Exploring Economics - 4e - Chapter 15.pdf - po ang - Januszek66

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CHAPTER

O LIGOPOLY AND

S TRATEGIC B EHAVIOR

15.1

Oligopoly

15.3

Other Oligopoly Models

15.2

Collusion and Cartels

15.4

Game Theory and Strategic Behavior

ligopoly is a market structure where a few

large firms dominate an industry. Examples

of oligopolistic markets include commercial

airlines, oil, automobiles, steel, breakfast

cereals, computers, cigarettes, tobacco, and sports

drinks. In all of these instances, the market is

dominated by anywhere from a few to several big

companies, although they may have many differ-

ent brands (e.g., General Motors, General Foods,

Dell Computers). In this chapter, we will learn

about the unique characteristics of firms in this

industry.

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SECTION

15.1

OLIGOPOLY

What is oligopoly?

What is mutual interdependence?

Are economies of scale a major barrier

to entry?

Why is it so difficult for the oligopolist to

determine its profit-maximizing price and

output?

WHAT IS OLIGOPOLY?

As we discussed in Chapter 13, oligopolies exist, by def-

inition, where relatively few firms control all or most of

the production and sale of a product (“oligopoly”

few

sellers). The products may be homogeneous or differen-

tiated, but the barriers to entry are often high, which

makes it difficult for firms to enter into the industry.

Consequently, long-run economic profits may be earned

by firms in the industry.

MUTUAL INTERDEPENDENCE

Oligopoly is characterized by mutual interdependence

among firms; that is, each firm shapes its policy with an

eye to the policies of competing firms. Oligopolists must

strategize, much like

good chess or bridge

players who are con-

stantly observing and

anticipating the moves

of their rivals. Oligopoly

is likely to occur when-

ever the number of firms

in an industry is so small

that any change in output or price by one firm apprecia-

bly impacts the sales of competing firms. In this situa-

tion, it is almost inevitable that competitors will respond

directly to these actions in determining their own policy.

Central Florida can get pretty hot and humid in August when

football practices begin, especially if you are wearing football

pads. Back in 1965, researchers at the University of Florida

decided to work on a formula for a drink that would replace

body fluids lost during high activity. The drink was tried on

the University of Florida Gator football team so the sports

drink became known as Gatorade. Forty years later you can

choose from a number of sports drinks on the market, but

most of them are controlled by just a few firms (such as

Gatorade, which is now part of Pepsi).

mutual

interdependence

when a firm shapes its policy with

an eye to the policies of competing

firms

MEASURING INDUSTRY CONCENTRATION

The extent of oligopoly power in various industries

can be measured by means of concentration ratios. A

concentration ratio indicates the proportion of total

industry shipments (sales) of goods produced by a

speciﬁed number of the largest ﬁrms in the industry,

or the proportion of total industry assets held by

these largest ﬁrms. We can use four-ﬁrm or eight-ﬁrm

concentration ratios; most often, concentration ratios

are for the four largest ﬁrms.

The extent of oligopoly power is indicated by the

four-ﬁrm concentration ratio for the United States

shown in Exhibit 1. Note that for breakfast cereals, to

take an example, the four largest ﬁrms produce 87

percent of all breakfast cereals produced in the United

States. Concentration ratios of 70 to 100 percent are

WHY DO OLIGOPOLIES EXIST?

Primarily, oligopoly is a result of the relationship

between the technological conditions of production

and potential sales volume. For many products, a ﬁrm

cannot obtain a reasonably low cost of production

unless it is producing a large fraction of the market

output. In other words, substantial economies of scale

are present in oligopoly markets. Automobile and

steel production are classic examples of this. Because

of legal concerns such as patents, large start-up costs,

and the presence of pronounced economies of scale,

the barriers to entry are quite high in oligopoly.

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Oligopoly and Strategic Behavior

CHAPTER 15

Four-Firm Concentration

Ratios, U.S. Manufacturing

Economies of Scale

as a Barrier to Entry

SECTION 15.1

E XHIBIT 1

SECTION 15.1

E XHIBIT 2

Share of Value of Shipments

Industry

by the Top Four Firms (%)

Tobacco products

P 1

Breweries

Motor vehicles

Electric lightbulbs

Small arms ammunition

Refrigerators

P 2

Breakfast cereals

ATC

Aircraft

Soaps, detergents

Tires

Q SMALL

Q LARGE

Motorcycles and bicycles

Quantity of Autos Produced

(per year)

Lawn and garden equipment

Coffee and tea

Economies of large-scale production make operation

on a small scale more costly, ceteris paribus.

Source: U.S. Census Bureau.

common in oligopolies. That is, a high concentration

ratio means that a few sellers dominate the market.

Concentration ratios, however, are not a perfect

guide to industry concentration. One problem is that

they do not take into consideration foreign competition.

For example, the U.S. auto industry is highly concen-

trated but faces stiff competition from foreign automo-

bile producers. The same is true for motorcycles and

bicycles.

ECONOMIES OF SCALE AS A BARRIER TO ENTRY

Economies of large-scale production make operation on

a small scale during a new ﬁrm’s early years extremely

unproﬁtable. A ﬁrm cannot build up a large market

overnight; in the interim, average total cost is so high

that losses are heavy. Recognition of this fact discour-

ages new ﬁrms from entering the market, as illustrated

in Exhibit 2. We can see that if an automobile company

produces quantity Q LARGE rather than Q SMALL , it will be

able to produce cars at a signiﬁcantly lower cost. If the

average total cost to a potential entrant is equivalent to

point A on the ATC curve and the price of automobiles

is less than P 1 , a new ﬁrm would be deterred from enter-

ing the industry.

Do you think economies of scale are important in this

industry? Unlike home-cooked meals, few cars are

“homemade.” The barriers to entry in the auto

industry are formidable. A new entrant would have to

start out as a large producer (investing billions of

dollars in plant, equipment, and advertising) to com-

pete with existing firms, which have lower average

total costs per unit because of economies of large-

scale production.

EQUILIBRIUM PRICE AND QUANTITY

IN OLIGOPOLY

It is difﬁcult to predict how ﬁrms will react in situa-

tions of mutual interdependence. No ﬁrm knows what

its demand curve looks like with any degree of cer-

tainty, and therefore it has a limited knowledge of its

marginal revenue curve. To know anything about its

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Households, Firms, and Market Structure

MODULE 3

demand curve, the ﬁrm must know how other ﬁrms

will react to its prices and other policies. In the absence

of additional assumptions, then, equating marginal

revenue and expected marginal cost is relegated to

guesswork. Thus, it is difﬁcult for an oligopolist to

determine its proﬁt-maximizing price and output.

SECTION * CHECK

1. Oligopolies exist where relatively few firms control all or most of the production and sale of a product. The

products may be homogeneous or differentiated, but the barriers to entry are often very high and, consequently,

they may be able to realize long-run economic profits.

2. When firms are mutually interdependent, each firm shapes its policy with an eye to the policies of competing firms.

3. Economies of large-scale production make operation on a small scale extremely unprofitable. Recognition of this

fact discourages new firms from entering the market.

4. Because in oligopoly the pricing decision of one firm influences the demand curve of competing firms, the

oligopolist faces considerable uncertainty as to the location and shape of its demand and marginal revenue

curves. Thus, it is difficult for an oligopolist to determine its profit-maximizing price and output.

1. How can concentration ratios indicate the extent of oligopolies’ power?

2. Why is oligopoly characterized by mutual interdependence?

3. Why do economies of scale result in few sellers in oligopoly models?

4. How do economies of scale result in barriers to entry in oligopoly models?

5. Why does an oligopolist have a difficult time finding its profit-maximizing price and output?

6. Why would an automobile manufacturer be more likely than the corner baker to be an oligopolist?

SECTION

15.2 Collusion and Cartels

Why do firms collude?

What is joint profit maximization?

Why does collusion break down?

UNCERTAINTY AND PRICING DECISIONS

The uncertainties of pricing decisions are substantial in

oligopoly. The implications of misjudging the behavior

of competitors could prove to be disastrous. An execu-

tive who makes the wrong pricing move may force the

ﬁrm to lose sales or, at a minimum, be forced himself to

back down in an embarrassing fashion from an

announced price increase. Because of this uncertainty,

some believe that oligopolists change their prices less

frequently than perfect competitors, whose prices may

change almost continually. The empirical evidence,

however, does not clearly indicate that prices are in fact

always slow to change in oligopoly situations.

agree to act jointly in

pricing and other mat-

ters. If ﬁrms believe

they can increase their

proﬁts by coordinating

their actions, they will

be tempted to collude. Collusion reduces uncertainty

and increases the potential for economic proﬁts. From

society’s point of view, collusion creates a situation in

which goods very likely become overpriced and

underproduced, with consumers losing out as the

result of a misallocation of resources.

collude

when ﬁrms act together to restrict

competition

JOINT PROFIT MAXIMIZATION

Agreements between or among ﬁrms on sales, pricing, and

other decisions are usually referred to as cartel agree-

ments. A cartel is a collection of ﬁrms making an

agreement.

COLLUSION

Because the actions and proﬁts of oligopolists are so

dominated by mutual interdependence, the tempta-

tion is great for ﬁrms to collude —to get together and

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Oligopoly and Strategic Behavior

CHAPTER 15

Cartels may lead

to what economists

call joint proﬁt maxi-

mization: Price is

based on the marginal

revenue function,

which is derived from

the product’s total (or

market) demand sched-

ule and the various

ﬁrms’ marginal cost

schedules, as shown in

Exhibit 1. With outright

agreements—necessarily secret because of antitrust

laws (in the United States, at least)—ﬁrms that make

up the market will attempt to estimate demand and

cost schedules and then set optimum price and output

levels accordingly.

Equilibrium price and quantity for a collusive

oligopoly are determined according to the intersec-

tion of the marginal revenue curve (derived from

the market demand curve) and the horizontal sum

of the short-run marginal cost curves for the oli-

gopolists. As shown in Exhibit 1, the resulting

equilibrium quantity is Q * and the equilibrium

price is P *. Collusion facilitates joint proﬁt maxi-

mization for the oligopoly. If the oligopoly is main-

tained in the long run, it charges a higher price,

produces less output, and fails to maximize social

welfare, relative to perfect competition, because P *

SECTION 15.2

E XHIBIT 1

Collusion in Oligopoly

cartel

a collection of ﬁrms that agree on

sales, pricing, and other decisions

joint proﬁt

maximization

determination of price based on the

marginal revenue derived from the

market demand schedule and mar-

ginal cost schedule of the ﬁrms in

the industry

MC MARKET

P *

Total

Profit

ATC MARKET

ATC

D MARKET

Q *

Quantity

In collusive oligopoly, the producers would restrict

joint output to Q ∗ , setting their price at P ∗ . The mem-

bers of the collusive oligopoly would share the profits

in the shaded area.

relative costs and sales of the various ﬁrms. Firms

with low costs and large supply capabilities will

obtain the largest proﬁts, because they have greater

bargaining power. Sales, in turn, may depend in

large measure on consumer preferences for various

brands if there is product differentiation. With outright

MC at Q *.

The manner in which total proﬁts are shared

among ﬁrms in the industry depends in part on the

in the news

The Crash of an Airline Collusion

Mr. Crandall: I think it’s dumb as @#$% for !@#$% ∗ sake, . . . to sit here and

pound the @#$% out of each other and neither one of us making a #!@

!$& ∗ dime. I mean, you know, @!#$, what the @#$!, is the point of it.

Mr. Putnam: Do you have a suggestion for me?

Mr. Crandall: Yes, I have a suggestion for you. Raise your @#$&!$% fares

20 percent. I’ll raise mine the next morning. . . . You’ll make more money

and I will, too.

Mr. Putnam: We can’t talk about pricing!

Mr. Crandall: Oh @#$% we can talk about any @#$%& ∗ # thing we want to talk

about.

CONSIDER THIS:

At the time of this conversation, Crandall was the president of American

Airlines and Putnam was the president of Braniff Airlines. According to

the Sherman Antitrust Act, it is illegal for corporate leaders to talk

about and propose price fixing with their competitors. Putnam turned

the tapes of this conversation over to the Justice Department. After

reviewing the tapes, the Justice Department ruled that attempts to fix

prices could monopolize the airline industry. American Airlines prom-

ised they would not engage in this type of activity again.

SOURCE: Staff, “American Air Accused of Bid to Fix Prices,” The Wall Street Journal,

February 24, 1983, pp. 2, 23.

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