
• http://www.youtube.com/watch?v=p3U
• http://www.zimbio.com/watch/zHJOxeX
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• Hotelling model of spatial competition:
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