Econ 160, Vardanyan
Oligopoly and Strategic Behavior
In this chapter we will discuss the forth market type, called oligopoly, which is the last
one we will consider.
Oligopoly is defined as a market served by just a few firms
Because the number of firms is so small, the actions of any single firms can have a big
effect on other firms, so they act strategically. Before any firm takes a particular action it
considers possible reactions of its rivals. To explore strategic interactions of oligopolists
we will use
game theory – a framework used to explore the actions and reactions of
interdependent decision makers
What Is an Oligopoly?
Because oligopoly is characterized by the presence of just a few firms, each of them will
have market power, i.e. the power to control prices.
The degree of concentration in an
oligopolistic market is measured using concentration ratios
. For example, a four-firm
concentration ratio of 99% means that four largest firms produce 99% of output in that
industry. The concentration ratios in selected manufacturing industries are given in Table
15.1. An alternative measure of market concentration is the Herfindahl-Hirschman Index
(HHI), which is calculated by squaring the market share of each firm and then summing
them up. For example, if there are only two firms one with 60% market share and another
with 40%, then HHI = 60
= 5,200. According to the U.S. Department of Justice, the
market is considered highly concentrated if HHI>1,800.
An oligopoly occurs for the following reasons:
Government barriers to entry
. In some industries a firm cannot enter the market
without a substantial investment in advertising (breakfast cereal industry)
Economies of scale in production
. Some industries are characterized by
substantial economies of scale so that the market can support only a few firms.
Cartel Pricing and the Duopolists’ Dilemma
We will consider a special case of an oligopoly, called
duopoly, which is defined as a
market with two firms
. Hence, suppose the market for air travel between two cities is
served by just two airlines. Suppose that the average cost of providing travel is constant
at $100, so that the marginal cost is constant as well (i.e. the LAC curve coincides with
the LMC curve and both are horizontal, Fig. 12.1). One solution for the airlines is to
collude and act as a
cartel – a group of firms that collude explicitly, coordinating their
. In this case, the two airlines will act as one, choose the monopoly
output of 60 passengers (i.e. serve 30 passengers each), and charge $400. The cartel
solution corresponds to the point
on the market demand curve. This strategy is also
price fixing – an arrangement in which two firms coordinate their pricing
. Because the price fixing allows duopolists to reap highest possible profit
thereby reducing the consumers’ welfare, it is illegal under the U.S. antitrust laws.