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  • Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10


  • Oligopoly market characteristics
  • Measure of market structure
  • Barriers in oligopoly market
  • Game theory approach to duopoly
  • Cooperative collusion
  • Cheating
  • Future of oligopoly


  • When just a few large firms dominate a market
    • So that actions of each one have an important impact on the others
    • In such a market, each firm recognizes its strategic interdependence with others
  • An oligopoly is a market dominated by a small number of strategically interdependent firms

Number of Firms

  • Oligopoly requires that a few firms dominate the market
    • How few?
  • At some point, number of firms is large enough—and interdependence weak enough—that oligopoly becomes a poor description
    • Monopolistic competition would fit better
    • No absolute number at which oligopoly ends and monopolistic competition begins

Market Domination

  • Strategic interdependence requires that a few firms dominate the market
    • Their share of market is large
  • As combined market share shrinks, strategic interdependence becomes weaker
  • Oligopoly is a matter of degree
    • Not an absolute classification

Economies of Scale: Natural Oligopolies

  • When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market
    • only a few large firms survive since small firms can’t compete
    • Market becomes an (natural) oligopoly
    • Remember, MES is defined as the lowest level of output at which it can achieve minimum cost per unit
      • The output level at which the LRATC first hits bottom

Figure 1: Natural Oligopoly

  • E
  • H
  • F
  • 25,000
  • Units per Month
  • 100,000
  • 0
  • 80
  • $200
  • Dollars
  • DMarket
  • LRATCTypical Firm

Reputation as a Barrier

  • Established oligopolists are likely to have favorable reputations
  • Investors decision: enter or not?
    • Critical thing: is it worthy to take the risk of being a new firm in such market?
    • If expected profit is greater than the initial loss, enter
    • If initial loss is too big, stay out.

Strategic Barriers

  • Strategies designed to keep out potential competitors, for example:
    • Maintain excess production capacity as a signal
    • Make special deals with distributors to receive best shelf space in retail stores
    • Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product

Legal Barriers

  • Patents and copyrights—which can be responsible for monopoly—can also create oligopolies
  • Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination

Measures of Market Structure

  • Concentration ratios: Aggregated market share of the largest N firms in the industry
  • Range: 0-100%
  • 4 Firm Concentration ratio: Market share controlled by the largest 4 firms
  • Data based on the 2002 Economic Census.
  • http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13
  • Measured Industry Concentration in Manufacturing
  • D: Not disclosed
  • Second and third columns: Percentage in value added in the industry
  • Last column: Herfindahl index from the 50 largest firms
  • Data based on the 2002 Economic Census.
  • http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13
  • Measured Industry Concentration in Manufacturing
  • D: Not disclosed

Oligopoly vs. Other Market Structures

  • Oligopoly presents the greatest challenge to economists
    • essence of oligopoly is strategic interdependence
    • economists have had to modify the tools used to analyze other market structures and to develop entirely new tools as well
  • One approach—game theory—has yielded rich insights into oligopoly behavior

The Game Theory Approach

  • Game theory approach
    • An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves
    • Elements
      • Players
      • Strategies
      • Payoffs
    • Pay off matrix
    • Game tree

Game Theory Approach

  • Some situations to which game theory can be applied:
    • firms competing for business
    • political candidates competing for votes
    • animals fighting over prey
    • bidders competing in an auction
    • legislators' voting behavior under pressure from interest groups

Game Theory – Short History

  • John Von Neumann (1903-1957)
  • “Theory of Games and Economic Behavior” with Oskar Morgenstern
  • This book established game theory as a field
  • “An introduction to game theory” by Martin J. Osborne. Oxford University Press, 2002

Game Theory – Short History

  • John F. Nash, Jr.(1928- )
  • One of the contributions is the introduction of the equilibrium notion now known as Nash equilibrium
  • 1994 Nobel prize winner in economics with the game theorists John Harsanyi and Reinhard Selten
  • “An introduction to game theory” by Martin J. Osborne. Oxford University Press, 2002

The Prisoner’s Dilemma

  • Simple example to explain why a technique for obtaining confessions, commonly used by police, is so often successful
  • Payoff matrix
    • Players: Rose and Colin
    • Payoffs: number in the matrix
    • Strategies: Confess (C) / not confess (NC) for either of the players

Figure 2: The Prisoner’s Dilemma

  • How to read the matrix?
    • Players:{Rose, Colin}
    • Strategies:{C, NC}
    • Payoffs
  • What will Rose do?
  • What will Colin do?
  • Rose
  • Colin
  • C
  • NC
  • C
  • -20, -20
  • -3, -30
  • NC
  • -30, -3
  • -5, -5

The Prisoner’s Dilemma

  • A dominant strategy: the player’s best strategy regardless of the other player’s strategy
    • Rose’s dominant strategy is “confess” regardless of Colin’s choice
    • So is Colin

Nash Equilibrium

  • Outcome of this game is an example of a Nash equilibrium
    • Exists when each player is taking the best action—given best actions taken by other players
    • Under the Nash Equilibrium, no players want to deviate

Figure 3: Working on a joint project

  • Elements
    • Players:{you, your friend}
    • Strategies:{work hard, Goof off}
    • Payoffs
  • What is the Nash Equilibrium?
  • Friend
  • You
  • W
  • G
  • W
  • 2, 2
  • 0, 3
  • G
  • 3, 0
  • 1, 1

Figure 4: Battle of Sex

  • Elements
    • Players:{Mr. R and Mrs. R}
    • Strategies:{ go shopping, watch a baseball game}
    • Payoffs
  • What is the Nash Equilibrium?
  • Mr. R
  • Mrs. R
  • S
  • B
  • S
  • 2, 1
  • 0, 0
  • B
  • 0, 0
  • 1, 2

Figure 5: Duopoly

  • Elements
    • Players:{Firm A, Firm B}
    • Strategies:{ Low price, High price}
    • Payoffs
  • What is the Nash Equilibrium?
  • Firm A
  • Firm B
  • L
  • H
  • L
  • 10, 10
  • 40, -5
  • H
  • -5, 40
  • 20, 20

Simple Oligopoly Games - Duopoly

  • Duopoly - oligopoly market with only two sellers
  • Assume that Firm A and B must make their decisions independently
    • Without knowing in advance what the other will do
  • A’s dominant strategy is to charge a low price
    • So is B’s dominant strategy
    • Outcome is a Nash equilibrium (Low, Low)

Example: Price Competition for Duopoly

  • Duopoly firms A & B have the same cost structure, produce the undifferentiated goods.
  • Suppose the MC and ATC is constant, equal to c.
  • If the two firms are going to set price to maximize their profit, what is the Nash equilibrium?

Oligopoly Games in the Real World

  • Typically more than two strategies
  • Usually more than two players
  • In some games, one or more players may not have a dominant strategy
    • A game with two players will have a Nash equilibrium as long as at least one player has a dominant strategy
    • When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

Oligopoly Games in the Real World -- Static v.s. Dynamic

  • We’ve limited the players to one play of the game
    • In reality, for gas stations and almost all other oligopolies, there is repeated play
      • Where both players select a strategy
      • Observe the outcome of the trial
      • Play the game again and again, as long as they remain rivals

Oligopoly Games in the Real World -- Cooperation in the long run

  • One possible result of repeated trials is cooperative behavior
    • Results may be very different from equilibrium in a game played only once
    • Explicit collusion
      • Simplest
      • Managers meet face-to-face to decide how to set prices
    • Tacit collusion
      • No formal discussion

Explicit Collusion

  • Most extreme form is creation of a cartel
    • Group of firms that tries to maximize total profits of the group as a whole
    • OPEC
  • However, it is not commonly observed. Why?
  • But oligopolists can collude in other, implicit ways

Tacit Collusion

  • Two most common forms
    • Tit for tat
      • A game-theoretic strategy of doing to another player this period what he has done to you in previous period
    • Price Leadership
      • One firm—the price leader—sets its price and other sellers copy that price

Tacit Collusion - Tit For Tat

    • Prominent in airline industry
    • However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion
    • Oligopolist will sometimes go further
      • Attempting to punish a firm that threatens to destroy tacit cooperation
        • Lead to price wars

Tacit Collusion – Price Leadership

  • No formal agreement
  • Rather the decisions come about because firms realize—without formal discussion—that system benefits all of them

The Limits to Collusion

  • Oligopoly power—even with collusion—has its limits
    • demand constraints
    • collusion—even when it is tacit—may be illegal
    • collusion is limited by powerful incentives to cheat on any agreement

The Incentive to Cheat

  • Will firm stick to the collusion?
  • Maybe, and maybe not
    • Problem—each player may conclude that he can do even better by cheating, Figure 5
    • Two players would be back to non-cooperative outcome based on their dominant strategies
    • May be in each player’s interest to cheat occasionally
  • Analyzing this sort of behavior requires some rather sophisticated game theory models
    • Economists are actively engaged in building them

When is Cheating Likely?

  • While no firm wants to completely destroy a collusive agreement by cheating
    • Since this would mean a return to the noncooperative equilibrium wherein each firm earns lower profit
    • Some firms may be willing to risk destroying agreement if benefits are great enough
    • Cheating is most likely to occur when there is
      • Difficulty observing other firms’ prices
      • Unstable market demand
      • Large number of sellers

The Future of Oligopoly

  • Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure
  • Prediction has not come true
    • Today, there are hundreds and thousands of ongoing businesses in United States
  • Possible reasons
    • Antitrust law
    • Globalization of markets
    • Technological change

Antitrust Legislation and Enforcement

  • Three types of actions
    • Preventing collusive agreements among firms
      • Such as price-fixing agreements
    • Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers
    • Preventing mergers that would lead to harmful market domination
  • While thrust of these policies is to preserve competition
    • Type of competition preserved—and zeal with which policies are applied—can shift

The Globalization of Markets

  • Globalization introduces competition
    • By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market
  • Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods
  • While consumers in each nation may have access to more firms, these may be larger and more powerful firms
    • Creating greater likelihood of strategic interaction and danger of collusion

Technological Change

  • Technological change works
    • To increase competition by creating new substitute goods
    • To reduce barriers to entry
    • To increase size of market
  • However, technologies on the other hand
    • encourage oligopoly by actually increasing MES of typical firm
      • Result could be strategic interaction, or collusion, among large national players
    • Thereby encouraging formation of oligopolies

The Four Market Structures: A Postscript

  • Different market structures
    • Perfect competition
    • Monopoly
    • Monopolistic competition
    • Oligopoly
  • Market structure models help us organize and understand apparent chaos of real-world markets

Summary on four types of market


  • Oligopoly market characteristics
    • Small number of large strategically interdependent firms
    • No free entry or exit
    • Either differentiated or standardized products
  • Measure of market structure
  • Barriers to enter the oligopoly market
    • Favorable reputation / legal / strategy / substantial economy of scale
  • Game theory approach to duopoly
    • Dominant strategy
    • Nash equilibrium
    • Prisoner’s dilemma
  • Repeated game: cooperative collusion
    • Explicit : Cartel
    • Implicit : Tit – for – Tat ; Price leadership
  • Cheating
  • Future of oligopoly depends on
    • Antitrust legislation / globalization of market / technological change

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