Oligopoly

Chapter 12

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Learning Objectives

After this chapter, you should be able to:1. Define and measure concentration ratios and the Herfindahl-

Hirschman index.

2. Describe and discuss the competitive spectrum.

3. Analyze the kinked demand curve.

4. Explain and discuss administered prices.

5. Experiment with game theory.

6. Discuss the effects of cutthroat competition in the college textbook market.

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Oligopoly Defined

Oligopoly: an industry with just a few sellers. How few? So few that at least one firm is large enough

to influence price. Product can be identical, similar, or differentiated. When we talk about big business in the U.S., we’re

talking about oligopolies. Examples are:• Coca Cola, McDonald’s, GM, ExxonMobil, IBM, Boeing, CBS,

NBC, Kellogg, General Mills, other industrial giants that have become household names.

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Oligopoly is the most prevalent type of industrial competition in the U.S. as well as in most of the noncommunist industrial west.

The vast majority of our GDP is accounted for by firms in oligopolistic industries.

Oligopoly’s Importance

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The crucial factor under oligopoly is the small number of firms.

Because there are so few firms, every competitor must think continually about the actions of its rivals.

• What each does could make or break the others.

Thus, there is a kind of interdependence among oligopolists.

Oligopoly Behavior

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Two Measures of the Degree of Oligopolization

1. Concentration Ratio

2. Herfindahl-Hirschman Index

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Concentration Ratios

The concentration ratio: the percentage share of industry sales of the top 4 (leading) firms in the industry.

• Industries with high concentration ratios are very oligopolistic.

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Concentration Ratios in Selected Industries, 2010

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Calculate the Concentration Ratio (CR)

Firm Percent of sales A 14 % B 4 C 23 D 5 E 2 F 8 G 17 H 10 I 2 J 5 Total 100 %

Concentration ratio is23 + 17 + 15 + 14 = 69

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Two Key Shortcomings of Concentration Ratios

1. Concentration ratios do not include imports.• Ignores imports; in car industry, ignores hundreds of thousands

of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royce's.

2. Concentration ratios tell us nothing about the competitive structure of the rest of the industry.

• Are all the firms relatively large or are they small?• When the remaining firms are large, they are not as easily

dominated by the top 4 as are dozens of relatively small firms.

CRs measured for the U.S. have become less meaningful with increased globalization; perhaps it’s better to calculate with global markets.

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Oligopoly in the Automobile Industry: The Growing Influence of Foreign Firms

April 2010 data

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HHI: the sum of the squares of the market shares of each firm in the industry.

• A monopoly has 100% of the market share.

• 1002 = (100 x 100) = 10,000

• You cannot get a bigger HHI number than 10,000.

Herfindahl-Hirschman Index (HHI)

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HHI: the sum of the squares of the market shares of each firm in the industry.

An industry has 2 firms, each with 50% of the market.• HHI = 502 + 502 = 2,500 + 2,500 = 5,000

An industry has 4 firms, each with 25% of the market.• HHI = 252 + 252 + 252 + 252 = 625 + 625 + 625 + 625 = 2,500

The U.S. Department of Justice uses the HHI to decide whether an industry is highly competitive; it considers an industry with HHI < 1,800 competitive.

Calculate the HHI

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The Competitive Spectrum The Degrees of Competition in Oligopoly

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Cartels

Cartel: a combination of firms that acts as if it were a monopoly.

• The leading firms in an industry band together to restrict output and, consequently, increase prices and profits.

• If the demand is there, oligopolistic firms can openly collude to control supply and, to a large degree, market price.

• Example: OPEC and the price of oil.

A cartel is the most extreme case of oligopoly

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Withholding Supply to Raise Price

When supply is lowered from S1 to S2, price rises from P1 to P2.

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Daily Output and Capacity of 12 Members of OPEC

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Open Collusion

Slightly less extreme than a cartel

Operates like the alleged Mafia

• Some type of territorial division of the market among the firms in the industry

This type of arrangement gives each firm in the market a regional monopoly.

The firm may have only 15 or 20 percent of the market, but under this type of arrangement, its pricing behavior is that of the monopolist.

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The Colluding Oligopolist

This graph could also belong to the monopolist or the monopolistic competitor in the short run.

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Covert Collusion Usually involves price-fixing

• In the late 1950s, General Electric, Westinghouse, Allis-Chalmers and other leading electrical firms conspired to fix the price of electrical transformers, turbines, and other equipment.

• They rigged government bids by taking turns making (high) low bids, bilking the public of hundreds of millions of dollars.

In 1961, the U.S. Supreme Court found 7 high ranking corporate officials guilty of illegal price-fixing and market sharing agreements.

They got short jail sentences. Their employers paid their fines and their salaries while in jail, and

they got their old job back after they got out.• Important 2008 price fixing case in the European Union; 4 companies in

the auto glass market were fined $1.77 billion. Executives met secretly in airports and hotels in Brussels,

Frankfurt, and Paris to divide the market and discuss their contracts with automakers.

No jail time; they were demoted.

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Examples of Other Cases of Collusion

In 1996, Archer Daniels Midland Company pleaded guilty and paid a $100 million criminal fine for its role in two international price-fixing conspiracies.

In 1999, an arrangement was uncovered that fixed worldwide vitamin prices as much as 25% above the market level.

In 2004, Schering-Plough (now merged with Merck) paid $350 Million in fines for overcharging Medicaid.

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Price Leadership

Playing follow the leader• One company raises prices and shortly after, the other

companies in the same market do the same.

Examples: the prime rate set by the big banks, price hikes by Delta Airlines.

Collusion is most likely to succeed when there are few firms and high barriers to entry.

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Cutthroat Competition

An extreme case, but common in the U.S.

The cutthroat competitor’s actions are based on assumptions about their rivals’ behavior.

Assumption #1: “If I raise my price, my competitors won’t raise their price.”

Assumption #2: “If I lower my price, my competitors will also lower their price.”

Therefore, the cutthroat competitor keeps the price just where it is—”sticky prices.”

Examples:• McDonald’s and Burger King• Costco and Sam’s Club• Coke and Pepsi

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The Kinked Demand Curve of the Cutthroat Oligopolist

Sticky priceat the kink

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Graph of the oligopolist is similar to that of the monopolist.

• Therefore, the oligopolist is analyzed in the same manner with respect to price, output, profit, and efficiency.

• Price is higher than the minimum point of the ATC curve, therefore the oligopolist is not as efficient as the perfect competitor.

• The oligopolist has a higher price and a lower output than does the perfect competitor.

• The oligopolist, like the monopolist, makes a profit.

Full Graph of the Oligopoly (Cutthroat Competitor)

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The Cutthroat Oligopolist

No cutthroat oligopolist will raise or lower price. They keep the price just where it is: at the kink in

the D curve.

Note discontinuity (gap) in MR curve.

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The Cutthroat Oligopolist

Find P* and Q* Calculate Profit P* = $27 Firms set Q* where MR =

MR, so Q* = 4 Profit = (P – ATC) x Q*

• ($27 – $24) x 4 = $12

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Game Theory

Definition: the study of how people behave in strategic situations.

One application is a duopoly: an industry with just 2 firms.• The behavior of one firm affects the other.• Should they collude or compete?

Example: 2 bottled water companies, Maine Water Company and Michigan Water Company.

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Four Profit Outcomes for the Bottled Water Duopoly

Should they collude to charge high prices?

Answer: Yes, because if your competitor lowers his/her price, you will also lower yours, so you both lose. You both win in collusion.

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Conclusion: The Competitive Spectrum

At one end, the cartel, which no longer operates within the U.S. economy, although it may be found in world markets.

At the other end, the cutthroat competitor, the firm that will stop at nothing to beat out its rivals. (e.g. fast food chains)

Where is the U.S. economy?

It depends upon the industry and the situation.

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Current Issue: Cutthroat Competition in the College Textbook Market

Unlike nearly any other market, you, as a consumer of college textbooks have only 1 choice.

• Do I buy my books new or used?• Typically, used books are bought back at 50% and then resold

next semester at 75% of the price.

If students had a say in choosing their own texts, you can be sure publishers would produce no-frills texts at much lower prices.

With only 3 major textbook publishers today, the odds of this happening are non-existent.

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Questions for Further Thought and Discussion

Think about the things that you buy in your local area (around school or home).

Are there any products that you purchase from a market dominated by only a few firms?

Are these local, regional, national or international oligopolies?

Are they in similar industries to those with very high concentration ratios listed in the text?

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The Four Types of Competition: A Review(Appendix)

Learning Objectives After this appendix, you should be able to:

1. Define and analyze perfect competition.

2. Define and analyze monopoly.

3. Define and analyze monopolistic competition.

4. Define and analyze oligopoly.

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The Four Types of Competition: Definitions (Number of Sellers and Type of

Product)

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The Four Types of Competition: Profit or Loss in the Short Run or Long Run

Perfect Competition• SR: profit or loss• LR: break even

Monopoly• No distinction between SR & LR (profit)

Monopolistic Competition• SR: profit or loss• LR: break even

Oligopoly• SR: profit or loss• LR: profit

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The Four Types of Competition

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Questions for Thought and Discussion

Which of the 4 market structures charges higher prices and sells less?

Which of the 4 market structures is efficient in the long run?

Suggest a name of a firm/company that operates under each of the 4 market structures, if possible.