Oligopoly

INTRODUCTION Oligopoly An oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service. An oligopoly has greater market power than monopolistic competition and perfect competition, but not as much market power as a monopoly. One of the measurement tools used to determine if a market is an oligopoly is the concentration ratio. The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). Typical oligopoly markets include:

Baby Food (Gerber, Heinz, Beech-Nut) Credit Cards (Visa, MasterCard, American Express, Discover) Batteries (Duracell, Eveready, Ray-O-Vac, Kodak) Beer (Anheuser-Busch, Miller, Coors, Stroh)

Oligopoly Market Characteristics Since there are only a few number of dominant participants, changes in pricing, marketing, and sales made by one will immediately be noticed by the others. If one company in a oligopoly market lowers its price, the others will immediately know and may or may not match it. If a companys sales are increasing at a faster rate than other participants, the loss of sales by other participants will be noticed. Oligopoly Market Characteristics Oligopolies engage heavily in product differentiation. Product differentiation is the process of highlighting features that make one product appear different or superior from competing products in the same market. Oligopolists prefer non-price competition using advertising and product differentiation to sell their products. Non-price competition consists of techniques used to persuade customers to prefer one product over another without using price. Product differentiation and advertising are commonly used forms of non-price competition.

The Kinked Demand Curve If an company in an oligopoly market reduces its price, the competitors may match the price reduction, or they may not. Competitors in this market will usually match price decreases but not price increases. This causes the kinked structure of the demand curve in an oligopoly market.
The Kinked Demand Curve Confronting an Oligopoly
Demand curve facing oligopolist if rivals match price changes
PRICE

Demand curve facing oligopolist if rivals match price cuts but not price hikes
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Demand curve facing oligopolist if rivals don't match price changes

QUANTITY DEMANDED

The demand curve will be kinked downward if rival oligopolists match price reductions but not price increases. This is represented by the heavy red line on the preceding graph. The demand curve will be normal if both price reductions and price increases are matched. The demand curve will be kinked tilted almost horizontally if competitors do not match any price changes. The kinked demand curve illustrates the complex, interdependent behavior of monopolists and how they react to competition. Game Theory When an oligopolist is planning to change its price or output, it must consider the response of its competitors. Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs. The successful oligopolist will be able to predict the competitive response and plan accordingly. For example if a diaper company plans a new price reduction campaign, it will know based on past campaigns how its competitors will react and plan accordingly.

Maximizing Profits Studies of oligopoly markets tend to be concerned with the total industry, not just a single company. This is due to the interdependence of all firms. Profits for the industry are maximized at the output level where marginal cost intersects marginal price. Graphs usually depict industry cost and revenue curves, not individual firms. Prices tend to stay at the same levels and do not change often this is the sticky price.
Maximizing Oligopoly Profits

Price or Cost (dollars per unit)

Profitmaximizing price Average cost at profitmaximizing output 0

Industry marginal cost Profits

Industry average cost Market demand Industry marginal revenue

Profit-maximizing output
Quantity (units per period)

Maximizing Oligopoly Profits

On the preceding graph, profits are maximized at the level of output (market demand) above where marginal revenue intersects marginal cost. At the level of output where MR=MC, prices are set based upon the demand for the product or service. Often there is a considerable range of profitability at that level of output. Costs Oligopolies tend to have a cost cushion or room to breathe between their marginal revenue curve and marginal cost curve. This cushion or gap enables oligopolies to withstand moderate cost increases without raising their prices. The gap is caused by the different competitive responses that could occur when price decreases/increases are matched or not. There is a separate marginal revenue curve for each kinked demand curve.

An Oligopolists Marginal Revenue Curve

Price

A F d1 G mr2 d2 mr1

H Quantity Demanded

The Cost Cushion The marginal cost curve on the preceding graph could intersect the marginal revenue curve at point G or at point F, depending upon the kinked demand curve. This distance or gap is the cost cushion for oligopolies. Increases or decreases of output within this gap do not affect the profit maximizing rate of output. Minor cost increases and decreases also do not affect the profit maximizing rate of output. Oligopoly Behavior/Situations There is a temptation among some oligopolies to engage in price fixing. Price fixing is the establishment of explicit agreements among producers regarding the price (s) at which a good is to be sold. OPEC (the oil exporting countries cartel) does this all the time. It is illegal in the U.S. for companies to engage in this practice, however since OPEC is a foreign entity the U.S. cannot forbid it from engaging in this practice. Oligopoly Behavior/Situations Price leadership is a legal and more common method to increase prices in an oligopoly market. Generally one firm (usually the one with the largest market share) establishes the market price (or percentage of price increase) for all firms in the industry. Other firms follow the increase or increase their prices at a slightly lower rate. Eventually all price changes are relatively the same. This process can frequently cause instability in prices and sales when it occurs.

Barriers Oligopoly markets tend to have significant barriers to entry. Often patents, control over the distribution system, and significant capital costs are incurred in oligopoly markets. Significant advertising occurs in this market. The intent is to build brand loyalty and help keep new competitors out. Brand loyalty exists when the consumer prefers one manufacturers product over another. Looking specifically at common products in the oligopoly market, do you have any brand loyalty towards particular brands? Anti-trust Anti-trust legislation and policies are designed to keep the level of competition high among markets. Within oligopoly markets, and monopolistic competition markets becoming more oligopolistic, mergers and acquisitions are common. The federal government examines potential mergers/acquisitions in these markets for anticompetitive effects. Anti-trust A common measurement tool is called the Herfindahl-Hirshman Index. This index measures the concentration of a market by examining the number of firms and the size of each. The index is used by the federal Justice Department as a tool to determine if a proposed merger/acquisition would cause anti-competitive effects. A value of 1800 or more indicates that the proposed merger will be challenged by the Justice Department. Anti-trust More information about industry concentration ratios and the HHI index can be found at http://www.census.gov/epcd/www/concentration.html Summary

Market power Concentration ratio. Oligopoly markets. Price and sales changes. Product differentiation and non-price competition. Kinked demand curve. Game theory. Profit maximization. Sticky prices. Price leadership, price fixing, entry barriers. Herfindahl-Hirshman Index. How do these concepts impact the government, business, and individuals?