Chapter%2012 - Econ 160, Vardanyan Chapter 12 Oligopoly and...

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Econ 160, Vardanyan 1 Chapter 12 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 2 +40 2 = 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 (licensing, patents). Advertising campaigns . 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 pricing decisions . 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 b on the market demand curve. This strategy is also known as price fixing – an arrangement in which two firms coordinate their pricing decisions . 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.
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Chapter%2012 - Econ 160, Vardanyan Chapter 12 Oligopoly and...

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