Unit 7: Oligopoly
Oligopoly describes a market where a few sellers control a large part of the market. Even if there are many firms, a market is an oligopoly as long as a few of these firms control a large market share.
The key feature of oligopoly is strategic interdependence. Since there are a few big firms, all their pricing decisions impact each other. For example, the fares that are set by one airline will undoubtedly impact the profit earned by other airlines. This interdependence means that, when firms make decisions, they have to take into consideration how other firms will act in response to these decisions.
Strategic interdependence is a unique feature of oligopolies. For monopoly, there is no strategic interdependence because there is only one firm. On the other hand, competitive markets don’t feature strategic interdependence either because each individual firm is too small to impact the overall market conditions. If I’m a rice farmer, I don’t really care what my neighbor is doing because each of us is too small to impact the market. Only in oligopoly, where there is more than one large firm, but not so many that the market is competitive, do firms behave with this kind of strategic interdependence in mind. Each firm has to consider the reaction of other firms when making pricing and output decisions.
Classification of Oligopolies
The most common measure of market power is the four-firm concentration ratio, which is the percentage of total sales in the market that are made by the four largest firms in the market. Typically, the government classifies a market as an oligopoly if the four-firm concentration ratio is more than 40%. This is enough market power by large firms for strategic interdependence to be important.
Why Oligopoly Exists
Oligopoly normally arises because of some kind of barrier to entry in a market that prevents competition, or at least makes new entry difficult. There are several common barriers to entry.
• High start-up costs: The reason that orange-growing is competitive but airlines are not is that it is very expensive to start an airline. Even when airlines are making high profits, it is difficult for new airlines to enter and compete. As another example, firms may advertise so heavily that it is difficult for a new firm to enter and even begin to penetrate.
• Regulation: Government regulation might limit competition. The government makes it difficult for new airlines and medical schools to enter the market. As another example, the government auctions off the broadcast spectrum to a few large television networks, which generates an oligopoly. Real estate zoning restrictions might limit competition. As a final example, the market for steel would be competitive if the government allowed imports, but quotas on foreign steel limit competition. Economists generally dislike regulation that stifles competition.
• Predatory pricing: Predatory behavior by existing firms might keep rivals out and limit competition. Predatory pricing occurs when firms set their prices so low as to deliberately drive other firms out of business. Typically, this happens when a large firm like Wal-Mart can afford losses at one location for awhile, which smaller firms cannot afford to maintain. Once the competitors are driven out, the large firm is free to raise prices as it wishes. If the large firm continues to repeat this tactic, it can successfully limit competition in a market.
All in all, the real enemy of competition is barriers to entry. Economists tend to get concerned about market power and excessive concentration in a market when there are barriers to entry that make it difficult for new entrants to compete.
Kinked Demand Curve Model
Consider an oligopoly market for air travel where the current price of a flight is 𝑃𝑃∗. We will derive the demand curve for a single firm in this market. This model is known as the “kinked demand curve” model, and is designed to model strategic interaction in an oligopoly market.
On the other hand, if our airline reduces its price to something lower than 𝑃𝑃∗ it faces a different problem. The other airlines aren’t going to just let our airline steal their customers; they will reduce their prices too. At the end, our airline doesn’t really end up with very many new customers when it lowers its price, because it starts a price war and all the other firms lower their prices too. Using economic language, the demand curve is inelastic if the firm tries to lower its price. It won’t end up with a lot of new sales.
This demand curve is said to be “kinked” at the current market price 𝑃𝑃∗. Raising price is a bad idea since it results in a large loss in sales when other firms do not raise their prices and steal our customers. Lowering price is a bad idea too because all the other firms lower their prices as well, so there isn’t much of an increase in sales. All in all, prices in oligopoly markets tend to be very stable. The kinked demand curve model was created to explain this phenomenon.
Then, like any other firm, our oligopoly sets its output where marginal revenue equals marginal cost, and charges the corresponding price on the demand curve.
But, notice something interesting. Since the optimal output 𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀 occurs on the vertical segment of the marginal revenue curve, the marginal cost 𝑀𝑀𝑀𝑀 could rise or fall quite a bit without any change in the profit maximizing output or price. Anywhere on the vertical segment of the marginal revenue curve, 𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀 at the same output level and price 𝑄𝑄∗ and 𝑃𝑃∗.
This justifies the claim that we made earlier – prices in oligopoly markets tend to be extremely stable. It takes a large change in costs for a firm to change its price or quantity sold.
Collusion
Collusion occurs when firms conspire to raise prices in a market. Typically, this is done by an agreement to cut output, which in turn increases the price.
A cartel is a formal agreement among firms to set prices. Cartels and other anti-competitive types of activities are illegal in the United States. Nevertheless, just because firms can’t formally make agreements on prices, that doesn’t mean that they never coordinate. Tacit collusion occurs when firms coordinate on prices without a formal agreement. Two common forms are:
• Price leadership: When one firm is obviously dominant in the market, and all other firms follow the pricing decisions of the “leader”. UPS is an example.
• Cost-plus pricing: When firms in a market follow an industry-standard markup over cost. Gas stations are a classic example. If you pull off of a highway, you see that all the gas stations are pretty much charging the same price. They’re not fixing prices formally, but there’s an industry standard for how much they mark up price over supply cost, so all their prices move basically together.
CRANDALL: I think it’s dumb as hell, to sit here and pound the %$#& out of each other and neither one of us is making a #%&$@#& dime.
PUTNAM: Do you have a suggestion for me?
CRANDALL: Yes, I have a suggestion for you. Raise your #%&$@#& fares twenty percent. I’ll raise mine the next morning. You’ll make more money, and I will too.
PUTNAM: We can’t talk about pricing!
CRANDALL: Oh %$#&, Putnam. We can talk about any #%&$@#& thing we want to talk about!
Putnam was correct, and the US Department of Justice filed a lawsuit against Crandall after obtaining a copy of the tape.
In another case, producers of animal feed pleaded guilty to criminal charges of price fixing. At a secretly recorded meeting (the executives had claimed that their meeting was a “trade meeting”) one executive said to a newcomer: “We have a saying at this company. Our competitors are our friends and our customers are our enemies.”
Both of these cases underscore the point. If firms can get together and make agreements not to compete with each other too much, they can raise their profits if they can pull it off. The ultimate losers from this kind of collusion are consumers, which is why the government vigorously prosecutes price fixing and other anticompetitive practices.
Failure of Collusion
Despite the incentive to collude and raise profits, cartels rarely work in practice. The problem is that each individual firm always has an incentive to cheat on the deal and undercut its rivals. The Organization of Petroleum Exporting Countries (OPEC), which is supposed to be a cartel that coordinates oil output and pricing, is a good example. Indeed, it is questionable whether OPEC has ever been successful at raising oil prices.
Suppose that all the OPEC countries get together and agree to restrict oil output in order to keep the price high. But an individual country is always better off by cheating on the agreement – they can take advantage of the high price in the market, and then increase their profit by selling more oil than they are supposed to. Of course, once all countries do this, then the price drops and everyone ends up worse off.
each firm is better off cheating on the agreement and undercutting its rivals. Once too many firms undercut, then the cartel falls apart. For this reason, cartels are unstable – especially cartels with many firms involved. It may be possible for two or three firms to sustain an agreement like this, but enforcing an agreement with 30 firms is more challenging.
This general problem is known as a prisoners’ dilemma, which describes a situation where everyone involved can achieve a better outcome by cooperating, but each individual has an incentive to defect in order to obtain a better outcome for himself.
Structure-Conduct-Performance Model
The structure-conduct-performance model is about relating the structure of the market to how the firms behave and to the outcomes that the market produces for society. Having studied the four main market structures we are now in a position to compare outcomes across these different markets.
First, economists generally agree that – all else equal – the price in markets falls as the level of competition rises. That is, monopolies have the highest prices of all, followed by oligopoly and monopolistic competition, with perfect competition having the lowest prices of all. There may be exceptions, such as economies of scale in markets where a single large firm has a big cost advantage, but the principle holds in general.
In terms of the ability to earn profits and the efficiency of the market outcome, the table below summarizes what we have said in the previous units.
Market Short-Run
Profits
Long-Run
Profits Price
Allocative Efficiency
Productive Efficiency
Perfect
Competition +, − or 0 0 P = MC Yes Yes
Monopolistic
Competition +, − or 0 0 P > MC No No
Oligopoly +, − or 0 + possible P > MC No No
Monopoly +, − or 0 + possible P > MC No No
particular, long-run profits can never persist in monopolistically competitive markets. Even though the products are differentiated, the lack of barriers to entry drives long-run profit to zero.
However, zero-profit and allocative efficiency are not the same thing. Firms in long-run equilibrium in both perfectly competitive and monopolistically competitive markets earn zero excess profits in the long run. But the equilibrium in perfect competition involves a price equal to marginal cost, whereas the equilibrium in monopolistic competition involves a price higher than marginal cost.
To see why, remember that perfectly competitive firms have a perfectly elastic demand curve, while monopolistically competitive firms have a downward sloping demand curve. Remembering that zero profit is where price and average total cost are equal, we can see from the diagram the difference in the zero-profit long-run equilibrium for the two markets. The zero-profit equilibrium for the perfectly competitive firm on the left involves a price equal to marginal cost, and for the monopolistically competitive firm on the right involves a price higher than marginal cost. Furthermore, the more inelastic is the demand curve, the higher the markup of price over marginal cost. This makes intuitive sense – more market power (inelastic demand) means higher prices.
Prices higher than marginal cost create deadweight loss, so monopolistically competitive, oligopoly and monopoly markets are not allocatively efficient. Price is set higher than marginal cost, so these markets do not maximize total surplus (gains from trade). In this sense, perfect competition is the gold standard for economists.
