Oligopoly A


1. Entry Barriers to Oligopoly

 Market organizations  
  In the spectrum of market organizations, there are two extremes. In terms of the number of firms, monopoly is on one extreme end of the market, and perfect competition lies on the other extreme. Monopolistically competitive markets and oligopolistic markets lie somewhere in between these two extremes.
 Definition “Oligopoly” comes from the Greek words, oligos = few, polein = selling. Thus, it is a market structure in which
(i) there are a few sellers who are price setters.
(ii) mutual interdependence exists among firms.
 Entry barriers Some entry barariers.
If there were no entry barriers, there would be lots of firms. There must be significant entry barriers so that only a few sellers overcome the barriers.
 role of patents

Patents cannot be entry barriers.

Patent protection last only 17 years. They cannot be permanent barriers.

Oligopoly arises from large capital costs or economies of scale.

Some firms overcome the hurdle while others don't. Accordingly, only a few firms survive.

Homogeneous oligopoly

Product differentiatiation is not easy in fruits and vegetables.

Three firms, Chiquita, Dole and Del Monte, own huge banana plantations in Central America, and control 65% of world banana exports.

Heterogeneous Oligopoly

Most oligopolies differentiate their products from the competition.

Most air routes are served by only two or three airlines.

Most cola beverages are sold by Coca-cola and Pepsi.

   

 

2. Demand Curve

 

How do oligopolists split the market demand? 

There is much uncertainty, because the behaviors of other firms are not predictable.

How to predict the outcome 

Certain assumptions are made about the behavior of oligopolists to predict prices and outputs. 

 Mutual Interdependence

One's price and output cannot be predicted independent of the prices and outputs of other oligopolists. 

An oligopolist's demand and MR depend on what the rival firms do.

Thus, it is important to make assumptions about what the rivals will do.

 Examples of oligopolies

Commercial airplanes: Boeing, Airbus, McDonell Douglas, Lockheed

Cereals: Kellogg's, General Mills, Quaker Foods, Posts

soft drinks: Coca-cola, Pepsi, 7-up.

beer

 Tools

price, output are main tools

Quality, innovation, industrial spying, bribes, and other illegal means, etc.

Oligopoly is like an Olympic game without rules.

 Cooperative games Some oligopolists cooperate and agree on prices and outputs. 
 Noncooperative games

Others do not cooperate. 

Some agree on policies and cheat.

Noncooperative oligopoly is like a war among states, and anything goes.

If Pepsi introduces diet cola, it has to consider the reaction of Coca-cola in a noncooperative game.

   

 

3. Empirical Measures of Oligopoly

 

 How do we differentiate oligopoly from competitive markets?

There are more than 100 oil companies in the US.

Is the US oil industry oligopolistic or competitive?

 4 Firm concentration ratio (CR4)

The 4-firm concentration ratio is the percentage of industry output produced by the industry's largest 4 firms.

This ratio varies from 0 to 100. If it is almost zero, the industry is competitive.

If it is 100, the four firms comprise the entire industry.

The higher the index, the less competitive the industry is.  

 8-firm concentration ratio (CR8) This is also commonly used. 
 examples
    4-firm concentration ratios, US 2007

> 80% high CR

tight oligopoly

 

cigarettes 98%

beer 90%

computers 87%

aircraft 81%

discount department stores 97%

 Medium CR (>50%)

electronic stores 70%

athletic footwear stores 68%

pharmacies/drugstores 63%

dog and cat food 71%

automobiles 68%

 Low CR (0 - 50%), 1982

petroleum 28%

pharmaceuticals 26% 

women's dresses 6%

nuts and bolts 13%

 

4. Oligopoly versus Monopolistic Competition

 

 Paul Krugman received a Nobel Prize in economics for his contribution to the theory of monopolistic competition.

 difference

(i) Oligopoly exists because of significant entry barriers, e.g., economies of scale.

Accordingly, relatively few sellers dominate the industry.

In monopolistic competition, entry is free, and a large number of firms compete one another. 

 product differentiation

(ii) In theory, there are homogeneous oligopoly and differentiated oligopoly.

In practice, there are few industries in which oligopolists sell homogenous products.

In a monopolistically competitive market, products are differentiated. 

 Mutual dependence (iii) Firms are not mutually interdependent in a monopolistically competitive market. 
price 

 (iv) In oligopoly, prices are relatively stable; they do not change frequently, except when there are price wars or when there is collusive price fixing.

In a monopolistically competitive market, prices can change frequently.

   

 

5. Cournot Solution

 

 The French mathematical economist Antoine Cournot published his theory of duopoly in 1838.

Although most of his models were crude and involved very unrealistic assumptions, his method of analysis has been useful for subsequent theoretical development in the area of oligopoly.

 two-person game  Cournot’s model is a very special example of a two-person game. Even when there are two players, in the real world there are no rules.

Cournot’s model is an example of games in which players make moves sequentially. If there are two players, A and B, A makes the first move, A1, then B responds by B1. In the second round, A2 and B2, and so on. It is like playing chess.

 multiple moves

In the real world, a player can make several moves at a time, as in boxing.

If several actioins can be combined as one move, the model applies.  

assumptions  1. There are two profit-maximizing duopolists.
2. Both duopolists produce an identical product.
3. Duopolists act independently without collusion.
4. Each duopolist assumes that the rival's output will remain unchanged
 naiveté

 When the game is played many times, the players will soon learn that rivals almost always respond.

The last assumption is very naïve because it implies that the duopolists do not learn from experience. But this assumption gives a deterministic solution to the problem.

 homogenous oligopoly

In Cournot's example, two firms produce mineral water from two adjacent springs, produced at zero marginal cost.

 

First Round,

morning and afternoon

 The First Round
In the morning, Firm #1 opens his business, selling mineral water. Production cost is zero, and hence marginal cost is also zero. Each consumer brings his bottles. His demand curve has a vertical intercept, equal to 1, and the horizontal intercept is also 1. From this demand curve, Firm #1 derives MR curve, which intersects MC at q = ½. Price is also ½.

In the afternoon, Firm #2 inspects the market and assumes Firm #1’s output is ½. Thus, he sees the remaining (blue) area as his demand curve. His MR curve intersects MC curve at q = ¼. His price is also ¼.

 morning, second day  In the morning, Firm #1 recognizes Firm #2 has entered the market, noticing his output (1/4). He subtracts this from the entire market. Firm #2 perceives that his demand curve now has a vertical intercept, ¾ (= 1 – ¼). The new MR curve intersects MC curve at q = 3/8. Accordingly, price is equal to 3/8.


 afternoon, second day

 In the afternoon, Firm #2 notices that Firm #1 reduced his output by 1/8.

Accordingly, Firm #2 perceives his demand curve increased to 5/8 (= 1 –3/8).
Equating the new MR curve with MC, he produces q2 = 5/16.

  You now notice that in the second round, Firm #1 reduced his output and Firm #2 increased his output. On the third round, Firm #2 again notices that Firm #1 increased output and adjusts is production, and Firm #2 responds to this change. This process goes on and on.
Sequence of outputs I: 1/2 -1/8 -1/32 -1/128 - ...

II: 1/4 + 1/16 + 1/64 + 1/256 + ...

Equilibrium output of firm 2

y = b + b2 + b3 + ...

by = b2 + b3 + b4 + ...

Thus, firm 2’s output is y = b/(1 - b) = 1/4 ÷ 4/3 = 1/3.

Since the two firms are symmetric with zero costs, industry output is Q = 2/3.

N oligopolists

When there are n firms, an oligopolist's output is:

1/(N + 1).

The industry output is: N/(N + 1).

If N is very large, then as N approaches ∞, N/(N + 1) approaches 1.

That is, as the number of firms approaches infinity, industry output approaches 1, which is the output of a perfectly competitive market.

   

 

6. Reaction Functions

 Reaction function

RF is also called the best response function.

Due to interdependence, firm 1's profit depends not only on its output but also on its rival's output, π(X,Y). Likewise, firm 2's profit depends on the outputs of both firms, Π(X,Y).

For instance, firm 1's reaction function X(Y) is its best response to firm 2's output Y. That is, for any given output Y, firm 1 chooses its best output, which maximizes firm 1's profit. This implies that firm 1's isoprofit curve is tangent to horizontal line.

 

 

Note that X(Y) is negatively sloped. That is,

firm 1 reduces its output X as Y increases.

Likewise, we can derive firm 2's reaction curve Y(X), which is also negatively sloped.

That is, firm 2 reduces its output Y as X increases.

 Cournot equilibrium

 Cournot Equilibrium is the intersection of two reaction curves: X(Y) and Y(X).

Since it is a noncooperative solution that was worked out by John Nash, it is also called Cournot-Nash equilibrium.

   
 Criticism

When a player changes his output, the rival almost always responds and changes his output.

Only at Cournot equilibrium, neither sides wishes to change.

Nevertheless, each player assumes his rival does not change his output. Neither player learns anything from experience.

  Why should output be the decision variables? 
   

 

7. Bertrand Equilibrium

   Cournot’s model is based on the assumption that duopolists use quantity as the strategic variable. Cournot's assumption that each firm believes that the rival firm will not change its output was criticized by a French mathematician Joseph Bertrand in his review of Cournot's book in 1883.

(i) Bertrand argued that a more realistic assumption is that each firm believes that the rival firm will not change its price.

(ii) He further added the assumption that each duopolist has sufficient capacity to satisfy the entire market.

To make the story more interesting, assume that the duopolists have constant costs, i.e., average cost is equal to marginal cost. In this case, firm I starts with the monopoly price. Firm II then enters the market reducing the price somewhat, and captures the whole market.

Firm I then lowers the price below that of Firm II, and captures the market and so on. Finally, the price war ends at point B (Bertrand point), where price is MC for both firms, and the total output is equal to the competitive market. Once price is equal to marginal cost, neither firm can undercut its rival, because it would be incurring a loss.

Reaction curve q(p) is slightly below the 45 degree line (not drawn) as Firm 1 charges a price slightly below that of its rival. Similarly, p(q) is slightly above the 45 degree line.

   
Result Due to price competition, price converges to the competitive level (unit Cost).