Chapter 13: Oligopoly

1
Chapter 13 Oligopoly
2
Objectives and Readings

• Oligopoly market structure
• Industry evolution
• Collusive arrangements and cartels
• Price leadership
• Strategy and performance
• Readings Textbook chapter 13, pages 523-554.

3
Oligopoly

• Oligopoly is a market structure with a small
  number of firms.
• Examples
• The US petroleum industry, where 8 firms account
  for about 60 percent of sales.
• The soft drinks industry, where Coca Cola and
  Pepsi Cola dominate the market.
• Oligopoly is a common market structure in
  manufacturing and services.
• In an oligopoly, each of the major firms must
  take into account the behavior of the others when
  formulating its strategy.
• No single, unified model of oligopoly exists.

4
Product Cycle Theory and Oligopoly

• Many industries pass through a number of stages
  over time as the characteristics of the product
  become more standardized.
• Four stages of product evolution
• 1. Introduction (The product is just discovered,
  it is non-standardized, monopoly market
  structure)
• 2. Growth (Imitation of technology occurs,
  oligopoly emerges, there is technological
  uncertainty, innovation takes the form of product
  improvements)
• 3. Maturity (Product is standardized, mature
  oligopoly market structure, global competition
  intensifies, process innovation becomes more
  profitable)
• 4. Decline (Product is completely standardized,
  it faces competition from other products, cost
  considerations determine profitability)

5
Stages of Industry Evolution
Growth
Maturity
Decline
Introduction
6
Industry Evolution and Managerial Decisions

• During the early stages, several managerial
  questions arise
• Which product improvement is the best?
• Which process technology will be more efficient?
• What is the best personnel policy?
• Which markets for the industrys product will
  tend to open first?

7
Industry Evolution and Managerial Decisions

• During the mature and declining stages there are
  also crucial questions to be answered
• How do companies deal with international
  competition?
• Does the company need to pull out of the market?
• How does a company deal with competition from new
  and better products?

8
Collusive Agreements

• In oligopolistic industries firms tend to
  collude, because firms recognize their
  interdependence.
• Collusive arrangements are hard to maintain.
• In the US, they are illegal (Sherman Act of 1890)
• Firms have an incentive to cheat by expanding
  their output.
• If a collusive arrangement is made openly and
  formally, it is called a cartel.
• If a cartel is established, two questions arise
• What price will the cartel charge?
• How is the total quantity produces will be
  allocated among the cartel members?

9
Output and Price Determination Under a Cartel
Agreement

• Market output and price under a collusive
  agreement.

P0 25
MR 15
Q0 100
10
Output Allocation Among Firms

• Suppose the cartel produces a homogeneous good
  (oil) and there are two firms (producers).
• If the cartel is interested in maximizing total
  profits, then total output is divided in such a
  way that the marginal costs (evaluated at the
  output produced by each firm) are equal MC1
  MC2 MC.
• If this rule is not satisfied the cartel can
  increase profits by reallocating output from the
  high to the low marginal cost producer.
• Once the output and price are determined, each
  firm can calculate its profits.

11
Output Allocation Among Firms
Profits for firm 1 equal (P - AC)Q (25-10)60
MC1 MC2
MC2
MC1
25
AC2
AC1
D
15
10
MR
Q Q1 Q2 100
Q1 60
Q2 40
12
Instability of Cartels

• Because at the output produced, MR exceeds MC,
  each cartel member has a tendency to expand
  output and cheat.

MC

P0 25
Firm 2 Demand
10
MR
Output
Q0 40
13
The OPEC Oil Cartel

• The Organization of Petroleum Exporting Countries
  (OPEC) consists of 12 major exporting countries,
  including Saudi Arabia, Iran, Venezuela, and
  Iran.
• In 1979 the price of oil reached 32 per barrel,
  and by 1993 it went down to 15 per barrel.
• The price of oil declined as a result of a
  downward shift in demand caused by conservation
  and of an outward shift in supply caused by
  several oil discoveries.
• In addition, the price decline was also due to
  cheating among members of the cartel.

14
Price Leadership

• In some oligopolistic markets one firm sets
  price and others follow.
• Examples of markets with price leadership are
  steel, alloys and agricultural implements.
• To illustrate the case of price leadership,
  assume that the industry is composed of a large,
  dominant firm and many small firms

15
Price Leadership

• The demand curve for the dominant firm (the
  residual demand) is derived by subtracting the
  amount supplied by the small firms at each price
  from the total output demanded at that price.
• The dominant firm maximizes profits by setting MR
  equal to its MC. The former is derived from the
  residual demand curve.

16
Price Leadership A geometric approach
Supply curve of small firms

E
B
Leaders Demand Curve
P0
Market Demand
MR
Output
Q0
Q1
17
Price Leadership Algebra

• Suppose that the industry demand is Q 1000-
  3P, where P is the price and Q is the quantity
  demanded.
• Assume that the supply curve for small firms is
  QS 100 2 P, where QS is total supply of all
  small firms at price P.
• Also, suppose that the dominant firms marginal
  cost is MC (3/5)QL.

18
Price Leadership Algebra

• The dominant firms demand curve is given by
• QL Q - QS (1000 - 3P) - (100 2P) 900 - 5P.
• The dominant firms inverse demand curve is
• P (900/5) - (1/5)QL 180 (1/5)QL
• Therefore the dominant firms marginal revenue
  function is
• MR 180 - (2/5)QL.

19
Price leadership Algebra

• The equilibrium output of the dominant firm is
  given by MR MC, which yields 180 - (2/5)QL
  (3/5)QL.
• Solving this equation yields the profit
  maximizing output of the dominant firm QL 180.
• Substituting QL 180 into the inverse demand for
  the dominant firm yields P 180 (1/5)180
  144.
• Substituting the price P144 into the supply of
  small firms yields QS 100 2(144) 388.

20
Successful Business Strategies

• What business strategies have been most
  successful?
• On the basis of data pertaining to 450 companies
  and 3,000 business units since 1972, Harvards
  Robert Buzzell and Bradley Gale concluded
• the most important single factor is the quality
  of the product relative to other rival products.

21
Summary

• Oligopoly is a market structure characterized by
  a small number of firms and interdependence.
• The evolution of oligopoly industries is
  characterized by a dinstict number of phases
  Introduction, growth, maturity and decline.
• There is no single model of oligopoly. Since the
  firms recognize their interdependence, in some
  cases they collude (explicitly or implicitly) and
  act as a cartel.
• Collusive arrangements are hard to maintain since
  each firm has an incentive to increase the
  quantity sold and profits.
• Another model of oligopolistic behavior is price
  leadership (or a dominant firm).