Chapter 14

Oligopolies: Firms in Less Competitive Markets

Introduction to Oligopolies

An oligopoly is a market structure characterized by a small number of interdependent firms competing, positioned between perfectly competitive markets (many firms) and monopolies (one firm). Oligopolies typically feature high barriers to entry and firms selling similar products.

• Few firms dominate the market.

• High barriers to entry prevent new competitors.

• Interdependence: Each firm's actions affect others.

Examples include the computer market (Microsoft and Apple) and OPEC (Organization of Petroleum Exporting Countries).

Barriers to Entry in Oligopolies

Barriers to entry are crucial in maintaining oligopolistic markets. They prevent new firms from entering and competing for economic profits.

• Economies of Scale: Large firms can produce at lower average total cost (ATC) than smaller firms, limiting the number of firms in the industry.

• Ownership of Key Inputs: Control over essential resources (e.g., bauxite for aluminum, diamonds for DeBeers, cranberries for Ocean Spray) restricts entry.

• Government-Imposed Barriers: Patents, licensing, and trade restrictions protect firms from competition.

Patents grant exclusive rights to a product for 20 years, incentivizing research and development, especially in pharmaceuticals.

Measuring Industry Competitiveness: Concentration Ratio

The concentration ratio (C4) measures the fraction of industry sales accounted for by the four largest firms. A C4 above 40% typically indicates an oligopoly.

Complexity of Oligopoly Pricing and Output Decisions

Unlike perfect and monopolistic competition, oligopolies cannot rely solely on demand and cost curves to determine profit-maximizing price and output. The actions of one firm directly affect the demand curves of others, making it difficult to construct demand and marginal revenue (MR) curves.

Game Theory in Oligopolies

Game Theory: Analyzing Strategic Interactions

Game theory studies how firms make decisions when their outcomes depend on the actions of other firms. It is essential for understanding oligopolistic competition.

• Rules: Define allowable actions.

• Strategies: Plans to achieve objectives.

• Payoffs: Outcomes resulting from strategies.

Payoff Matrix: Duopoly Example (Apple and Dell)

A payoff matrix shows the profits each firm earns from every combination of strategies. In a duopoly, the price each firm chooses affects both their own and their rival's profits.

Apple Price	Dell Price	Apple Profit	Dell Profit
$1,200	$1,200	$10 million	$10 million
$1,000	$1,200	$15 million	$5 million
$1,200	$1,000	$5 million	$15 million
$1,000	$1,000	$7.5 million	$7.5 million

Dominant Strategy and Nash Equilibrium

A dominant strategy is the best choice for a firm regardless of what the other firm does. The Nash equilibrium occurs when each firm chooses the best strategy given the other's choice, and no firm can improve its outcome by changing strategies unilaterally.

• In the Apple-Dell example, both firms have a dominant strategy to charge $1,000, resulting in a Nash equilibrium with lower profits than if they cooperated.

Cooperative vs. Non-Cooperative Equilibrium

• Cooperative equilibrium: Firms cooperate to maximize mutual payoffs (e.g., both charge $1,200).

• Non-cooperative equilibrium: Firms pursue self-interest, often resulting in lower profits (e.g., both charge $1,000).

Prisoner's Dilemma in Oligopolies

The prisoner's dilemma illustrates how dominant strategies can lead to non-cooperation and suboptimal outcomes for all players.

Payoff Matrix: Advertising Example (Pepsi and Coca-Cola)

Advertising decisions can also be analyzed using game theory. Both Pepsi and Coca-Cola have a dominant strategy to advertise, leading to a non-cooperative Nash equilibrium.

Pepsi	Coca-Cola	Pepsi Profit	Coca-Cola Profit
Don't Advertise	Don't Advertise	$750 million	$750 million
Advertise	Don't Advertise	$900 million	$400 million
Don't Advertise	Advertise	$400 million	$900 million
Advertise	Advertise	$500 million	$500 million

Cartels and Collusion

A cartel is a group of firms that collude to restrict output and increase prices and profits. OPEC is a classic example. Collusion is illegal in the U.S., but even when allowed, maintaining cooperation is difficult due to differing incentives.

Payoff Matrix: OPEC Example (Saudi Arabia and Nigeria)

In OPEC, larger producers like Saudi Arabia have more incentive to cooperate, while smaller producers may break quotas to maximize profits, leading to fluctuating oil prices.

Saudi Arabia Output	Nigeria Output	Saudi Arabia Profit	Nigeria Profit
Low	Low	$100 million	$10 million
Low	High	$75 million	$15 million
High	Low	$80 million	$7 million
High	High	$60 million	$10 million

Sequential Games: Entry Deterrence and Bargaining

Entry Deterrence: Sequential Game Example

Sequential games involve firms making decisions one after another. Entry deterrence is a strategy where an incumbent sets a lower price to discourage new entrants.

• If Apple charges $1,000, Dell enters and both earn lower returns.

• If Apple charges $800, Dell is deterred from entering, and Apple maintains higher returns.

Bargaining: Sequential Game Example

Bargaining between firms can also be analyzed as a sequential game. Firms negotiate prices with suppliers, and decision trees help predict outcomes.

• If Dell offers $20, TruImage may accept if the profit is sufficient.

• Decision trees help firms assess the credibility of threats and offers.

Five Competitive Forces Model

Analyzing Industry Competition

The five competitive forces model identifies factors affecting competition and profitability in an industry:

1. Competition from existing firms: More firms increase competition and reduce profits.

2. Threat from potential entrants: Firms take actions to deter entry, increasing costs.

3. Competition from substitute goods/services: New products can reduce demand for existing ones.

4. Bargaining power of buyers: Powerful buyers can demand lower prices and better terms.

5. Bargaining power of suppliers: Suppliers with control over key inputs can limit firm profits.

These forces are dynamic and change over time, affecting the level of competition and profitability in any industry.

Summary

Oligopolies are characterized by a few firms, high barriers to entry, and strategic interdependence. Game theory provides tools to analyze their complex interactions, including pricing, advertising, collusion, entry deterrence, and bargaining. The five competitive forces model offers a comprehensive framework for understanding industry competition.