Unformatted text preview: Oligopoly
Oligopoly: Characteristics and Occurrence Oligopoly exists where a few large firms producing a homogeneous or differentiated product dominate a market. There are few enough firms in the industry that they are mutually interdependent—each must consider its rivals’ reactions in response to its decisions about prices, output, and advertising. Some oligopolistic industries produce standardized products (steel, zinc, copper, and cement), whereas others produce differentiated products diff (automobiles, detergents, and greeting cards). Barriers to entry. Economies of scale may exist due to technology and market share. The capital investment requirement may be very large. Other barriers to entry may exist, such as patents, control of raw materials, preemptive and retaliatory pricing, substantial advertising budgets, and traditional brand loyalty.
1 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 2 L9: L9: Oligopoly and Game Theory (Chapter 11) 11) Oligopoly and Barriers to Entry
Economies of Scale Help Determine the Extent of Competition in an Industry Oligopoly and Barriers to Entry
In addition to economies of scale, other barriers to entry include: • Ownership of a key input • Government–Imposed Barriers
• Patent The exclusive right to a product for a period of 20 years from the date the product was invented. Economies of scale Economies of scale exist when a firm’s long-run average costs fall as it increases output. 3 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 4 1 Oligopoly
Measures of Market Concentration
Herfindahl-Hirschman Herfindahl-Hirschman index (HH): measure of market concentration concentration (max HH = 10,000)
n Herfindahl Index
Sum of the squared percentage market shares for all firms in the industry – Places greater weight upon the larger firms (%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2 HH
i1 S i2 n: number of firms in the industry Si: firm’s market share A high Herfindahl index number indicates a high degree of concentration in one or two firms.
A lower index might mean that the top four firms have rather equal shares of the market 5 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 6 Measures of Market Concentration Oligopoly
Oligopoly Behavior: A Game Theory Overview Oligopoly behavior is similar to a game of strategy, such as poker, chess, or bridge.
Each player’s action is interdependent with other players’ actions. Game theory can be applied to analyze oligopoly behavior. A two-firm model or duopoly will be used. Examples of Oligopolies in Retail Trade and Manufacturing RETAIL TRADE INDUSTRY Warehouse Warehouse Clubs and Superstores Discount Department Stores Hobby, Toy, and Game Stores Radio, Radio, Television, and Other Electronic Electronic Stores Athletic Footwear Stores College Bookstores Pharmacies and Drugstores
FOUR-FIRM FOUR-FIRM CONCENTRATION RATIO RATIO MANUFACTURING INDUSTRY Cigarettes Beer Aircraft Breakfast Cereal Automobiles Dog and Cat Food Computers
FOUR-FIRM FOUR-FIRM CONCENTRATION RATIO RATIO 90% 88% 70% 62% 62% 58% 47% 99% 90% 85% 83% 80% 58% 45% 7 8 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 2 Using Using Game Theory to Analyze Oligopoly Oligopoly
Game theory The study of how people make decisions in situations where attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms. Key characteristics of all games: Rules that determine what actions are allowable. determine what actions are allowable Strategies that players employ to attain their objectives in the game. Payoffs that are the results of the interaction among the players’ strategies. Business strategy Actions taken by a business firm to achieve a goal, such as maximizing profits. Asymmetric Information
Asymmetric Asymmetric Information: market situation in which one party in a transaction has more information than the the other party. Leads to many problems in markets.
Too much or too little production Difficult contracting Possible fraud Market may dissappear 9 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 10 Markets with Asymmetric Information
Adverse Adverse Selection: prior to transaction, one party may know know more about the value of a good than the other. Moral Moral Hazard: transaction changes the incentives of a party because it cannot be monitored after the transaction. transaction. Games of Particular Relevance in Economics
Prisoners’ Dilemma TwoTwo-Person, Non-Zero-Sum, Non-Zero-Sum, NonNon-cooperative Always has a dominant strategy Equilibrium is stable Confessing Confessing is a dominant strategy for each player for each player. Best Best strategy no matter what other other player chooses Each Each player has no incentive to unilaterally unilaterally change his strategy. 11 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 12 3 Games of Particular Relevance in Economics
Another Another Example of Prisoners’ Dilemma Dilemma (Low/Low) (Low/Low) is a stable equilibrium. No incentive for either either firm to deviate. Better Better off at (High/High) but it is not stable. Each firm has an incentive to deviate. (High/High) (High/High) would be an equilibrium if the firms were allowed allowed to cooperate. Games of Particular Relevance in Economics
Beach Kiosk Game
TwoTwo-Person, Zero-Sum, Non-cooperative ZeroNonZero-Sum: Zero-Sum: the benefits and losses to all players sum to the same value. The gain of one player is offset by the loss of another player, resulting resulting in the sum of zero.
Chess: Chess: impossible for both players to win or to lose. Thus, it is a zero-sum zero-sum game; game; one person will lose and one person will win. The win (+1) + the loss ((1) 1) = 0. Two Two companies provide snacks and sunscreen on a beach.
Beachgoers spread themselves out evenly along the beach. Both Both companies ultimately locate at the midpoint of the beach, otherwise the other company has an advantage (closer to more beachgoers) beachgoers) Real life example: location of gas stations
13 14 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 Games of Particular Relevance in Economics
Repeated Repeated Game: game is played repeatedly over a period of time. time.
In In a repeated game, equilibria that are not stable may become that stable stable due to the threat of retaliation. Games of Particular Relevance in Economics
Repeated Repeated Game: game is played many times, and equilibria that are not stable may become stable due to the threat of retaliation. retaliation. Assume Assume (High, High) equilibrium reached and both firms start off charging the high price. In the next period if one firm cheats (charges low price) it In the next period, if one firm cheats (charges low price), it receives receives 600 in that period. Other Other firm will change to low prices in the next period to “retaliate” “retaliate” and both will end up at (Low, Low) equilibrium. Thus, Thus, incentive exists not to “cheat” in a repeated game and (High, High) is a viable equilibrium, though it is not in a singlesingle-period game. If If number of periods are fixed, both firms will have incentive to cheat (charge low price) in the last period due to lack of threat of retaliation, which will then allow them to cheat in all16 periods. periods. Principles of Microeconomics, SP 2010 Non-cooperative, non-zero-sum game (both players may win non sum game (both players may win or or lose. Gains and losses are either less than or more ains than than zero. The outcome would be either equally good or he ). equally bad for the parties ).
Seller Seller wants to sell at highest price, buyer wants to buy at lowest lowest price. 15 Principles of Microeconomics, SP 2010 4 Games of Particular Relevance in Economics
Simultaneous Simultaneous games are games in which players make make their strategy choices at the same time. Sequential Sequential games are games in which players make their their decisions sequentially. In sequential games, the first mover may have an fi advantage. advantage. Another Example
The figure illustrates the profit payoffs for firms in a duopoly in an imaginary athletic-shoe industry. Pricing strategies are classified as high-priced or low-priced, and the profits in each case will depend on the rival’s pricing strategy. Mutual interdependence is demonstrated by the following: RareAir’s best strategy is to have a low-price strategy if Uptown follows a high-price strategy.
However, Uptown will not remain there, because it is better for Uptown to follow a low-price strategy when RareAir has a lowprice strategy. Each possibility points to the interdependence of the two firms. This is a major characteristic of oligopoly. 17 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 18 Another Example
Another conclusion is that oligopoly can lead to collusive behavior. In the athletic-shoe example, both firms could improve their positions if they agreed to both adopt a high-price strategy. RareAir’s Price Strategy High Low Uptown’s Price Strategy However, such an agreement is collusion and is a violation of U.S. antitrust laws. A
High $12 B
$6 $15 If collusion does exist, formally or informally, there is much incentive on the part of both parties to cheat and secretly break the agreement.
For example, if RareAir can get Uptown to agree to a high-price strategy, then RareAir can sneak in a low-price strategy and increase its profits.
19 Principles of Microeconomics, SP 2010 $12 C
Low $6 D
$8 $8 $15 20 Principles of Microeconomics, SP 2010 5 RareAir’s Price Strategy High Low RareAir’s Price Strategy High Low Uptown’s Price Strategy Uptown’s Price Strategy A
High $12 B
$6 $15 $12 Greatest Combined Profit A
High $12 B
$6 $15 $12 Independent Actions Stimulate Response C
Low $6 D
$8 $8 C
Low $6 D
$8 $8 $15 $15 21 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 22 RareAir’s Price Strategy High Low
Independent Actions Stimulate Response RareAir’s Price Strategy High Low Uptown’s Price Strategy High Uptown’s Price Strategy A
$12 $12 B
$6 $15 A
High $12 B
$6 $15 $12 Collusion Invites a Different Solution C
Low $6 D
$8 $8 Gravitating to the Worst Case C
Low $6 D
$8 $8 $15 $15 23 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 24 6 OLIGOPOLY BEHAVIOR
RareAir’s Price Strategy High Low RareAir’s Price Strategy High Low Collusion Invites a Different Solution Uptown’s Price Strategy High Uptown’s Price Strategy A
$12 $12 B
$6 $15 A
High $12 B
$6 $15 $12 Collusion Invites a Different Solution But, the incentive to cheat is very real
Low $6 D
$8 $8 C
Low $6 D
$8 $8 $15 $15 25 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 Example
Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit figures are in thousands. a. Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries. b. Assuming no collusion between C and D, what is the likely pricing outcome? In view of your answer to b, explain why price collusion is mutually profitable. Why might there be a temptation to cheat on the collusive agreement? Example
The matrix shows the four possible profit outcomes for each of two firms, depending on which of the two price strategies each follows. Example: If C sets the price at $35 and D at $40, C’s profits will be $59,000, and D’s $55,000. 27 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 28 7 Oligopoly and Advertising Product development and advertising campaigns are more difficult to combat and match than lower prices. Oligopolists have substantial financial resources with which to support advertising and product development. Advertising can affect prices, competition, and efficiency both positively and negatively. Oligopoly Oligopoly
The economic efficiency of an oligopolistic industry is hard to evaluate. Allocative and productive efficiency are not realized because price will exceed marginal cost and, therefore, output will be less than minimum average-cost output level. Informal collusion among oligopolists may lead to price and output decisions that are similar to that of a pure monopolist while appearing to involve some competition. The economic inefficiency may be lessened because Foreign competition has made many oligopolistic industries much more competitive when viewed on a global scale. Oligopolistic firms may keep prices lower in the short run to deter entry of new firms. Over time, oligopolistic industries may foster more rapid product development and greater improvement of production techniques than would be possible if they were purely competitive. Advertising reduces a buyers’ search time and minimizes these costs. By providing information about competing goods, advertising diminishes monopoly power, resulting in greater economic efficiency. By facilitating the introduction of new products, advertising speeds up technological progress. If advertising is successful in boosting demand, increased output may reduce long-run average total cost, enabling firms to enjoy economies of scale. Not all effects of advertising are positive.
Much advertising is designed to manipulate rather than inform buyers. When advertising either leads to increased monopoly power, or is self-canceling, 29 economic inefficiency results.
Principles of Microeconomics, SP 2010 30 Principles of Microeconomics, SP 2010 Oligopoly
The Beer Industry: Oligopoly Brewing? In 1947 there were 400 independent brewers in the U.S.; by 1967 the number had declined to 124; by 1987 the number was 33. In 1947, the five largest brewers sold 19 percent of the nation’s beer; currently, the big four brewers sell 87 percent of the total. Anheuser-Busch and Miller alone sell 69 percent. Demand has changed. Tastes have shifted from stronger-flavored beers to lighter, dryer products. Consumption has shifted from taverns to homes, which has meant a has shifted from taverns to homes, which has meant different kind of packaging and distribution. Supply-side changes have also occurred. Technology has changed, speeding up bottling and can closing. Large plants can reduce labor costs by automation. Large fixed costs are spread over larger outputs. Mergers have occurred but are not the fundamental cause of increased concentration. Advertising and product differentiation have been important in the growth of some firms, especially Miller. 31
Principles of Microeconomics, SP 2010 A major cause of persistent dumping is international price major discrimination. This can occur when a firm can separate its total market into two or more markets with different elasticities of demand for for its product The The firm can increase profits by charging different prices in each market. In international price discrimination, the firm is serving both a domestic market and an export market domestic The demand curves indicate that the firm faces more elastic demand The demand curves indicate that the firm faces a more elastic demand for its product in its export market, indicating that firm has more market power in the home market than in the export market. Firm will maximize its profit in each market by producing and selling level of output at which marginal cost equals marginal revenue. Note that the price charged in the export market is less than the price charged in the home market for the same unit of cloth. Could be subjected to the untidumping laws of the importing country.
32 Principles of Microeconomics, SP 2010 PRICE DISCRIMINATION 8 PRICE DISCRIMINATION
International Price Discrimination
Price of Cloth Price of Cloth Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence
Mutual Mutual Interdependence: relatively few sellers create a situation where each is carefully watching the others others as it sets its price. Kinked Demand Curve Model
Basic Basic Assumption: competitor will follow a price decrease but will not make a change in reaction to a price price increase. PH PE MC MC DE MRH DH QE MRE Quantity of Cloth, Export Market 33 Principles of Microeconomics, SP 2010 QH Quantity of Cloth, Home Market 34 Principles of Microeconomics, SP 2010 Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence
If If reduce price and competitors match the price cut then move along more inelastic demand segment segment Di. If If increase price and competitors do not follow then move along the more more elastic segment Df. Marginal Marginal Revenue curve will be discontinuous where the kink occurs occurs (at point A).
Competitors do not match price increases Competitors match price cuts Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence
Price Price Leader: one firm in the industry takes the lead in in changing prices.
The The price leader assumes that firms will follow a price increase. It assumes that firms may follow a reduction in price but will not go even lower in order not to in price, but will not go even lower in order not to trigger trigger a price war. Non-Price Non-Price Leader: firm that leads the differentiation of of products on other, non-price attributes. non- 35 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 36 9 Competing in Imperfectly Competitive Markets
Non-Price Non-Price Competition: any effort made by firms other than a change in the price of the product in question in order to change change the demand for their product. Efforts intended to influence the non-price determinants of non-price demand demand
Tastes and preferences and preferences Income Prices of substitutes and complements Number of buyers Future expectations of buyers about the product price Competing in Imperfectly Competitive Markets
Non-price Non-price variables: any factor that managers can control, any influence, or explicitly consider in making decisions affecting the the demand for their goods and services. Advertising Promotion Location and distribution channels and distribution channels Market segmentation Loyalty programs Product extensions and new product development Special customer services
Pre-emptive Pre-emptive new product announcements 37 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 38 Competing in Imperfectly Competitive Markets
Equalizing Equalizing at the margin: general economic concept which managers managers can use to help make an optimal decision. Can Can be used to decide the optimal expenditure level of a nonnon-price factor that influences a firm’s demand. MR = MC is an example of equalizing at the margin. Revenue and costs may be realized over a long period of time. Firm must adjust MR, MC for the time value of money. Strategy: Strategy: The Fundamental Challenge for Firms Firms in Imperfect Competition
Strategy Strategy is important when firms are price makers and and are faced with price and non-price competition as non-price well well as threats from new entrants into the market. More important for firms in imperfectly competitive More markets markets than those in perfectly competitive markets or or monopoly markets. 39 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 40 10 Strategy: Strategy: The Fundamental Challenge for Firms Firms in Imperfect Competition
Economics Economics and strategy can be said to be linked almost by definition definition Managerial Managerial Economics: the use of economic analysis to make business decisions involving the best use of an organization scarce resources organization’s scarce resources. Strategy: Strategy: the means by which an organization uses its scarce resources to relate to the competitive environment in a manner that is expected to achieve superior business performance performance over the long run. Strategy: Strategy: The Fundamental Challenge for for Firms in Imperfect Competition
Industrial Industrial Organization: studies the way that firms and markets are organized and how this organization affects the economy from the viewpoint of social welfare. welfare.
How How does industry concentration affect the behavior of firms firms competing in the industry? 41 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 42 Strategy: Strategy: The Fundamental Challenge for for Firms in Imperfect Competition
Structure-ConductStructure-Conduct-Performance (S-C-P) Paradigm (SStructure affects conduct which affects performance Structure: Structure: number of firms in industry, conditions of entry, entry, product differentiation Conduct: pricing strategies and other activities such as advertising, product development, legal tactics, choice of of product, and potential for collusion Performance: maximization of society’s welfare Sources
Paul G. Keat and Philip K.Y. Young, Managerial Economics, 5th Edition, Prentice Hall, 2006. Mark Hirschey, Managerial Economics, 10th Edition, South-Western, 2003. McConnell and Stanley Brue McConnell and Stanley Brue, Microeconomics, 16th 16th edition, 2006. R. Glenn Hubbard and Anthony P. O'Brien, Microeconomics,1st edition 2006. 43 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 44 11 ...
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