Managerial Economics (chapter 9)

Oligopoly and Firm architecture Instructor: Maharouf Oyolola

Oligopoly : Meaning and Sources • Oligopoly is a form of market organization in which there are few sellers of homogeneous or differentiated product. • If there are only two sellers, we have a duopoly. • If the product sold is homogenous, we have a pure oligopoly. • If the product is differentiated, we have a differentiated oligopoly.

• Some oligopolistic industries in the United States are automobiles, Steel, electrical equipment, cigarettes, soaps and detergents. • Some of the products (such as steel and aluminum) are homogenous, while others (automobiles, cigarettes, soaps and detergents) are differentiated.

• Since there are only a few firms selling a homogenous or differentiated product in oligopolistic markets, the action of each firm affects the other firms in the industry and vice versa.

Example • When General Motors introduced price rebates in the sales of its automobiles, Ford immediately followed with price rebates of its own. • Since price competition can lead to ruinous price wars, oligopolists prefer to compete on the basis of product differentiation, advertising, and service.

Concentration ratios • Concentration ratios: measures the degree by which an industry is dominated by a few firms. • These give the percentage of total industry sales of the 4,8, or 12 largest firms in the industry (see page 367 in the textbook) • An industry in which the four-firm concentration ratio is close to 100 is clearly oligopolistic, and industries in which the ratio is higher than 50 or 60 percent are likely to be oligopolistic

The Herfindahl Index (H) • It is also another method of estimating the degree of concentration in an industry. • This is given by the sum of the squared values of the market shares of all the firms in the industry. • The higher the Herfindahl Index, the greater is the degree of concentration in the industry.

Example • If there is only one firm in the industry (monopoly), so that its market share is 100 percent, H=1002=10,000 • If there are 2 firms with market shares of 90 percent and 10 percent H=902+102=8200 • If each firm has a market share of 50 percent H=5000 • With 100 equal-sized firms in the (perfectly competitive) industry, H=100

The Herfindahl Index (H) • The Hefindahl index has become of great practical importance since 1982, when the Justice Department announced new guidelines for evaluating proposed mergers based on this index.

Oligopoly models • We will present - The Cournot Model • -The Cartel arrangements • - The price Leadership model

The Cournot Model • The French economist Augustin Cournot introduced the first formal oligopoly model more than 160 years ago. • This model is useful in highlighting the interdependence that exists among oligopolistic firms.

Cartel Arrangements • There are two types of cartel: The Centralized cartel and the market-sharing cartel. • The market-sharing cartel gives each member the exclusive right to operate in a particular geographical area. • The centralized cartel, which is the most wellknown, is a formal agreement among the oligopolistic producers of a product to set the monopoly price, allocate output among its members, and determined how profits are to be shared. For instance, OPEC

Example • It is often asserted that OPEC was able to sharply increase petroleum prices and profits for its members by restricting supply and behaving as a cartel. • Current members of OPEC: Algeria, Nigeria, Indonesia, Iran, Iraq, Saudi-Arabia, Venezuela, Qatar, Kuwait, Libya and the United Arab Emirates ( OPEC used to have 13 but Ecuador and Gabon left) (see page 375)

Price Leadership • With price leadership, the firm that is recognized as the price leader initiates a price change and then other firms in the industry quickly follow. • The price leader is usually the largest or dominant firm in the industry. • The followers behave as perfect competitors or price-takers.