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ECON 152 – PRINCIPLES OF MICROECONOMICS
Chapter 27: Oligopoly
and Strategic Behavior
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
Oligopoly

Oligopoly
A
market situation in which there
are very few sellers
 Each seller knows that the other sellers will
react to its changes in prices and quantities
2
Oligopoly

Characteristics of oligopoly
 Small
number of firms
 Interdependence
 Strategic dependence
A situation in which one firm’s actions with respect to
price, quality, advertising, and related changes may
be strategically countered by the reactions of one or
more other firms in the industry
3
Oligopoly

Why oligopoly occurs
Economies of scale
Barriers to entry
Mergers

Vertical Merger


The joining of a firm with another to which it sells an
output or from which it buys
an input
Horizontal Merger

The joining of firms that are producing or selling a similar
product
4
Oligopoly

Determining the Existence of an Oligopoly
 Concentration

Ratio
The percentage of all sales contributed by the
leading four or leading eight firms in an industry
 It
is difficult to specify an arbitrary absolute
number to demonstrate the existence of an
oligopoly, but it is a good indicator.
 Verification is usually based on the observed
strategies and behavior of the firms of the
industry.
5
Computing the Four-Firm
Concentration Ratio
Firm
Annual Sales
($ Millions)
1
2
3
4
5 through 25
150
100
80
70
50
Total
450
Total number
of firms in
Industry = 25
400
= 88.9%
Four-firm concentration ratio =
450
Table 27-1
6
E-Commerce Example:
Concentration in the Search-Engine Industry
Internet search-engines collect revenue
through advertisements posted on their
websites.
 To measure the concentration ratio in this
industry, economists count the number of
searches conducted on each site.

7
E-Commerce Example:
Concentration in the Search-Engine Industry
The four most frequently used searchengines are Google, Yahoo, AOL Time
Warner, and MSN.
 The four-firm concentration ratio in this
industry is 91 percent, indicating that it
qualifies as an oligopoly.

8
Oligopoly, Inefficiency, and
Resource Allocation



Oligopolistic firms have some degree of market
power, which means each one can affect the
market price.
This creates some inefficiency in resource
allocation.
But to the extent that U.S. oligopolies must
compete with firms from other countries, their
market power is limited.
9
Strategic Behavior
and Game Theory

Explaining the pricing and output behavior
of oligopoly markets
 Reaction

Function
The manner in which one oligopolist reacts to a
change in price, output, or quality made by another
oligopolist in the industry
10
Strategic Behavior
and Game Theory

Game Theory
A
way of describing the various possible
outcomes in any situation involving two
or more interacting individuals when those
individuals are aware of the interactive nature
of their situation and plan accordingly
11
Strategic Behavior
and Game Theory

Cooperative Game
A
game in which the players explicitly
cooperate to make themselves better off

Noncooperative Game
A
game in which the players neither negotiate
nor cooperate in any way
12
Strategic Behavior and Game Theory

Zero-Sum Game
A
game in which any gains within the group
are exactly offset by equal losses by the end
of the game

Negative-Sum Game
A
game in which players as a group lose at
the end of the game

Positive-Sum Game
A
game in which players as a group are better
off at the end of the game
13
Strategic Behavior
and Game Theory

Strategies in noncooperative games
 Strategy
Any rule that is used to make a choice
 Any potential choice that can be made by players
in a game

 Dominant

Strategies
Strategies that always yield the highest benefit
14
Example: The Prisoner’s Dilemma

You and your partner rob a bank and get
caught.
15
Prisoner’s Dilemma

You are separated and given these
options:
 Both
confess and get five years in jail
 Neither confess and get two years
 One confess and the other does not
Confessor goes free
 One who does not confess gets ten years


Assume you are Sam reacting to the possible
actions of Carol.
16
The Prisoners’ Dilemma Payoff Matrix
Figure 27-1
17
The Prisoners’ Dilemma Payoff Matrix
Confessing is better than not confessing.
Figure 27-1
18
The Prisoners’ Dilemma Payoff Matrix
Confessing is better than not confessing.
Confessing is better than not confessing.
Figure 27-1
19
Strategic Behavior and Game Theory

Applying game theory to pricing strategies
 Would

you choose a high price or a low price?
Remember

No collusion
20
Pricing Dilemma


The firms are separated and given these options:
 Both charge high price and each gets $6 million
 Both charge low price and each gets $4 million
 One charges low price and the other high
 Lower priced firm gets $8 million
 Higher priced firm gets $2 million
Assume you are Firm #2 reacting to the possible
actions of Firm #1
21
Strategic Behavior and Game Theory
Figure 27-2
22
Strategic Behavior and Game Theory
Low is better than high.
Figure 27-2
23
Strategic Behavior and Game Theory
Low is better than high.
Low is better than high.
Figure 27-2
24
Strategic Behavior and Game Theory

Opportunistic Behavior
 Actions
that ignore the possible long-run
benefits of cooperation and focus solely on
short-run gains
 An example might be writing a check that you
know will bounce
 Not realistic
Consequences tend to be more obvious
 We make repeat transactions

25
Strategic Behavior and Game Theory

Tit-for-Tat Strategic Behavior
 In
game theory, cooperation that continues
so long as the other players continue to
cooperate
26
Price Rigidity and the
Kinked Demand Curve
Price and Marginal Revenue per Unit
Panel (a)
d1
A
P0
d1
q0
Figure 27-3, Panel (a)
Quantity per Time Period
27
Price Rigidity and the
Kinked Demand Curve
Panel (a)
Price and Marginal Revenue per Unit
d2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share
d1
A
P0
d1
d2
q0
Figure 27-3, Panel (a)
Quantity per Time Period
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
28
Price Rigidity and the
Kinked Demand Curve
Panel (a)
Price and Marginal Revenue per Unit
d2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share
d1
A
P0
d1
MR 1
d2
q0
Figure 27-3, Panel (a)
Quantity per Time Period
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
29
Price Rigidity and the
Kinked Demand Curve
Panel (a)
Price and Marginal Revenue per Unit
d2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share
d1
A
P0
d1
MR 1
MR2
d2
q0
Figure 27-3, Panel (a)
Quantity per Time Period
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
30
Price Rigidity and the
Kinked Demand Curve
Price and Marginal Revenue per Unit
Panel (b)
d1
P0
MR 1
The kinked demand curve
indicates the possibility
of price rigidity
A
d2
MR 2
q0
Figure 27-3, Panel (b)
Quantity per Time Period
31
Price Rigidity and the
Kinked Demand Curve
Price, Marginal Revenue, and
Marginal Cost per Unit
d1
P0
MR1
MC '
MC
MC"
Changes in cost do
not impact output
and prices as long as
MC remains in the
vertical portion of MR
d2
MR2
q0
Quantity per Time Period
Figure 27-4
32
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership

Price Leadership
A
practice in many oligopolistic industries in
which the largest firm publishes its price list
ahead of its competitors, who then match
those announced prices
 Price leadership behavior is apparent in the
overnight package delivery industry
33
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership

Price War
A
pricing campaign designed to drive
competing firms out of a market by repeatedly
cutting prices
34
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership

Markets where price wars are common
 Cigarettes
 Long-distance
telephone companies
 Airlines
 Diapers
 Frozen
foods
 PC hardware and software
35
Deterring Entry Into an Industry

Entry Deterrence Strategy - Any strategy undertaken
by firms in an industry, either individually or together,
with the intent or effect of raising the cost of entry into
the industry by a new firm
 Increasing entry cost


Threat of price wars
Government regulations
Strategies – A group of colluding sellers
will set the highest common price without new firms
seeking to enter the industry
 Raising switching costs for customers
 Limit-Pricing


Non-compatible software
Non-transferability of college courses
36
Network Effects and Industry
Concentration



A network effect is a situation in which a
consumer’s inclination to use an item depends
on how many others use it.
In an industry selling products subject to network
effects, a small number of firms may be able to
secure the bulk of the payoffs resulting from
positive market feedback.
Oligopoly is likely to emerge as the prevailing
market structure.
37
Comparing Market Structures
Market
Structure
Number
of
Sellers
Unrestricted
Entry and
Exit
Ability
to Set
Price
Long-Run
Economic
Profits
Possible
Product
Nonprice
Differentiation Competition Examples
Perfect
competition
Numerous
Yes
None
No
None
None
Agriculture,
roofing nails
Monopolistic
competition
Many
Yes
Some
No
Considerable
Yes
Toothpaste
toilet paper,
soap, retail
trade
Oligopoly
Few
Partial
Some
Yes
Frequent
Yes
Recorded
music, college
textbooks
Pure
monopoly
One
Not
for entry
Considerable
Yes
None
(product is
unique)
Yes
Some electric
companies,
some local
telephone
companies
Table 27-3
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ECON 152 – PRINCIPLES OF MICROECONOMICS
Chapter 27: Oligopoly
and Strategic Behavior
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.