Microeconomics Notes Oligopoly

Oligopoly: Assumptions of the model: 1. There are a small number of large firms, each of which is aware of the presence of others. 2. Firms sell either a homogenous product (ex., Oil) or a differentiated product (ex., cars). 3. There are high barriers to entry. 4. The firms are interdependent. Due to their small number, each action affects the others. Interdependence, game theory, and price and non-price competition: The interdependence of oligopolistic firms has important implications for their behavior: Strategic behavior: Each firm tries to predict rival firms' actions and base its actions on how it expects its rivals to behave. Their strategic behavior leads them to conflicting incentives: 1. Incentive to collude: The term collusion refers to an agreement between firms to limit competition, usually by fixing prices and, therefore, lowering the quantity produced. By colluding to limit competition, firms reduce uncertainties resulting from not knowing how rivals will behave and maximize profits for the industry as a whole. 2. The incentive to compete or cheat in a collusive agreement: At the same time, firms face the incentive to compete to capture part of their rival firms’ market share. If firms have formed a collusive agreement, they face the incentive to “cheat” on their partners in the agreement to increase their profits at their expense. Game theory: Strategic interdependence and the incentives to compete or to collude: Game theory: A mathematical technique used to analyze the behavior of interdependent decision-makers who use strategic behavior. One such game is based on the prisoner’s dilemma: It shows optional decision-makers who try to make themselves as well off as possible by using strategic behavior to become worse off. Game theory is instrumental in demonstrating important features of oligopolistic firms' behavior. Suppose there are two firms. A and B each have two pricing strategies, “high price” and low “price.” There are four possible outcomes. 1. The firms begin in outcome four, where, due to price competition, they both use the low-price strategy and earn low profits of $20 million each. 2. They realize that if they agree to collude and fix the price at a higher level, they can achieve outcome 1, in which they both make higher profits of $50 million each. 3. While colluding, they face a dilemma. Each one thinks that if it breaks the agreement and lowers the price, it will profit more than $70 million while the rival will make $30 million. Each also thinks that it doesn’t the other firm will and will beat it to the higher profits. Game theory: The prisoner’s dilemma and oligopoly. Key points demonstrated by the pay-off matrix: 1. The firms show strategic behavior as each bases its actions on what it guesses the other will do. 2. The firms show strategic interdependence as each tries to guess what the other will do. The actions of one affect outcomes not only for itself but also for the other. 3. The firms face conflicting incentives, which are to compete (price) and the incentive to collude by fixing the price. 4. Both become worse off due to price competition or cutting prices to capture part of the rival’s market share. 5. Therefore, price competition is strongly avoided, as it may lead to a price war, a situation in which firms retaliate against each other by lowering prices to the point that they may end up making losses. The importance of non-price competition in oligopoly: 1. Fear of price wards leads to oligopolistic firms competing based on non-price factors. 2. Important nonprice factors are new products and product differentiation, advertising, and branding. 3. Oligopolistic firms earn abnormal profits, offering them the resources for research and development, advertising, and branding. 4. Product differentiation, advertising, and branding lead to greater monopoly power, the ability to influence price, and greater abnormal profits. Collusive Oligopoly: Collusive oligopoly refers to situations where firms agree to collude, which means they form an agreement to limit competition, increase market power, and increase profits. The most common form of collusion involves agreements to fix prices, such as holding prices constant at some level or raising prices by some fixed amount. A formal collusion is a collusion between firms leading to the formation of a cartel. A cartel is an agreement between forms to maximize profits by behaving like a monopoly and restricting competition, usually by fixing prices at a higher level and limiting output. Collusive oligopolies form cartels. The profit-maximizing production level is split between the cartel members (possibly using historical market shares or other measures). 1. The monopoly diagram shows profit maximization by a cartel. 2. Cartels are illegal in most countries because their members behave like monopolies. Significant monopoly power leads to higher processes and lower output than what arises in more competitive markets and substantial welfare loss. Firms participating in a cartel have much to gain: - Increased market power and hence the ability to control the product's price. - Increased profits due to higher prices. - Elimination of competition between firms, and therefore, no more uncertainty or need to outguess. However, cartels are difficult to maintain for the following reasons: 1. Cartel members face the incentive to cheat on the cartel by secretly lowering prices and capturing the other members' market share, 2. Cheating leads to price wars and cartel breakdowns. 3. Differing COP among cartel members may lead to disagreements as higher-cost firms want to fix a higher price and vice versa. 4. It is important for a dominant firm to take a leadership role when arriving at agreements. A lack of a dominant firm can lead to cartel breakdown. 5. During recessions, with falling sales and profits, firms have a greater incentive to cheat by lowering prices. 6. The larger the number of firms in an industry joining the cartel, the more difficult it is to reach an agreement and the easier it is for the agreement to break down. Other types of Collusion: Informal collusion: cooperation between firms in an oligopoly to restrict competition and fix prices without a formal agreement. An example of an informal collusion is price leadership, where a dominant firm sets a price and initiates a price change, and the remaining firms become price-takers. Non-Collusive Oligopoly: Non-collusive oligopolies refer to oligopolistic firms that do not collude to fix prices and limit competition. Each firm behaves independently but is still aware of its rival’s pricing decisions and displays strategic behavior. In the real world, prices tend to be rigid and inflexible for oligopolies; once a particular price is reached, it tends to be stable over long periods of time. Moreover, when prices do change, all the firms change the price to that level. This can be easily understood when oligopolies conspire to form a cartel or price leadership. For firms that do not collude, the same concept occurs and is explained due to the three following reasons: 1. Firms that do not collude are forced to consider their rivals' actions when making price decisions; otherwise, they risk lowering their revenues and profits, which could lead to price instability. 2. Even though firms do not collude, there is still price stability because firms are reluctant to change their prices due to the likely actions of their rivals, which could result in lower profits for the firm initiating price changes. 3. Firms do not compete with each other based on price. (refer to the importance of non-price competition in oligopoly to avoid price wars). Concentration Ratio: Concentration ratio: A measure used to determine the degree of competition in an industry and whether firms have too much monopoly power. It measures the percentage of output produced by the largest firms in the industry. A seven-firm ratio of 50 percent means that the top 7 firms are responsible for 50% of output. The higher the concentration ratio, the lower the degree of competition in the industry and the higher the degree of monopoly power. An industry is held to be oligopolistic if the four largest firms are responsible for 40 percent of the output. The concentration suffers from some limitations: 1. Whereas concentration ratios reflect concentration in a national market, they do not reflect competition from abroad arising from imports. 2. It does not consider the relative sizes of firms within that ratio (for example, a 3-term 90% could be all three firms having 30 or 1 having 80 and the other two having 5). 3. Does not consider the importance of firms in the global market. There may be some competition in the domestic market, but the firms may have very strong positions in the global market. 4. Do not account for competition from other industries, which may be necessary in the case of substitute goods. For example, the aluminum industry may have a high concentration ratio, but it would be lower if it were combined with copper. Evaluating Oligopoly: Criticisms: Pros: 1. Research and development. 2. Economies of scale. 3. Possible lower prices due to technical innovation. 4. Product development leads to increased product variety, thus providing consumers with greater choice (unlike monopoly, which does not offer much product differentiation and variety). Cons: 1. Allocative and productive inefficiency. 2. Higher prices and lower output for consumers. 3. Loss in CS as an expense of gain in PS. 4. Negative impacts on income redistribution: Some monopolies charge higher prices than perfectly competitive firms. There is a redistribution of income away from consumers who must pay these higher prices towards the owners of the monopoly in the form of higher profits. 5. X inefficiency due to lack of competition. 6. Potentially less innovation: No pressure to innovate because they are shielded from competition from high barriers to entry. 7. Different from monopoly: Although many countries have anti-monopoly legislation, the difficulties of detecting and proving collision amongst oligopolistic firms mean that such firms may actually behave like monopolies by colluding and yet get away with it.