Oligopoly

This reading explains how a firm decides whether to operate, shut down or change its scale, and how price and output are set under perfect competition, monopolistic competition, oligopoly and monopoly. It ends with the concentration ratio and the Herfindahl-Hirschman Index, the measures used to identify a market structure.

LOS 12.a — Breakeven, shutdown and scale

Short run versus long run

The short run is the period over which at least one factor of production (usually capital: plant and equipment) is fixed, so the firm cannot change its scale. In the long run every input is variable: leases can lapse and equipment can be sold, so no cost is fixed.

Revenue and cost measures

The breakeven and shutdown rules compare revenue with cost, either in totals or per unit of output ($Q$):

Breakeven and shutdown for a price taker

A firm in perfect competition is a price taker: it can sell any quantity at the market price, so price = AR = MR.

• Breakeven point: $P=AR=ATC$ (minimum of ATC for a price taker), where $TR=TC$ and economic profit is zero.
• Short-run shutdown point: minimum of AVC; below it the firm shuts down.
• Long-run shutdown point: minimum of ATC, the same price as the breakeven point; a firm that expects price to stay below ATC leaves the market.

Both shutdown rules ask one question: does revenue cover the costs the firm could avoid by closing? In the short run only variable costs are avoidable, because fixed costs such as a lease must be paid anyway, so price is compared with AVC. In the long run every cost is avoidable, so price is compared with ATC.

MC cuts both AVC and ATC at their lowest points. When the next unit costs less than the current average, producing it pulls the average down; when it costs more, it pulls the average up. The averages therefore fall while MC lies below them and rise once MC is above them. Minimum AVC comes at a smaller output than minimum ATC. The shutdown point therefore sits below and to the left of the breakeven point, both on the MC curve.

A price taker is too small relative to the market to raise the market price by cutting its own output. Reducing output to push the price up is therefore never a remedy under perfect competition.

Breakeven and shutdown in total terms (all market structures)

For price searchers (downward-sloping demand), price no longer equals MR, so total revenue and total cost are the cleaner test. The same test works for price takers:

1. Compare TR with TC. If $TR\ge TC$, the firm stays in the market in both the short run and the long run; $TR=TC$ is the breakeven point.
2. If $TR<TC$, compare TR with TVC. If $TR\ge TVC$, keep operating in the short run and exit in the long run unless conditions are expected to improve.
3. If $TR<TVC$, shut down now and exit in the long run as well.

With a straight-line TR (price taker) and a cubic-shaped TC there can be two breakeven quantities. Economic profit is largest where the vertical gap $TR-TC$ is greatest, which is where the slope of TC (marginal cost) equals the slope of TR (marginal revenue, here the price). At the lower breakeven quantity MC is below MR, so producing more adds profit; at the upper breakeven quantity MC is above MR, so producing less adds profit. If TC lies above TR everywhere, the firm operates (if at all) where the loss $TC-TR$ is smallest, which is the same as where $TR-TC$ is largest (least negative).

Economies and diseconomies of scale

The long-run average total cost (LRATC) curve shows the lowest ATC achievable at each output level when plant size can be chosen freely; it is the envelope of the short-run average total cost (SRATC) curves for the different plant sizes.

The plant size at which LRATC first reaches its lowest level is the minimum efficient scale. Under perfect competition firms must operate there in long-run equilibrium, where price = minimum LRATC and economic profit is zero; a firm that has chosen a scale with higher ATC earns economic losses and must either move to the minimum efficient scale or leave the industry. A firm still in the economies-of-scale range can become more competitive by expanding output and lowering its unit cost. A firm experiencing diseconomies of scale should reduce its plant size (scale) toward the minimum efficient scale. This is a long-run decision, because plant size cannot change in the short run. The US auto industry is a commonly cited case of diseconomies of scale. Economies of scale are a long-run concept: they describe the LRATC curve. The cost curve of a single existing plant cannot show them.

LOS 12.b — The four market structures

Every firm maximizes profit by producing the quantity at which marginal revenue (MR) equals marginal cost (MC). What differs is the demand curve the firm faces. Demand is elastic when buyers react strongly to a price change (a small price rise loses many sales) and inelastic when they react little:

Why $MR<P$ for a price searcher: to sell one more unit the firm must cut its price, and the lower price applies to every unit it sells, not only to the extra one. MR is the price of the extra unit minus the revenue given up on the units that could have been sold at the higher price.

Quantity	Price ($)	Total revenue ($)	Marginal revenue ($)
1	50	50	50
2	46	92	42
3	42	126	34
4	38	152	26
5	34	170	18
6	30	180	10

Where a market sits on the spectrum depends on five factors: the number and relative size of firms, the degree of product differentiation, the firms' pricing power, barriers to entry and exit, and how much firms compete on things other than price.

Feature	Perfect competition	Monopolistic competition	Oligopoly	Monopoly
Number of sellers	Many	Many	Few	One
Barriers to entry	Very low	Low	High	Very high
Substitute products	Very good substitutes (identical)	Good substitutes, but differentiated	Good substitutes or differentiated	No good substitutes
Nature of competition	Price only	Price, marketing, features	Price, marketing, features	Advertising
Pricing power	None	Some	Some to significant	Significant
Firm demand curve	Horizontal (perfectly elastic)	Downward sloping, relatively elastic	Downward sloping	Downward sloping (market demand)
Long-run economic profit	Zero	Zero	May be positive	May be positive

Perfect competition. Many small firms sell identical (homogeneous) products, barriers to entry and exit are very low, and firms compete only on price. No firm can affect the market price; each can sell all it wants at that price, so charging less than the market price simply lowers its revenue. Example: a regional market for a standard grade of grain. The market price comes from market supply and demand, and the market demand curve slopes downward as usual. Each firm takes that price as given, so the demand curve facing the individual firm is horizontal at it.

Monopolistic competition. Many independent sellers, each a price searcher, with differentiated products (quality, features, branding, marketing) and low barriers to entry. Example: toothpaste or restaurants. Heavy advertising is typical.

Oligopoly. A few sellers, each with a large market share; products may be similar or differentiated; high barriers to entry, often due to large economies of scale. The defining feature is interdependence: each firm's best price and output depend on how its rivals will react. Firm demand slopes downward and can be more or less elastic than under monopolistic competition. Examples: automobiles, commercial aircraft, oil.

Monopoly. One firm is the only seller, buyers have no good substitutes for its product, and very high barriers to entry keep rivals out. The barriers can be patents and copyrights, control of a key resource, or government licensing and regulation (e.g., a local utility). The firm faces the market demand curve and has significant pricing power.

LOS 12.c — Monopolistic competition: price, output and strategy

Features that drive behavior:

1. Many independent sellers. Each firm's share is small, so no firm has significant power over price; firms watch the average market price rather than individual rivals' prices; there are too many firms for collusion (price-fixing) to work.
2. Differentiated products that are close substitutes. Firms compete more on quality, features and marketing than on price. Because close substitutes exist, firm demand is relatively elastic: a firm that raises its price loses many customers.
3. Low barriers to entry: because entering and exiting cost little, new firms arrive whenever existing firms earn economic profit.

Short run. The firm sets its price and output in three steps (left panel below):

1. Find the output $Q^{\ast }$ at which $MR=MC$.
2. Go up from $Q^{\ast }$ to the demand curve and read off the price $P^{\ast }$ that buyers will pay for that quantity.
3. Compare $P^{\ast }$ with ATC at $Q^{\ast }$. Economic profit is $(P^{\ast }-AT{C}^{\ast })\times Q^{\ast }$, positive when price exceeds ATC and negative when it falls short.

Long run. Low barriers attract entrants, and each existing firm's demand shifts left until it is just tangent to ATC: $P=ATC$ and economic profit is zero (right panel). The same outcome can arise without entry if firms keep raising marketing spending (part of ATC) to defend market share. Accounting profit can stay positive even while economic profit is driven to zero.

Long-run comparison with perfect competition: in monopolistic competition $P>MR=MC$, ATC is not at its minimum (excess capacity), price is higher and quantity lower. The offset is product variety, which consumers value.

Product differentiation and brands. The fewer close substitutes buyers see for a product, the steeper (less elastic) its demand curve. A medicine that some patients tolerate better than its rivals faces steeper demand than one brand of shampoo among many, and a new product with no close rival is in the same position. Brand names can signal quality and help consumers choose. There is no well-defined firm supply curve.

LOS 12.d — Oligopoly: interdependence and pricing models

Because oligopolists are interdependent, a price change by one firm is likely to trigger a response that shifts the others' demand curves. The optimal price therefore depends on what a firm assumes about its rivals' reactions. Four models:

1. Kinked demand curve model. Rivals are assumed not to match a price increase but to match a price cut. The firm's demand curve is therefore relatively elastic above the current price $P_K$ and relatively inelastic below it, creating a kink at $P_K$. Each segment of demand has its own MR curve, and the MR of the steep lower segment starts well below the MR of the flat upper segment, so MR drops straight down at $Q_K$ and leaves a gap. Any MC curve passing through the gap leaves the profit-maximizing price at $P_K$ and output at $Q_K$. A rise in costs that keeps MC inside the gap (from MC to $M{C}_2$ in the figure) therefore leaves price and output unchanged, so prices tend to be sticky. Only a cost change that pushes MC above or below the gap moves them.

2. Cournot duopoly model. Two firms with identical MC curves selling a homogeneous product; each chooses its output (quantity) assuming the competitor's output will not change, and the firms choose simultaneously each period. The market price is whatever single price clears the combined output. In the long-run equilibrium both firms sell the same quantity and split the market equally, at a price below the monopoly price but above the perfectly competitive price. With more firms, the price moves toward the competitive price.

3. Stackelberg model (the Stackelberg dominant firm model). Decisions are sequential: the leader chooses its output first and the follower then chooses its own output in response. The leader exploits this first-mover advantage to produce the larger quantity and so gains the larger market share and the larger share of total profits, even in the long run. Both firms still sell the homogeneous product at one common market price; the leader does not charge a different price from the follower.

Exam convention: both models are described with each firm choosing its selling price; a Cournot firm assumes the rival keeps last period's price, and the Stackelberg leader sets its price first, charges a higher price and earns the larger share of total profit. Current practice: both are the quantity-setting models described above, with one market price. Both are rules-based models and fall under strategic games, decision models in which a firm's best choice depends on rivals' expected actions.

4. Nash equilibrium. A Nash equilibrium is reached when no firm can improve its profit by unilaterally changing its choice, given the others' choices. The Cournot outcome is a Nash equilibrium. Absent collusion, the long-run oligopoly equilibrium is a Nash equilibrium.

To find a Nash equilibrium in a payoff table:

1. For each choice the rival could make, mark the firm's best reply, meaning the choice that earns the firm more.
2. Repeat for the rival, taking each of the firm's choices in turn.
3. A cell in which both choices are marked is a Nash equilibrium.

	Osprey: high price	Osprey: low price
Kestrel: high price	Kestrel 700, Osprey 700	Kestrel 250, Osprey 850
Kestrel: low price	Kestrel 850, Osprey 250	Kestrel 400, Osprey 400

Collusion. Collusion is an agreement among competitors to charge a given price or to limit output to agreed levels. If the firms could agree on (and enforce) high prices, both would earn more; side payments can make the collusive outcome better for each firm than the Nash equilibrium. That is the incentive behind a cartel such as OPEC, whose members agree to restrict output to raise price. Members have an incentive to cheat by producing more. Collusion is more likely to hold when there are fewer firms, products are more similar, cost structures are more similar, purchases are small and frequent, retaliation against cheaters is more certain and severe, and there is little competition from outside the cartel. Such agreements are illegal in many countries.

Dominant firm model. One firm with a large market share, owing to its greater scale and lower cost structure, effectively sets the market price; the smaller competitive firms (CFs) take that price as given and produce where their MC equals it. The dominant firm's demand curve is market demand minus the CFs' supply (the CFs supply less at lower prices); the dominant firm sets price where its own MR equals its MC. If CFs cut price, the dominant firm follows; in the long run the CFs reduce output or exit, and the dominant firm's market share rises.

Range of outcomes. Oligopoly price lies between two limits: the collusion (monopoly) price that maximizes joint profit, and the perfectly competitive price that yields zero economic profit. Example: if the joint-profit-maximizing price is $80 and the competitive price is $60, the oligopoly price should be somewhere in between, e.g. about $70, and neither above $80 nor below $60.

As in monopolistic competition, $P>MR=MC$ in equilibrium, there is no well-defined supply curve, and economic profit may be positive in the long run, though it may erode over time.

LOS 12.e — Identifying the market structure and measuring concentration

Identifying the structure

To classify the market a firm operates in, compare the industry with the characteristics of each structure (see the comparison table in Module 12.2): the number of firms and their relative sizes, the barriers to entry, the nature of substitute products (identical, differentiated, none), and the nature of competition (price only versus marketing and features). For an analyst trying to gauge pricing power, these are the factors that matter. Significant interdependence in pricing and output is present in every oligopoly, and some interdependence can appear even under monopolistic competition.

Classifying a market does not, however, show how much pricing power each firm has. The ideal would be to measure the elasticity of firm demand directly, but that is statistically difficult and imprecise. Regulators and analysts therefore use measures based on market shares, called concentration measures, as a proxy for market power and to help identify the market structure. Competition authorities often block mergers when the combined firm's share would be too high.

The two concentration measures

where $s_i$ is firm $i$'s market share as a decimal. With shares in percent, the HHI is expressed on a 0 to 10,000 scale. A market served by one firm has a concentration ratio of 100% and an HHI of 1 (10,000 in percent terms), the highest possible values.

To compute either measure:

1. Rank the firms by market share and keep the N largest. If the data are sales rather than shares, first divide each firm's sales by total industry sales, including the sales of all the smaller firms.
2. For the concentration ratio, add their shares. For the HHI, square each share and add the squares.
3. To assess a merger, combine the merging firms' shares into one firm, re-rank all the firms and repeat steps 1 and 2. The list of the N largest can change: the merged firm may move up the ranking, and if two of the top N firms merge, the next-largest firm moves into the top N.

Firm	Market share
Ashby	28%
Brennan	22%
Corlett	16%
Dunmore	10%
Easton	8%
All others (each below 5%)	16%

Before the merger: 4-firm ratio $=28+22+16+10=76\%$; 4-firm HHI $=0.28^2+0.22^2+0.16^2+0.10^2=0.0784+0.0484+0.0256+0.0100=0.1624$.

After the merger the combined firm has 18%, and the top four are 28%, 22%, 18%, 16%: 4-firm ratio $=84\%$; 4-firm HHI $=0.0784+0.0484+0.0324+0.0256=0.1848$.

Limitations common to both measures

• Neither considers barriers to entry or potential competition. Firms with large market shares may still have little pricing power if entry is easy: would-be entrants stand ready to come in if incumbents raise prices, so firm demand can be quite elastic despite high concentration. A few firms making an easily copied product with no brand or patent protection may therefore behave much like perfectly competitive firms.
• Neither measures the elasticity of firm demand (market power) directly.