principles of microeconomics - oligopoly

8/3/2019 Principles of Microeconomics - Oligopoly

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Oligopoly

Dr. Katherine Sauer

Principles of Microeconomics

ECO 2020


2/25

Classifying an industry as an oligopoly

Recall the characteristics of an oligopoly market:

few firms (more than 1, less than many)identical or differentiated products

high barriers to entry


3/25

When is an industry an oligopoly?

- when the 4-firm concentration ratio is largerthan 40%

or

- when the HHI is greaterthan 1800


4/25

1. The 4-firm concentration ratio is thepercent of total

output in the industry that isproduced by the 4 largestfirms.


5/25

Here are the market shares for the top 8 firms in two

different industries:

Firm Industry A Industry B1 0.10 0.46

2 0.10 0.24

3 0.08 0.10

4 0.08 0.05

5 0.05 0.04

6 0.03 0.03

7 0.02 0.02

8 0.01 0.01

The 4-firm concentration ratio for Industry A is:

0.10+0.10+0.08+0.08= 0.36

The 4-firm concentration ratio for Industry B is:

0.46+0.24+0.10+0.05 = 0.85


6/25

2. Herfindahl-Hirshman Index (HHI)

!

!

I

i

eimarketsharHHI1

2)(

HHI = (market share firm 1) + (market share firm 2) + 2 2

HHI greater than 1800: highly concentrated market

HHI less than 1000: unconcentrated market


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Firm Industry A Industry B

1 0.10 0.46

2 0.10 0.24

3 0.08 0.104 0.08 0.05

5 0.05 0.04

6 0.03 0.03

7 0.02 0.028 0.01 0.01

Industry As HHI = (10) + (10) + (8) + (8) + (5)

+ (3) + (2) + (1) + (53)(1)

= 420

In Industry A, suppose that the remaining 53% of market share is

equally split by 53 firms each have 1% of market.

In Industry B, suppose that the remaining 5% of market share is

equally split by 5 firms each have 1% of market.2 2 2 2 2

2 2 2 2


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Firm Industry A Industry B

1 0.10 0.46

2 0.10 0.24

3 0.08 0.104 0.08 0.05

5 0.05 0.04

6 0.03 0.03

7 0.02 0.028 0.01 0.01

Industry Bs HHI = (46) + (24) + (10) + (5) + (4)

+ (3) + (2) + (1) + (5)(1)

= 2852

2 2 2 2 2

2 2 2 2


9/25

Firm Behavior

The group of oligopolists isbetter off cooperating andacting like a monopolist, producing a small quantity of

output and charging a price above marginal cost.

Yet, because the oligopolist cares about his own profit,there is an incentive to act on his own. This will limit

the ability of the group to act as a monopoly.

A key feature of oligopoly is the tension between

cooperation and self-interest.


10/25

The oligopoly outcome is likely to be in between the

competitive market outcome and a monopoly market

outcome.

Competitive Price < Oligopoly Price < Monopoly Price

Competitive Q > Oligopoly Q > Monopoly Q


11/25

Size of an Oligopoly Affects the Market Outcome

As the number of firms in an oligopoly increases, the

output approaches the competitive output level.

The oligopoly output level will converge to n / (n+1) of

the competitive output level.


12/25

Ex: If the competitive market outcome would be 1000units of output and there are 5 oligopolists, then the

oligopoly level of output would be

(5 / 6)1000 = 833.33

If the competitive market outcome would be 800 units

of output and there are 2 oligopolists, then the oligopoly

level of output would be

(2/3) 800 = 533.33


13/25

The larger the number of sellers in the industry, the less

concerned each seller is about its own impact on marketprice.

- as the number of sellers in an oligopoly grows larger,

an oligopolistic market looks more and more like acompetitive market.

- Price will approach marginal cost.

- The quantity of output produced will approach the

socially efficient level.


14/25

When an oligopolist decides to increase output, twothings occur.

- Because price is greater than marginal cost,

increasing output will increase profit.This is the output effect.

- Because increasing output will raise the total

quantity sold, the price will fall and will thereforelower profit.

This is the price effect.


15/25

Because of the strategic nature of an oligopoly industry,

a tool called game theory is often used to analyze the

firms behavior.

game theory: the study of how people behave in

strategic situations

By strategic, we mean a situation in which each person,

in deciding what actions to take, must consider howothers might respond to that action.


16/25

Each firm in an oligopoly must act strategically,

because its profit not only depends on how much outputit produces, but also on how much other firms produce

as well.


17/25

Introduction to Game Theory

Apayoff matrix is used for games where decisions aremade simultaneously.


18/25

Ex: Russia and South Africa both produce diamonds.

They are considering entering an agreement where they

each reduce production to drive up prices.

Russia

South

Africa

abide cheat

abide $18

$18

$20

$15

cheat $15

$20

$16

$16*

This outcome is aNash Equilibrium.


19/25

Nash Equilibrium: when each player is doing the best

he/she can, given what the other player is doing.

Given that Russia has decided to cheat, would South

Africa want to change its strategy?

Russia

South

Africa

abide cheat

abide $18

$18

$20

$15

cheat $15

$20

$16

$16*

No: 15 < 16


20/25

Given the South Africa has decided to cheat, would

Russia want to change its strategy?

When given what the other players are doing, if no one

wants to change strategies, you have found a Nash

Equilibrium.

Russia

South

Africa

abide cheat

abide $18

$18

$20

$15

cheat $15$20

$16$16

No: 15 < 16

*


21/25

A Nash Equilibrium isnt necessarily the bestoutcome.

Both countries could get the highest payoff if they agreednot to cheat.

Russia

SouthAfrica

abide cheat

abide $18

$18

$20

$15

cheat $15

$20

$16

$16

- But each has an incentive to cheat!

- The cheating outcome is not the best for either party.


22/25


23/25

A Prisoners Dilemma is a situation where the actual

outcome is not as good as the outcome would be if the

firms could enter into a binding agreement with one

another to do something else.

It illustrates why agreements are hard to maintain even

when they are mutually beneficial.


24/25

The Classic Prisoners Dilemma example:

Bonnie

Clyde

confess not confess

confess 5years5years

10years1year

not confess 1year

10years

2years

2years

*


25/25

Some situations have more than one Nash Equilibrium.

Suppose you are on a first date. It is the end of the date

and you are both deciding whether to lean in for a kiss.

Your Date

You

lean in for kiss don't lean in for kiss

lean in for

kiss

okay

okay

awkward

awkwarddon't leanin for kiss

awkwardawkward

okayokay

*

*

principles of microeconomics - oligopoly

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