Transcript Oligopoly is a market

Oligopoly
Chapter 10
In This Chapter…
10.1. Revisit Market Structure and Market
Power
• What determines how much market power a
firm has?
10.2. Profit Maximization Under Oligopoly (Kinked
Demand Curve and Sticky Prices)
• How do firms set prices and outputs?
10.3. Coordination, Problems and the Government
• What problems oligopolists have in
maintaining price and output levels?
10.1. Revisiting Market Structure
and
Market Power
Market Structure and Market
Power
 We classify firms into specific market
structures based on the number and
relative size of firms in an industry.
– Market structure – The number and
relative size of firms in an industry.
 Most firms possess some market power.
Degrees of Power
 In imperfect competition, individual firms
have some power in a particular product
market.
 Oligopoly is a market in which a few firms
produce all or most of the market supply
of a particular good or service.
Degrees of Power
 Oligopoly is a market in which a few firms
produce all or most of the market supply of
a particular good or service.
 Examples:
– Sports Shoes
– Cereals Producer
– Auto Manufacturers
Characteristics of Market
Structures
Market Structure
Characteristics
Perfect
Competition
Monopolistic
Competition
Oligopoly
Number of firms
Very large
number
Many
Few
Barriers to entry
None
Low
High
Market power
(control over price
None
Some
Substantial
Type of product
Standardized Differentiated Standardized
or
differentiated
Characteristics of Market
Structures
Market Structure
Characteristics
Perfect
Competition
Duopoly
Monopoly
Number of firms
Very large
number
Two
One
Barriers to entry
None
High
High
Market power
(control over price
None
Substantial
Substantial
Type of product
Standardized Standardized Unique
Unique
or
differentiated
One
Determinants of Market Power
 Market power of a firm is a function of:
•
•
•
•
The Number of producers
The Size of each firm
The Barriers to entry
The Availability of substitute goods
Determinants of Market Power
Market power increases:
• The fewer the number of firms in the
market.
• The larger the relative size of the firms
in the market.
• The higher the entry barriers.
• The fewer the substitutes.
Determinants of Market Power
 Barriers to entry determine to what extent
the market is a contestable market.
– Contestable market – An imperfectly
competitive industry subject to
potential entry if prices or profits
increase.
Measuring Market Power
 The standard measure of market power is
the concentration ratio.
 It relates the size of firms to the size of the
market.
– What proportion of the market supply is
concentrated in the hands a few firms?
Concentration Ratio
 Concentration Ratio:
– is the proportion of total industry output
produced by the largest firms (usually
the four largest).
• Market power isn’t necessarily
associated with firm size.
• ….because a small firm could possess
a lot of power in a relatively small
market.
The Herfindahl-Hirshman Index
 The Herfindahl-Hirshman Index (HHI):
is a measure of the concentration of
market only on some of the firms in the
market.
equals the sum of the squares of the
market shares of each firm in an
industry.
The Herfindahl-Hirshman Index
 HHI:
n
share of
HHI =   firm i 


i=1
2
2
2
share of
share of
share of
HHI =   firm 1  +  firm 2  +     firm n 

 



2
Measurement Problems
 HHI doesn’t tell it all
 Concentration ratios do not convey the
extent to which market power may be
concentrated in a local market.
 That is, many smaller firms acting in unison
can achieve market power.
Summary Note
 Oligopoly is a market in which a few firms
supply significant amount of the market
supply
 …and thus can have market power ( the
ability to alter prices/outputs) to maximize
profits
10.2: Profit Maximization Under
Oligopoly (Price and Output
Decisions under Oligopoly)


Kinked Demand Curve
and
Sticky Prices
Oligopoly Behavior
Like all other markets, under Oligopoly as
well, the Profit Maximizing Output is the
level of output at which MR=MC
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
MC
ProfitMax.
price
Market
demand
Profits
ATC
at profitMax. Q
J
Profit-max Q
0
ATC
Marginal
Revenue
Quantity (units per period)
Oligopoly Behavior
 However, market structure affects market
behavior (strategic actions) and outcomes
(Profit and Utility Max).
 As there are only a few firms in the
market, Oligopolies Might
•Cut/raise prices even if it is not
warranted by Costs of production
•Not respond to changes in Costs of
Production
Oligopoly Behavior
 Assume that the computer market has
three oligopolists:
– Universal Electronics
– World Computers
– International Semiconductor
Price (per computer)
Initial Conditions in Computer
Market
$1000
Market demand
Industry output
0
20,000
Quantity Demanded (computers per month)
Initial Equilibrium
 Market share - The percentage of total
market output produced by a single firm.
 Consider that the data in the following
table describes each firms market share
Initial Market Shares of
Microcomputer Producers
Producer
Output
Market Share
1. Universal Electronics
8,000
40.0%
2. World Computers
6,500
32.5%
3. International
Semiconductor
5,500
27.5%
20,000
100.0%
Total industry output
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
Profitmaximizing
price
Industry
marginal
cost
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
Battle for Market Shares
 Given the above graph:
– Will the profit be equally shared among
the three markets?
– If so, which producer will have higher
share of the profit?
– What would those with the lower profit
share do?
– How?
Increased Sales at Reduced Prices
 It is possible that lowering price may
expand total market sales and increase the
sales of an individual firm without affecting
the sales of its competitors.
 There is no way that a firm can do so
without causing alarms to go off in the
industry.
– There are few firms in the market, and
they closely follow each other’s action
Increased Sales at Reduced Prices
 In an oligopoly, increased sales on the part
of one firm will be noticed immediately by
the other firms.
 …because increase in the market share of
one oligopolist necessarily reduces the
shares of the remaining oligopolists
Retaliation

Oligopolists respond to aggressive
marketing by competitors by either of the
following methods.
1. Non-Price Competition
– Step up marketing efforts
2. Price Competition
– Cut prices on their product(s).
Retaliation—Non-Price
 One way oligopolists market their products
is through product differentiation.
– Product differentiation – Features
that make one product appear
different from competing products in
the same market.
– This Could be Virtual (Artificial) or
Real
Retaliation-Prices
 Price War
 However, an attempt by one oligopolist to
increase its market share by cutting prices
may lead to a general reduction in the
market price….
!
• This is why oligopolists always want to
avoid price competition and thus pursue
nonprice competition.
Rivals’ Response to Price
Reductions/Increases
 A typical characteristic of oligopoly is thus
the presence of close interdependence in
the activities and decisions of firms in the
market.
 The presence of such close
interdependence imposes limitations on
price and output decisions of Oligopoly
firms
Rivals’ Response to Price
Reductions/Increases
 The degree to which sales increase when
the price is reduced by one Oligopolist thus
depend on the response of the rival
oligopolists.
 We expect Oligopolists to match any price
reductions by the rival oligopolist.
 However, rival Oligopolists may not match
a price increase ….why?
– …..in order to gain market share.
The Kinked Demand Curve
Confronting an Oligopolist
 The shape of the demand curve facing an
oligopolist thus depends on how its rivals
responded to a change in the price of its
own output.
 The demand curve will be kinked if rival
oligopolists match price reductions but not
price increases.
Price or Cost (dollars per unit)
Recall:The Starting Point
Profitmaximizing
price
Industry
marginal
cost
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
PRICE (per computer)
The Demand Curve Confronting an
Oligopolist….
Demand curve facing
oligopolist if rivals match
price changes
$1100
1000
900
B
C
Demand curve
facing oligopolist if
rivals match price
cuts but not price
hikes
0
M
A
D
Demand curve
facing oligopolist if
rivals don't match
price changes
8000
QUANTITY DEMANDED (computers per month)
PRICE (per computer)
The Kinked Demand Curve
Confronting an Oligopolist
B
1000
Kinked Demand Curve
0
8000
QUANTITY DEMANDED (computers per month)
Game Theory
 Oligopoly Price and Output Decisions are thus strategic!
 Game theory is the study of decision making in
situations where strategic interaction (moves and
countermoves) between rivals occurs.
 Each oligopolist considers the potential responses of
rivals when formulating price or output strategies.
 The payoff to an oligopolist’s price cut/increase
depends on how its rivals respond.
The Payoff Matrix
 The decision to initiate a price cut requires
a risk assessment.
Expected =  Probability of  Size of loss 


value
 rivals matching from price cuts 
 Probability of
Gain from lone 
+


rivals
not
matching
price
cut


Oligopoly Payoff Matrix
Rivals’ Actions
Universal’s Options
Reduce Price
Don’t Reduce
Price
Reduce price
Small loss for
everyone
Huge gain for
Universal; rivals
lose
Don’t reduce price
Huge loss for
Universal; rivals
gain
No change
Oligopoly vs. Competition
 Thus oligopolists would want to coordinate
their behavior in a way that maximizes
industry profits.
– There is a Motive for Coordination
 An oligopoly will want to behave like a
monopoly, choosing a rate of industry
output that maximizes total industry profit
Price and Output
 To maximize industry profit, the firms in
an oligopoly must agree:
1. on a monopoly price and maintain it,
2. by limiting production and allocating
market shares.
• Cartel:
• is a group of firms with an explicit
agreement to fix prices and output shares in
a particular market.
• Example: OPEC
Sticky Prices
 Prices in oligopoly industries tend to be
stable.
 Like all producers, oligopolists want to
maximize profits by producing where MR =
MC.
Sticky Prices
 The kinked demand curve is really a
composite of two separate demand curves.
• Creates a gap in an oligopolist’s marginal
revenue (MR) curve.
– Marginal revenue – The change in total
revenue that results from a one-unit increase in
the quantity sold.
Sticky Prices
 As a result, modest shifts of the cost curve
will have no impact on the production
decision of an oligopolists.
Price (dollars per computer)
An Oligopolist’s Marginal
Revenue Curve
S
A
The kink in the demand curve
F
d1
The MR gap
G
mr2
0
d2
mr1
8000 H
Quantity Demanded (computers per month)
Price or Cost (dollars per unit)
The Cost Cushion
Marginal revenue
MC2
MC1
MC3
0
Quantity (units per period)
10.3. Coordination, Problems and
the Government
–What problems oligopolists
have in maintaining price and
output levels?
Some Problems
 There is an inherent conflict in the joint and
individual interests of oligopolists.
– Each oligopolist wants the industry
profits to be maximized.
– Each oligopolist also wants to maximize
it’s own market share.
Coordination Problems
 To avoid self-destructive behavior, each
oligopolist must coordinate production
decisions so that:
– Industry output and price are maintained at
profit-maximizing levels.
– Each oligopolistic firm is content with its
market share.
Price Fixing---Collusion
 The most explicit form of coordination
among oligopolists is called price fixing.
 Price fixing is an explicit agreement among
producers regarding the price(s) at which a
good is to be sold.
 Such an action is however, illegal (stifling
competition)
Examples of Price Fixing
 Electric Generators - In 1961, General Electric
and Westinghouse were convicted of fixing
prices on electrical generators.
– They were charged again in 1972 for
continued price fixing.
 School Milk – Between 1988 and 1991, the
U.S. Justice Department filed charges
against 50 companies for fixing the price of
milk sold to public schools in 16 states.
Examples of Price Fixing
 Vitamins – Seven firms from four nations
were accused of fixing global prices on bulk
vitamins from 1990 - 1998.
 Baby Formula – Two makers of baby formula
agreed to pay $5 million in 1992 to settle
Florida charges that they had fixed prices
on baby formula.
 Cola – The Coca-Cola Bottling Co. of North
Carolina agreed to pay a fine and give
consumers discount coupons to settle
charges of conspiring to fix soft-drink
prices from 1982 to 1985.
Examples of Price Fixing
 Music CDs – In 2001, the FTC charged AOLTime Warner and Universal Music with
fixing prices on the “Three Tenors” CD.
 Laser Eye Surgery – The FTC charged VISX
and Summit Technology with price-fixing
that raised the price of surgery by $500 per
eye.
 Memory chips – In 2004, prosecutors
claimed the world’s largest memory-chip
(DRAM) makers (Samsung, Micron, and
Infineon) fixed prices in the $16 billion-ayear market
Allocation of Market Shares
 One way to allocate market share is a
cartel agreement.
• A cartel is a group of firms with an
explicit agreement to fix prices and
output shares in a particular market.
Price Leadership
 Price leadership is an oligopolistic pricing
pattern that allows one firm to establish
the market price for all firms in the
industry.
Allocation of Market Shares
 An oligopolist may resort to predatory
pricing when market shares are not being
divided in a satisfactory manner.
– Predatory pricing - temporary price
reductions designed to alter market
shares or drive out competition.
The Role of the Government
Antitrust Enforcement
 Market failure is an imperfection in the
market mechanism that prevents optimal
outcomes.
 Market power contributes to market failure
when it leads to resource misallocations or
greater inequity.
 Antitrust law is government intervention
designed to alter market structure or
prevent abuse of market power.
Industry Behavior
 There are several problems with the
behavioral approach to antitrust law:
– Limited government resources.
– Public apathy.
– Difficulty of proving collusion.
Industry Structure
 Public efforts to alter market structure
have been less frequent than efforts to
alter market behavior.
Objections to Antitrust
 Some argue that we shouldn’t punish those
who achieved monopolies through hard
work and innovation.
 Noncompetitive behavior, not industry
structure, should be the only concern of
antitrust.
The Herfindahl-Hirshman Index
 For policy purposes, the Justice
Department decided it would draw the line
at a value of 1,800.
Contestability
 If entry barriers were low enough, even a
highly concentrated industry might be
compelled to behave more competitively.
Behavioral Guidelines: Cost
Savings
 The FTC now also looks to see if a proposed
merger will allow for greater efficiencies
and lower costs.