Unit 11: Oligopoly

Jim’s Guide for Unit 11: Oligopoly

Picture of historical marker denoting Adam Smith's birthplace

 

People of same trade seldom meet together even for merriment and diversion but conversation ends a conspiracy against the public or in some contrivance to raise prices.

– Adam Smith, The Wealth of Nations

 

 

 

images of monopoly game money and property deedsYou, like most students, have probably played the board game Monopoly at some time (personally, I always wanted to be the race car token). Technically speaking, the game is misnamed. If the game had been invented by an economist, she would probably have named it Oligopoly. As soon as someone actually achieves a monopoly in the game Monopoly (meaning they own all the property), the game is over – the monopolist has won. But until a monopoly is achieved, the game actually consists of just a small number of players, each trying desperately to become the monopolist by outwitting each other, but each also having to watch out for what the other players are doing. The real-world market structure called oligopoly works pretty much the same as the board game of Monopoly.

In this unit we will study oligopoly. We will also be introduced to an analytical tool called game theory. Game theory is the tool economists use when analyzing how oligopolies work. Analyzing a market using game theory isn’t as much fun as actually playing a game, but it can be very interesting.

We have these main objectives:

  • List the characteristics of oligopoly and give examples.
  • Describe and show, using a simple Prisoner’s Dilemma game, what game theory is about and how it is applied to the analysis of oligopoly.
  • Explain the dynamics of what happens in oligopoly.
  • Describe how well oligopoly achieves social goals of productive efficiency, allocative efficiency, and innovation.

Oligopoly: Getting Close to Monopoly

In earlier units I used the graphic on the right to describe the relationship between the different market structures. Perfect Competition involves many small firms competing purely on price. Monopolistic Competition also involves many firms, but now the firms are competing through product differentiation so that some monopolistic profits are possible. At the other extreme is the very profitable Monopoly, where no competition exists.

In this unit we consider what happens when the number of firms has dropped to only a small number. If there’s only one firm, that’s a Monopoly, and no competition exists. What happens if there are only 2 firms though? Or if there are only 3 or 4 firms? Do they still compete? How? And what’s the outcome? These are the questions we consider in looking at Oligopoly.

Oligopoly: The Critical Condition (and the Implications)

The essential feature of oligopoly is that there are only a small number of firms. All the other characteristics of oligopoly result from this fact.

Since there only a few firms, then logically, each firm is relatively large compared to the total market. For example, when there are 500 firms each firm has less than 0.2% market share on average. But if there are only 4 firms, then each firm has an average market share of 25%. Market shares that large mean that each firm’s decisions about price and quantity to produce can easily affect the overall market supply. Change the market supply and you change market equilibrium price for everybody. In other words, in oligopoly, each firm knows it has the power to lower the market price that it’s competitors get paid. Even more significant, each firm knows that if it raises price and the few other firms that exist follow suit, then the market price will rise to almost the price a monopolist would charge. This means that the results of each firm depend on what the other firms decide. Each firm is therefore interdependent.

The Nature of Competition Changes – The Dream of Monopoly Beckons

Each firm is interdependent, meaning each firm’s profits depend not only on what price and quantity it chooses, but also on what price and quantity the small number of competitors chooses. This changes the nature of competition in oligopoly dramatically. In Perfect Competition, each firm competes on price — survival depends on having low costs and being efficient. In Monopolistic Competition, success is possible by understanding the customer better and developing better products and advertising. But in Oligopoly, success depends largely on predicting what the other firm(s) are going to do and then making an optimal decision on price, quantity, or product design.

In oligopoly, products may be homogenous or they might be differentiated. Firms might compete aggressively on price, or they might not. It all depends on what each firm thinks the other firms will do and what options that leaves them. Because there are only a small number of firms, a new possibility exists that is totally impractical in Perfect or Monopolistic Competition. In these very competitive markets, there are too many firms to be able to coordinate the decisions of so many firms. That’s not necessarily the case in Oligopoly. Lurking in the back of the mind of every oligopolist is the knowledge that IF the few competitors were eliminated then the firm would be a monopolist and earn high profits. Also lurking is the knowledge that IF the few firms in the oligopoly could only coordinate their price and production decisions, then the group of them could earn monopoly profits together – they could be a shared monopoly. But, also lurking in the mind of every oligopolist is the uncertainty about whether the other firms will cooperate.

Strategic Thinking

In Oligopoly, everything depends on what each firm chooses. The market could end up resembling a shared monopoly with each firm earning a share of what a monopolist would have made. Or, the market could end up in bloody price-cutting competition as each firm undercuts the others in an attempt to force the other firms to lose so much money they go out of business, leaving only one firm left as monopolist. Or, the market could become stagnant and resistant to change as each firm is reluctant to “rock the boat” for fear of how the competitors will react. It all depends on what the firms choose.

But what each firm chooses depends on what that firm thinks the other firm will choose. Consider the situation of a duopoly (2 firm industry), a type of oligopoly, with Cogswell Cogs, Inc. vs. Spacely Sprockets. Before Cogswell chooses a price and production quantity, it needs to know the market price. But market price depends on what price both Cogswell and Spacely pick. So Cogswell needs to know Spacely’s price before it can choose its own best price. So Cogswell bases its price on what Cogswell thinks Spacely will charge. But Spacely bases its price on what Spacely thinks Cogswell will charge. But Cogswell knows that Spacely will do that, so Cogswell needs to know what Spacely thinks Cogswell will charge — which is based on what Spacely thinks Cogswell will think that Spacely thinks Cogswell will charge. And on and on. Each firm needs to “get inside the head” of the competitors. This is called strategic thinking.

Game Theory: Analyzing Strategic Thinking

image of man seeing reflection in mirror of himself seeing his reflection in a mirrorStrategic thinking is a bit like looking at the image of a mirror in a mirror. You see an image of a mirror inside each image of a mirror in the mirror. Our ordinary graphic tools and models aren’t much help in analyzing this kind of situation. So economists (and other social scientists & mathematicians) have developed techniques called game theory. The Oscar-winning movie in 2001, A Beautiful Mind, is the biography of the John Nash, the economist who helped co-invent game theory. John Nash also won the Nobel prize for his contributions of game theory to economics.

In game theory, economists describe a situation or market by using the metaphor of a “game”. Just like a real-life game, there “rules” that are defined, players identified, possible strategies or decisions by those players, and then outcomes (or “payoffs”) are identified as the result of different possible strategies. These various strategies are analyzed, often using some sophisticated mathematical techniques, and the “best” options are identified for each player. Sometimes, the best choices for each individual player lead to outcomes that are less than attractive for the whole group.

Oligopolies lend themselves well to analysis using game theory. Some of the more common “games” that are played in real-world oligopolies are Follow-the-leader, Collusion, Price Signaling, and even Gin game (firms keep buying up smaller companies and then selling them). One particular game situation is called Prisoner’s Dilemma. It is a famous game theory “game” and we will study it closely in this unit.

Oligopoly Performance: Uncertain

Because everything in oligopoly depends upon what each firm thinks the other firms will do, it’s very difficult to predict the outcome (pricing or output) of any particular oligopoly. It all depends on who is “playing” the game. Oftentimes, the “game” itself can change. For example, in the 1950’s through the 1970’s, the U.S. Big Three automakers (Ford, GM, and Chrysler) played a very stable game of “follow the leader”. The leader was GM who set pricing levels and Ford & Chrysler followed. Other rules of the game included:

  • It’s OK to compete on styling and horsepower.
  • It’s not fair to compete on labor costs, productivity, quality, or fuel efficiency.
  • The United Auto Workers (UAW) made sure all three companies had similar labor costs – for which the UAW was rewarded with above-average wages.

Unfortunately for the Big Three, the game expanded in the late 1970’s-1980’s to include Toyota, Honda, Nissan, Volkswagen, and Mercedes. These foreign firms didn’t “understand” these unwritten rules and began to compete on cost, quality, and efficiency. By the time Big Three executives understood the game had changed (I’m not sure they really know yet!), they had lost enormous market share and profits to the foreign companies, most of whom have now become large U.S. producers.

Oligopoly in the Real-World

Mergers and acquisitions by large corporations, financed by Wall Street, have greatly expanded the number of industries/markets that are effectively oligopolies. In the past 25 years, a wave of consolidation in many industries has reduced what used to be monopolistic competitions into oligopolies. For example, consider hair cutting and styling. Twenty years ago, barber shops and hair styling salons were definitely a monopolistic competition: thousands of individual salons each with a slightly different service depending on who the barber/stylist was. Now, despite the appearance of hundreds of brand names, the industry is on its way to consolidating into an oligopoly. It is interesting to check out this page where a website called Oligopoly Watch describes Regis Corp., one of the biggest players in the hair cutting business. Check it out, you’ll be surprised at how many firms you thought were independent are in fact owned by the same corporation.

This has happened in many industries. Consumer products in particular are very concentrated in the hands of a few large, global corporations. Much of this oligopolistic consolidation has happened in just the last 25 years. For a look at some major corporations and the many brands they own, check out the Oligopoly Watch Company Profiles.

Firms in oligopoly find that the most profitable strategy is not to focus on customers, new products, or new technology. Instead, firms in oligopoly seek to limit the entry of new competitors and to find ways to coordinate the behavior of the remaining few mega-firms. In this way the entire oligopoly industry can behave the way a single monopolist would behave: driving up prices, restricting output, and earning more-than-necessary economic profits. Increasingly this means spending large sums of money on lobbying, campaign contributions, and “political speech advertising”. While the sums spent to get their way in government may dwarf the money that individual consumers or households can spend, the sums spent by these firms are actually extremely profitable “investments”.¬† They are “investments” in the sense that future profits are much higher as a result of the money spent on government, although no improved productivity or consumer benefits result. Examples of large oligopolies that have significantly increased their profitability in the last 20 years as a result of these “investments” in manipulating government include:

  • “Big Pharma”, the large prescription drug companies (Medicare drug benefit, ACA Healthcare reform bill, patent laws, international trade treaties)
  • “Big Oil” (environmental regs, leases on federal land, exemption from liability, tax subsidies)
  • Wall Street and Big Banks (the bank bailout, lax enforcement of securities laws, subsidies, preferred tax rates, restrictions on competition, international trade treaties, elimination of decades-old regulations)
  • Hollywood and the commercial Music business (extension of copyright laws, international trade treaties, preferred tax rates and subsidies)

What’s Next?

This unit concludes our study of market structures, and with it Part III of the course. Oligopolies are concentrations of economic power. Often the firms in an oligopoly seek government assistance to help regulate prices or keep competitors out. For example, think of how just a few firms in Hollywood, the large music studios, have manipulated the U.S. Congress into extending copyright protection for music in recent years. The objective has been to support Hollywood prices and profits while preventing competitive forms of music distribution such as peer-to-peer. Oligopolies also are important in the increase in international trade called globalization.

In the next part, we start looking beyond markets to examine how government makes decisions that affect markets. We also start looking beyond our borders at International Trade and Globalization.

Business will be either better or worse.
– Calvin Coolidge, 29th President of the U.S.


To finish this unit, be sure to:

  1. Read the textbook (see the Reading Guide for what chapters and pages to read in the textbook or other source)
  2. Take a look at any tutorials, videos, or articles in Closer Look
  3. Try the practice quiz
  4. Complete the Graded assignments in your school’s Learning Management System