Unit 5 Topic 6: Oligopoly (Part 1)

Summary

This lecture explores the market structure of oligopoly, where a few dominant firms control the majority of sales in an industry. Oligopolies can have standardized or differentiated products, and firms in this structure possess significant market power due to high barriers to entry. The behavior of oligopolists is marked by interdependence, where firms react to each other's actions, making predictions difficult. Key concepts like the Herfindahl-Hirschman Index (HHI) and game theory (including the kinked demand curve) help explain oligopoly dynamics. The lecture also covers behaviors such as collusion, sales maximization, and non-cooperative competition among firms.

Takeaways

• 😀 Oligopoly is a market structure with few dominant firms that control the majority of sales, either with standardized or differentiated products.
• 😀 In an oligopolistic industry, there are high barriers to entry, giving dominant firms significant market power and the ability to control prices and output.
• 😀 The Herfindahl-Hirschman Index (HHI) is used to measure the concentration of an industry, with a score above 1,800 indicating an oligopoly.
• 😀 Oligopolistic markets often experience tension between cooperation and self-interest, with firms interdependent on each other’s actions.
• 😀 Oligopolistic behavior is harder to predict compared to other market structures, and it often involves strategic reactions to competitors’ moves.
• 😀 An oligopoly can sometimes behave as a cartel, where firms collude to fix prices and quantities, though this is illegal in many countries.
• 😀 Oligopolistic firms can also act as sales maximizers, focusing on increasing sales volume rather than maximizing profits, often due to executive compensation structures.
• 😀 Game theory is used to analyze decision-making in oligopolies, with firms considering the potential responses of competitors before taking action.
• 😀 The kinked demand curve illustrates why oligopolistic firms tend not to change prices: they assume different responses from competitors depending on the price direction.
• 😀 In oligopolies, firms often reach a Nash equilibrium, where no player has an incentive to deviate from their strategy, even if it isn’t the best mutual outcome.

Q & A

What does the term 'oligopoly' refer to?

Oligopoly refers to a market structure characterized by a small number of dominant firms that control a large portion of the market. These firms have significant market power, but there may be other smaller firms with minimal market influence.

What is the difference between standardized and differentiated products in an oligopoly?

In an oligopoly, products can either be standardized, like industrial goods (steel, oil, etc.), or differentiated, like consumer goods (cars, cereal, airlines). Standardized products are identical, while differentiated products have distinct features that make them stand out.

What role do barriers to entry play in an oligopoly?

Barriers to entry in an oligopoly make it difficult for new firms to enter the market. These barriers help the dominant firms maintain control over the market, allowing them to have substantial market power and influence over prices and output.

How does price leadership work in an oligopolistic market?

In price leadership, one dominant firm in an oligopoly adjusts its prices, and other firms in the industry follow suit. This system allows firms to maintain stable prices and avoid price wars, although it can be a form of tacit collusion.

What is the significance of the Herfindahl-Hirschman Index (HHI) in analyzing oligopolies?

The Herfindahl-Hirschman Index (HHI) measures market concentration by summing the squares of each firm's market share. A higher HHI indicates a more concentrated market, which is characteristic of an oligopoly. An HHI above 1,800 signals an oligopoly.

Why is predicting behavior in an oligopoly challenging?

Predicting behavior in an oligopoly is difficult because firms are interdependent. Each firm's actions, such as changes in price, output, or advertising, can prompt reactions from rival firms. The long-term outcomes are uncertain due to this interdependence.

How is monopolistic competition different from oligopoly in terms of predictability?

In monopolistic competition, firms can predict their behavior as they operate independently. In contrast, oligopolies involve firms that must consider how rivals will react to their actions, making outcomes harder to predict, especially in the long run.

What are the potential behaviors of firms in an oligopoly?

Firms in an oligopoly can behave in three main ways: as a cartel (colluding to act like a monopoly), as sales maximizers (prioritizing revenue over profits), or as non-cooperative competitors (fighting for market share independently).

What is a cartel and why is it illegal in the United States?

A cartel is a group of firms that collude to fix prices or output to maximize joint profits. In the U.S., cartels are illegal because they reduce competition and harm consumers by keeping prices high.

What is the 'kinked demand curve' in the context of oligopoly, and how does it relate to price stability?

The kinked demand curve in oligopoly suggests that firms face two different demand curves: one where competitors don't respond to price changes (elastic) and one where they do (inelastic). Firms tend to avoid changing prices because they anticipate unpredictable reactions from rivals, leading to price stability in many oligopolies.

What is game theory, and how is it applied in oligopoly behavior?

Game theory is a tool used to analyze strategic interactions where the outcome depends on the actions of multiple players. In oligopoly, firms use game theory to predict competitors' reactions and make decisions accordingly, often leading to Nash equilibria where firms choose strategies that are best for them given others' choices.