Discussion 2

1. Small Number of Firms: An oligopoly exists when the few top firms account for an overwhelming percentage of total industry output.

2. Interdependence: This is also called strategic dependence, which is a situation in which one firm’s actions with respect to output, price, quality, advertising, and related changes may be strategically countered by one or more other firms in the industry. Such dependence can only exist when there are a few major firms in an industry.

B. Why Oligopoly Occurs

1. Economies of Scale: The strongest reason that has been offered for the existence of oligopoly is economies of scale. Economies of scale are defined as a production situation in which a doubling of output results in less than a doubling of total costs. The firm’s average total cost curve will slope downward as it produces more and more output. Average total cost can be reduced by continuing to expand the scale of operation.

2. Barriers to Entry: These barriers include legal barriers, such as patents, and control and ownership over critical supplies.

3. Oligopoly by Merger: A merger is the joining of two of more firms under a single ownership or control. There are two types of mergers. A horizontal merger involves firms producing or selling a similar product. A vertical merger occurs when one firm merges with another from which it purchases an input or to which it sells an output.

II. Measuring Industry Concentration

A. Concentration Ratio: The percentage of all sales contributed by the leading four or leading eight firms in an industry: sometimes called the industry concentration ratio. The concept of an industry is necessarily arbitrary. As a consequence, concentration ratios rise as we narrow the definition of an industry and fall as we broaden it. (See Table 26-1 and Table 26-2.)

B. The Herfindahl-Hirschman Index:

1. Limitation of the Centration Ratio: Concentration ratios fail to reflect differences in the relative sizes of firms within an industry. (See Table 26-3.)

2. Defining and Computing the Herfindahl-Hirschman Index: The sum of the squared percentage sales shares of all firms in an industry. (See Table 26-3.)

III. Strategic Behavior and Game Theory: When there are relatively few firms in an industry, each reacts to the price, quantity, quality, and new product innovations that the others undertake. Each oligopolist has a reaction function, which is the manner in which one oligopolist reacts to a change in price (or output or quality) of another oligopolist. Game theory is the analytical framework in which two or more individuals, companies, or nations compete for certain payoffs that depend on the strategy that the others employ. The plans made by these individuals are known as game strategies.

A. Some Basic Notions about Game Theory: Games can be cooperative or noncooperative. They are classified by whether the payoffs are negative, zero, or positive. A cooperative game is one in which players explicitly collude to make themselves better off. With firms, it involves companies colluding in order to make higher than competitive rates of return. A noncooperative game is a game in which players neither collude nor negotiate in any way. Applied to firms, it is a situation in which there are few firms and each firm has some ability to change price. A zero-sum game is a game in which one player’s losses are exactly offset by the other player’s gains. A negative-sum game is a game in which both players are worse off at the end of the game. A positive-sum game is a game in which both players are better off at the end of the game.

1. Strategies in Noncooperative Games: A strategy is any rule that is used to make a choice, e.g., always pick heads. The goal is to devise a dominant strategy. A dominant strategy will yield the highest benefit for the player using it. These strategies are generally successful no matter what actions other players take.

B. The Prisoner’s Dilemma: An example of game theory in which two people involved in a bank robbery are caught.

1. The Structure of the Prisoner’s Dilemma: The payoff matrix shows two possibilities for each of the two prisoners: “confess” and “don’t confess.” (See Figure 26-1.)

C. Applying Game Theory to Pricing Strategies: An example of the use of game theory is presented. (See Figure 26-2.)

D. Opportunistic Behavior: Actions that ignore possible long-run benefits of cooperation and focus solely on short-run gains. This kind of behavior can be contrasted to tit-for-tat strategic behavior when repeat transactions are likely. Here, a player will behave well as long as others do likewise.

IV. The Cooperative Game: A Collusive Cartel: This section looks at why firms collude to increase prices, how they work to do so, and what they have to do to be successful.

A. Collusive Production and Pricing and the Seeds of a Cartel’s Undoing: Firms in an industry must collude if they decide to form a cartel so that they can achieve the same outcome as a monopoly and increase their profits above a competitive level.

1. Collusive Price and Output Determination by Firms in a Cartel: To operate a profit-maximizing cartel, member firms must be willing and able to set up and maintain an arrangement for coordinating overall cartel production at a common price. Then they can share the maximized profits. (See Figure 26-3.)

b. Boosting Economic Profits via a Collusive Cartel Price: If firms in the market form a joint cartel enterprise, they coordinate their production and regard the sum of their marginal costs as the overall marginal cost of the cartel. All firms will agree to charge the price at which the market marginal revenue equals the cartel’s overall marginal cost. (See Figure 26-3 (b).)

c. Profit-Maximizing Collusion Requires Reducing Total Production: The cartel production is lower than output under perfect competition. Firms thereby will raise its economic profits from zero under perfect competition to a positive amount. (See Figure 26-3.)

2. The Temptation to Cheat on a Cartel Agreement: Any one member of the cartel can increase its total own revenues and profits by lowering price slightly as long as all of the other firms in the cartel honor their agreement to reduce production.

B. Enforcing a Cartel Agreement: There are four conditions that make it more likely that firms will be able to coordinate their efforts to restrain output successfully and deter cheating.

1. A Small Number of Firms in the Industry: The smaller the number of firms in the industry, the easier it is to prevent cheating.

2. Relatively Undifferentiated Products: If the cartel members sell a homogeneous or nearly homogeneous product, it is easier for them to agree on how much each firm should reduce production.

3. Easily Observable Prices: If the terms of industry transactions are publically available, cartel members can more readily observe a firm’s efforts to cheat.

4. Little Variations in Prices: Stable demand and cost conditions help a cartel form and continue to operate effectively.

C. Why Cartel Agreements Usually Break Down: Most cartels usually do not last for more than 10 years. Monopoly profits attract new entrants to the industry, and price falls. In addition, downturns in overall economic activity cause the cartel’s demand and thus the demand for all member firms to decrease. This increases the incentive to cheat on the cartel agreement.

V. Network Effects and Two-Sided Markets: A network effect is a situation in which a consumer’s willingness to purchase a good or service is influenced by how many others also buy or have bought the item.

A. Network Effects and Market Feedback: Industries in which network effects are important can experience sudden surges in growth as well as significant and sudden reversals.

1. Positive Market Feedback: A tendency for a good or service to come into favor with additional consumers because other consumers have chosen to buy them.

2. Negative Market Feedback: A tendency for a good or service to fall out of favor with more consumers because other consumers have stopped purchasing the item.

B. Network Effects and Industry Concentration: In an industry that produces and sells products subject to network effects, oligopoly is likely to emerge. The reason is that in an industry that sells differentiated products subject to network effects, when the products of a few firms catch on, these will capture the bulk of the sales of the industry.

C. Two-Sided Markets, Network Effects, and Oligopoly: A two-sided market is a market in which an intermediary firm provides services that link groups of producers and consumers.

1. Types of Two-Sided Markets: In a two-sided market, the intermediary firm is a platform and the groups of producers and consumers are end users. (See Figure 26-4.)

a. Audience Seeking Markets: Media platforms link advertisers to audiences.

b. Matchmaking Markets: Platform firms, such as real estate agents and online dating firms, bring end users together.

c. Transaction-based Markets: Banks, credit- and debit-card companies are platforms that finalize transactions between retailers and card holders.

d. Shared-Input Markets: Groups of end users utilize a key input obtained from a platform.

2. Network Effects in Two-Sided Markets: Network effects are a common feature of two-sided markets. Groups of end users benefit from the network effects in different types of two-sided markets.

3. Two-Sided Oligopolistic Pricing: Oligopoly is the most common industry structure in two-sided markets with network effects. In these markets, a few firms are often able to capture most of the payoffs associated with market feedback. In a two-sided market, platform firms that set prices must consider group differences in network effects. In some two-sided markets, platform firms maximize profits by charging an explicit price of zero or even negative prices, or subsidies, for one group of end users.

D. Comparing Market Structures: Market structures are compared in Table 26-4.