Lecture 15 Oligopoly

Measuring Market Concentration

1. Concentration ratio: percentage of the markets total output
supplied by its four largest firms
2. The higher the concentration ratio, the less competition.
3. Oligopoly is a market structure with high concentration ratios.

Oligopoly
- Market structure in which only a few sellers offer similar or identical
products
- Strategic behavior in oligopoly:
o A firms decisions about P or Q can affect other firms and
cause them to react. The firm will consider these reactions
when making decisions.
- Game theory: the study of how people behave in strategic
situations.

Example: Cell phone Duopoly in Bayang Munti

- Bayang Munti has 140 residents
- The good: cell phone service with unlimited anytime minutes and
free phone
- Bayang Muntis demand schedule
- Two firms: Bright Mobile, Orb Mobile
- FC= Php 0, MC= Php10

P Q Reven Cost Profit

ue
0 14 0 1400 -1400 Competitive outcome
0 P=MC=Php 10
5 13 650 1300 -650 Q=120
0 Profit = 0
1 12 1200 1200
0 0 Monopoly outcome
1 11 1850 1100 P=40
5 0 Q=60
2 10 2000 1000 Profit =1800
0 0
2 90 2250 900 - One possible duopoly: collusion
5 - Collusion: an agreement among
3 80 2400 firms in a market about
0 quantities to produce or prices
3 70 2450 to charge
5 - Bright Mobile and Orb Mobile
4 60 2400 600 1800 could agree to each produce half
0 of the monopoly output:
4 50 o For each firm: Q= 30,
5 P=4-, profits=900
 - Cartel: a group of firms acting in unison a.k.a collusion

Collusion vs. self-interest

Duopoly outcome with collusion:
Each firm agrees to produce Q=30, each profit= P900

If Bright Mobile reneges on the agreement and produces Q= 40, what

happens to the market price? Bright Mobiles profits?

Is it in Bright Mobiles interest to renege on the agreement?

If both firms stick to the agreement, each firms profit= P900

If Bright Mobile reneges on agreement and produces Q=40
Market Quantity = 70, P=P35
Bright Mobiles profit= 40 x (P35-10) = P1000
Bright Mobiles profits are higher if it reneges
Orb Mobile will conclude the same so both firms renege
Both firms Q=40
Quantity=80

Both firms would be better off if both stick to the cartel agreement
But each firm has incentive to renege on the agreement
Lesson: It is difficult for oligopoly firms to form cartels and honor their
agreements

The oligopoly equilibrium

P Q If each firm produces Q=40, market quantity= 80, P=30
0 14 Profit= 800
0 If B. Mobile Q=50
5 13 Market quantity=90
0 P=P25
1 12 B. Mobile profit 50 x (P25-10) =750
0 0 B. Mobiles profits are higher at Q=40 than Q=50
1 11
5 0 Same for O. Mobile
2 10
0 0
2 90
5
3 80 The equilibrium for an oligopoly
0 - Nash Equilibrium - situation in which economic
3 70 participants interacting with one another each choose their
5 best strategy given the strategies that all the other have
4 60 chosen
0 - Out duopoly example has a Nash equilibrium in which each
firm produces Q=40.
4 50
o Given that Orb Mobile produces Q=40.
5
Bright Mobiles best move is to produce Q=40
o Given that Bright Mobile produces Q=40.
 Orb Mobiles best move is to produce Q=40.

A Comparison of Market Outcomes

- When firms in an oligopoly individually choose production to
maximize profit
o Oligopoly Q is greater than monopoly Q but smaller than
competitive Q.
o Oligopoly P is greater than competitive P but less than
monopoly P.

The Output and Price Effect firm is profit maximizing

- Increasing output has two effects on a firms profits:
o Output Effect
If P>MC, selling more output raises profits
o Price Effect
Raising production increases market quantity which
reduces market price and reduces profit on all units sold.
- If output effect > price effect
o The firm increases production
- If price effect > output effect
o The firm reduces production

The Size of the Oligopoly

- As the number of firms in the market increases,
o The price effect becomes smaller
o The oligopoly looks more and more like a competitive market
o P approaches MC
o Market quantity approaches the socially efficient quantity

Another benefit of international trade: Trade increases the number of firms

competing, increases Q, bring P closer to MC. -> approaching perfect
competition

Game Theory