Oligopoly

Assumptions
• A small number of large firms
The Term “Oligopoly” has been derived from
two Greek words.
‘Oligi’ which means few and ‘Polien’ means
sellers.
• High barriers to entry
All the barriers to entry discussed under
monopoly. Additional barrier includes high
start up costs (the cost of starting a new
firm)
• Differentiated or homogeneous
(undifferentiated ) products
Eg; for differentiated products pharmaceuticals, cars, aircrafts, cigarettes, refrigerators, cameras,
tyres, bicycles, motorcycles, soaps, detergents etc.

Eg; for homogenous products: Oil, steel, aluminum, copper,

cement
• There is a small number of large firms.
• There is mutual interdependence: Decisions taken by
one firm affect other firms in the industry, so they depend on
each other. If any one firm changes its behaviour, this can have
a major impact on the demand curve facing the other firms.
Therefore, firms are keenly
aware of the actions of their rivals.
Mutual interdependence

•Strategic behaviour. Strategic behaviour is based on plans of

action that take into account rivals’ possible courses of action.
•Conflicting incentives: Incentive to collude –collusion
•refers to an agreement between firms to limit competition
between them, usually by fixing price and therefore lowering
quantity produced.
•Incentive to compete –with its rivals in the hope that it will
capture a portion of its rivals’ market shares and profits, thereby
increasing profits at the expense of other firms.
Oligopoly
monopolistic

Oligopolistic industries are dominated by large

firms who have the majority of the market share
There may also be a large number of smaller
firms in the same market
Think about the supermarkets – there are
hundreds of little corner shops but have no real
affect on the conduct or performance of the larger
firms
Perfect Monopolistic
competition competition Oligopoly Monopoly

0% 50% 80% 100%

Low Medium High

concentration concentration concentration
Concentration ratios
We use concentration ratios to indicate the market
structure
Concentration ratios are expressed in the form CRx
where X represents the number of the largest firms
CR4 would show the percentage of market share held by 4
firms
The higher the percentage the more concentrated
If the CR4 was 90% this would mean that 4 firms have 90% of
the market which would be very concentrated and would indicate
an oligopolistic market structure
If the CR4 was 19% this would suggest low concentration and
a monopolistic market structure
Barriers to Entry Predatory
A key feature of an oligopoly is the desire to want
pricing - The
to keep other firms out of the industry
practice of selling
If this barrier does not exist oligopolists will create
a product or
barriers (artificial barriers to entry) as follows
service at a very
Limit and predatory pricing – a firm may lower its
low price,
prices so that another cannot survive
intending to drive
Advertising
competitors out of
if you are a large firm you can spread the cost the market, or
of advertising over a large number of units. create
If you are just entering you will need to match barriers to entry
the amount of advertising but won’t have the for potential new
number of units to spread the costs
competitors.
This could explain why there Setting a price
are only two detergent firms in the UK
that may bankrupt
Multiplicity of brands – if consumers a competitor firm
switch brands frequently a firm can
capture a larger share of the market in order to try to
by having lots of brands e.g. soap take it over
powder manufacturers
Artificial Barriers to Entry Integration -
combining with
Integration – to control the supply of
other firms
resources and sources of distribution they can
integrate – backwards, forwards, horizontally,
vertically.
This would enable them to use predatory
pricing
Non-price competition – techniques used to
Price war -
persuade customers to buy without changing where firms
the price and risk starting a price war. competitively
Branding – the brand should make demand lower prices to
more inelastic and encourage loyalty increase their
market share
Research and development – create new
products that give them an edge over their
competitors
Competitive oligopoly Interdependent –
actions by one
In this market structure firms pursue an firm will have an
independent strategy but they are interdependent effect on the sales
and revenue of
If one decides to increase its price and the other large firms
others leave theirs the firm that raises its pricein the market
will lose market share
If one decreases its price then the others will lose market
share if they do not do the same creating a price war where
all lose revenue
In this market structure firms have to anticipate what their
competition are going to do before making decisions on price
or output
Oligopoly is characterised by
reactive behaviour (firms
react in response to other firms)
Game Theory
As a consequence of interdependence firms
want to be able to predict their rivals response
to a strategy or to have strategies to respond
themselves
This is the basis of game theory which
explores the reactions of one play to changes Game theory –
in strategy by another player an analysis of
how games
When applied to oligopoly players react to
the players are the firms changing
the game is played in the market circumstances
and plan their
Their strategies are their price or output
response
decisions
The payoff is their profits
Zero sum game
We assume that it is a zero sum game – where a gain by
We also assume that the players are risk one player is
averse matched by a loss
by another player
The Prisoner’s
Dilemma
Play the game
Two people are put in different
rooms with their team
Give them instructions
You are accused of a joint crime
If you and your partner both plead
innocent you will both receive a light
sentence
If you plead innocent but your partner
pleads guilty you will receive a heavy
sentence but your partner will be let off
If you both plead guilty you will get a
medium sentence
Ask them to write down how they
came to their decision
The Prisoner’s Dilemma
If you could have got together you would both have
pleaded innocent and got a light sentence
In isolation you cannot trust each other so each
chose to plead guilty and both suffer
A reasons as follows:
If B pleads innocent
A will get a light sentence if they plead innocent 0 Yrs
A will get no sentence if they plead guilty
A pleads guilty because it is the better outcome
If A assumes B pleads guilty
A gets a severe sentence if he pleads innocent 0 Yrs

A gets a medium sentence if he pleads guilty

Once again guilty is the best plea for A
this is A’s dominant strategy
B reasons in the same way collusion –
As a result they will both have the same dominant where firms co-
strategy and both plead guilty operate in their
If they had been able to collude (get together and pricing and output
co-operate) they could both have agreed to plead policies
inno
cent and got off with a light sentence
https://www.youtube.com/watch?v=t9Lo2fgxWHw
The Prisoner’s Dilemma – payoff
matrix
This is called a payoff matrix
It shows the payoff for each strategy
This is the payoff matrix for the prisoner’s dilemma

0 Yrs

0 Yrs
Competing and colluding

Using game theory we can illustrate the basic dilemma of oligopolistic firms
– to co-operate or to compete
They are often better to co-operate or collude but this is most often illegal
Firms will want to work out what the other firm’s actions will be so that they
can decide what to do
The dominant strategy (their best option) is the action they will take
regardless of what the other firm does
Watch these videos to get more understanding and more practice
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..\..\videos\Econ concepts in 60 seconds\practice of game theory matrices.flv
• The Nash equilibrium shows that there is sometimes a
conflict between the pursuit of individual self interest
and the collective firm interest. This conflict is the
prisoner’s dilemma. Although the firms could be
better off by cooperating, each firm, trying to make
itself better off, ends up making both itself and its
rival worse off.
Real world application of game
theory
Game theory analysis has direct relevance to our
study of the behaviour of businesses in oligopolistic
markets
For example the decisions that firms must take
over pricing of products, and also how much money
to invest in research and development spending.
Costly research projects represent a risk for any
business
If one firm invests in R&D, can another rival firm
decide not to follow?
They might lose the competitive edge in the
market and suffer a long term decline in market
share and profitability.
The dominant strategy for both firms is probably
to go ahead with R&D spending.
If they do not and the other firm does, then their
profits fall and they lose market share.
However, there are only a limited number of
patents available to be won and if all of the leading
firms in a market spend heavily on R&D, this may
ultimately yield a lower total rate of return than if
only one firm opts to proceed.
 Collusive oligopoly
• If the firms under oligopoly market
combine together instead of
competing it is known as Collusive
Oligopoly.
• The collusive may take place in the
form of a common agreement or an
understanding between the firms.
• Collusion may be formal, usually
taking the form of a cartel or it may
be informal such as price leadership.
 Formal collusions: cartels
• A cartel is a formal agreement between
firms in an industry to undertake concerted
actions to limit competition.
• In effect, when the firms in an industry
collude (agree to limit competition between
them) they collectively behave like a
monopoly. The best known cartel is OPEC
composed of a group of 13 oil producing
countries.
Obstacles to forming and maintaining cartels
• Cost differences between firms
• Firms face different demand curves
• Number of firms
• The possibility of cheating
• The possibility of a price war
• Recessions
• Potential entry into the industry
• The industry lacks a dominant firm
• Legal barriers ( cartels are illegal in many
countries like EU, UK,US
Tacit/Informal collusion: price leadership and
other approaches
• Price leadership is where a dominant firm
in the industry (which may be the largest,
or it may be the one with lowest costs) sets
a price and also initiates any price
changes.
• The remaining firms in the industry in effect
become price takers ,accepting the price
that has been established by the leader.
• For eg; US steel, Kellogg’s( breakfast
cereals), R.J Reynolds (cigarettes)
• Obstacles to sustained price leadership
are similar to the obstacles faced by
cartels
-cost differences between firms
- some firms may follow the leader, others
may not
- high industry profits can attract new
firms that will cut into market shares and
profits of established firms and endanger
the price leadership arrangement
Non-price competition
Given the problems associated with
price competition oligopolies engage in
many forms of non-price competition
such as advertising or promotions
UK supermarkets use techniques such
as
In-store advertising/marketing
Loyalty cards
Increasing range of services e.g.
cash back
In-store chemists, post offices and
currency exchange
Home delivery services
Discounted petrol at hypermarkets
Extension of opening hours (24
hour opening)
However they spend a lot of time
advertising the fact that their prices are
lower than their competitors
Collusive Oligopoly – Formal Restrictive
collusion (explicit collusion) agreements –
where firms
Formal collusion is where some
collude to indulge
agreement exists between key firms in in anti-competitive
the same industry about price and policy
output Joint profits –
where firms agree
One way of doing this is to have to maximise
restrictive agreements shared rather than
refuse to supply outlets that sell below their individual
an agreed price (Volkswagen) profits
Agreeing to all increase prices of
selected products (European
pharmaceuticals and vitamins pills)
The aim is to increase the level of
joint profits at the consumer’s expense
(price, quality or availability)
It is unlikely to be in writing as huge
fines can be levied against firms with
restrictive agreements
Informal collusion (implicit collusion)
Informal collusion is much more difficult to detect and in many countries is not
illegal
An example is price leadership
If the cartel nominates a price leader as soon as that price leader changes
price the other members of the cartel will follow
Price leadership may take various forms
The price leader may be the dominant firm in the industry (the one with
the most market share)
The role may be taken by the smaller firm that is more sensitive to
changes in market conditions – barometric price leadership
Collusive price leadership and parallel pricing are where identical prices
and price movements are maintained in the industry
Firms follow the industry norm – firms reach agreement as to each
other’s behaviour as a result of repeated observations over time
Explain why firms in oligopolies engage in non-price competition
(10)
Distinguish between a collusive and a non collusive oligopoly
(10)
Evaluate the view that government should maintain strong
policies to control collusive behaviour by oligopolies (15)
Monopolistic competition- comparison
with Perfect Competition

• Number of firms
• Free and entry and exit
• Normal profit in the long run,
supernormal profit or loss in the short
run.
• Market power and the demand curve
• Productive and allocative efficiency.
• Excess capacity
• Product variety
• Economies of scale
Monopolistic competition with
monopoly
• Number of producers
• Size of firms
• Barriers to entry.
• Normal and economic profits
• Competition and prices ( monopolist maintain profit over the long run)

• Market power…price,…DD downward…. Substitutes

• Allocative and productive efficiency
• Economies of scale
• Research and development