Transcript Oligopoly: Competition has a face and a name.

Oligopoly
Few Firms in the Industry
Oligopoly
Few mutually interdependent firms:
take into account the expected reaction
Produce either identical products
(homogeneous oligopoly) or heterogeneous
products (differentiated oligopoly).
Mutual interdependence means that each
firm must of other firms.
Oligopoly: Competition has a face
and a name.
Oligopoly is an intermediate market structure
between PC and Monopoly.
Firms might compete (non-cooperative oligopoly)
or cooperate (cooperative oligopoly)
Whereas firms are price makers, their control
over the price is determined by the level of
coordination among them.
There are often significant barriers to entry and
exit.
Examples of Oligopolies
Tennis Balls: Wilson, Penn, Dunlop and
Spalding.
Cars: GM, Ford, DaimlerChrysler
Cereal: Quaker, Ralston Food, Kellogg, Post
and General Mills.
Airlines: American and Delta with US Airways,
Northwest and TWA struggling along.
Aircraft: Boeing (McDonnell Douglas) and
Lockheed Martin
Grocery stores(Ralphs, Trader Joe’s)
The Most Famous Oligopoly
OPEC
The Organization of Petroleum Exporting Countries:
founded in Baghdad, Iraq, on September 1960 by Iran, Iraq, Kuwait,
Saudi Arabia and Venezuela.
Qatar (1961), Indonesia (1962), Libya (1962), the United Arab
Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973),
Gabon (1975) and Angola (2007).
Models of Oligopoly Behavior
No single general model of oligopoly
behavior exists. Three models of
oligopoly behavior are:
The cartel (Collusion) model
The group behaves as ONE (monopoly)
The contestable market model.
The group behaves as PC market.
The Kinked Demand Model (for the
special oligopoly case of Duopoly)
The Cartel Model
A cartel is a combination of firms acting
as a single firm.
In the cartel model, an oligopoly sets
price as a monopoly.
If the cartel can limit the entry of other
firms, they can increase their profits.
Restrict output to maximize profit
For this they must assign output quotas to
member firms
Implicit (tacit) Price Collusion
Formal collusion is illegal in the U.S. while
informal collusion is inevitable:
Implicit price collusion: when multiple firms
make the same pricing decisions even though
they have not consulted with one another.
Price leadership: the dominant firm sets
prices and the others follow.
The Collusion Model
Suppose there are only two firms
Producing identical products
Face identical demand
Have identical cost structures
The Sum of the Firms’
Demand = Market Demand
Each Firm’s Demand
One=Firm’s
Half Market
Demand
Demand
P0
Market Demand
1000
2000
The Sum of the Firms’
Demands = Market Demand
The Sum of the MR lines for both firms = deach firm
dA+ dB = Market
Demand
deach
MRfirm
mreach firm
Market Demand
Collusion: The two firms agree
to behave as One Monopolist
Together these two firms will sell Qo
each firm selling half.
MC
Po
MR
Qo
D
Oligopoly Collusion Solution is
Inefficient
The efficient solution is the perfectly
competitive Price and Output
combination (Ppc, Qpc)
MC
Po
Oligopolies restrict
output and charge higher
prices (Po, Q o)
Ppc
D
MR
Qo
Qpc
The Kinked Demand Model
Developed to explain why prices in
oligopoly markets tend to be sticky.
We observed that changes in costs were
only rarely met by changes in oligopoly
prices
We also observed that when prices did
change, they were large in magnitude.
The Kinked Demand Model of
Oligopoly
We assume that firms follow the following
strategy:
If I increase my price
My competition will not increase
their price and I
would lose sales.
If I decrease my price
My competition will also decrease
their price and I
would gain very little in additional
sales.
The Kinked Demand Model
Quantity
If I increase my price
say by 10%, no one
follows and I lose
sales
If I decrease my price
by 10%, everyone
follows and I gain
little or nothing at all!
demanded
drops by 20%
P1
P0
D0
Q1
Q0
Quantity
demanded
increase 5%
D0
P0
P1
Q0 Q1
Above P0 demand is more elastic
Above P0 MR looks like this
Below P0 demand is less elastic
Below P0 MR looks like this
Ignore the lower part of D0
and MR0
Ignore the upper part of D1
and MR1
P0
Note: this Kink in
demand, translates
into a gap in the MR
line
D1
Q0
MR1
MR0
D0
The Kinked
Demand Model
For prices above the
current price
Marginal Revenue is
flatter
Demand is more elastic
P0
MR
D
Demand is less elastic
For prices below the
current price
Marginal Revenue is
steeper
Q0
MR
Why are prices
sticky under
oligopoly?
P1 =
MC2
MC1
P2
P0
MC0
Price changes only
when MC shifts out
of the MR gap
Prices change infrequently in Oligopolistic Industries
D
MR = MC1
If Costs increase
within the MR gap… MR = MC0
MR = MC
Price does not
change
Q1 Q0
MR
Free entry
When costs of entry are recoverable (say airplanes, cars,
buildings, etc which can be resold).
A firm has little to lose by entering because it can
always recover its investment.
Free exit
If to enter, a firm has to purchase assets with no
alternative use (non-recoverable ‘sunk costs’)
A nuclear power plant
Or the firm must incur costs that are unavoidable
once they have been committed at a particular
moment in time
The money that the telecoms spent to win mobile
phone licenses at auction in 2000.
Exit is costly and acts as a deterrent to entry.
The Contestable Market Model
A contestable market is defined as
one into which there are no
barriers to entry or exit.
Entry is free and exit is costless.
The firms in the industry must charge
price = ATC to make profit zero to
prevent firms from entering.
The Contestable Market Model
A contestable market is defined as
one into which there are no
barriers to entry or exit.
Entry is free and exit is costless.
In this case we predict that even in a market
with only one firm, that firm will make zero
profits, just as in a perfectly competitive
market. WHY?
Comparing the Contestable
Market and Cartel Models
The stronger the ability of Oligopolists
to collude and prevent entry, the closer
the oligopoly price would be to
monopoly pricing.
The weaker the ability to collude is, the
more competitive the oligopoly price is.
Most Oligopoly markets lie between
these two extremes.
Strategic Pricing and Oligopoly
Both the cartel and contestable market
models use strategic pricing decisions
where firms set their price based on the
expected reactions of other firms.
People of the same trade seldom meet
together for merriment and
diversion, but the conversation ends
in a conspiracy against the public, or
on some contrivance to raise prices.
Adam Smith, An Inquiry into the Nature and
Causes of the Wealth of Nations (1776)
Game Theory and Strategic
Decision Making
Most oligopolistic strategic decision
making is carried out with explicit or
implicit use of game theory.
Game theory is the application of
economic principles to interdependent
situations.
Prisoner’s Dilemma
Two suspects are arrested. The police have
insufficient evidence for a conviction so they put
the prisoners in separate rooms to prevent them
from talking to each other. They are offered the
following deal:
If you confess you go free and your partner receives
a 10-year sentence.
If neither confess, both get six months in jail for a
minor charge.
If both confess, each receives a five-year sentence.
How should the prisoners act?
Prisoner’s Dilemma
Prisoner B Stays
Silent
Prisoner A Stays
Silent
Prisoner A Confess
Each
serves 6
months
Prisoner A:
goes free
Prisoner B:
10 years
Prisoner B confess
Prisoner A:
10 years
Prisoner B:
goes free
Each
serves 5
years
Prisoner’s Dilemma
Prisoner B Stays
Silent
I Stay Silent
I Confess
Prisoner B confess
I do 6
months
I do 10
years
I go Free
I do 5
years
I should confess
I should confess
"No matter what he does, I am better off confessing than staying
silent. Therefore, for my own sake, I should confess."
Prisoner’s Dilemma and a
Duopoly Example
All possible courses of action are
represented in a table called
A payoff matrix: a table that contains the
outcomes of a strategic game under
various circumstances.
Enforcement of Cartel agreements
is difficult
Antitrust Laws make collusive
agreements illegal
There is a strong incentive to cheat.
Collusion: The two firms agree
to produce only 30 units
These two firms will produce and sell
60 units (with each firm producing
and selling 30 units).
MC
60
MR
60
D
Assume: MC = 10
The Incentive to Cheat
the Agreement
Profit Maximizing OutputEach
for Cartel
firm at: MC = MR
Q
0
10
20
30
40
50
60
70
80
90
100
110
120
P
120
110
100
90
80
70
60
50
40
30
20
10
0
TR
0
1100
2000
2700
3200
3500
3600
3500
3200
2700
2000
1100
0
sellstr
30 units MR
0
and
charges 110
550
Price
= $60 90
1000
1350
1600
1750
1800
1750
1600
1350
1000
550
0
70
50
30
10
-10
-30
-50
-70
-90
-110
Each firm should produce 30
units
Total sold = 60 units
Price =$60
Each firm’s Total Revenue = $3600/2
= 1,800
ToIf onemaximize
Profit, both firms will
firm sells 30
and the other
Total
revenues
cheat.
“cheats”
selling
40, for
the cheating firm
total units for sale =
Q
A
beP50
x 40Firm
=
70 andwould
the price
will
0
120
30
then drop to2,000
$50
10
110
30
20
100
30
30
90
30
40
80
30
50
70
30
60
60
30
70
50
30
80
40
30
Each firm 30
can
90
30
increase
100 profits
20by
30
cheating the
110
10
30
agreement0
.
120
30
If each firm sells
30 units, revenue
forrevenues
each firm
Total
for =
the
cheated firm
1800would be
x 30
= 1,500
Firm B can sell50
TR
for
Firm B
10
20
30
40
50
60
70
80
90
800
1400
1800
2000
2000
1800
1400
800
0
Payoff Matrix
Firm A’s Strategies
Produce 30 units
Firm B’s Strategies
PP==50
60
50
40
Cheat ( Produce 40
units)
Produce 30 A’sIf Profit
= 1,800
Profit
2,000
both firms
sell 30 A’s
If A
sells=40,
and B
units
(30
x $60
= Quantity
1,800) = (40 xsells
$5030,
= 2,000)
units,
total
total
B’s60Profit
= 1,800
Profit ==1,500
and price
= $60 B’s
Quantity
70 and
(30 x price
$50 ==1,500)
$50
Cheat
(Produce
40 units)
A sells= 30,
and B
A’sIfProfit
1,500
sellsx 40,
Quantity
(30
$50total
= 1,500)
= 70
and=price
= $50
B’s
Profit
2,000
(40 x $50 = 2,000)
A’s
Profit
= 1,600
If both
firms
sell 40
(40
x $40
1,600)
units,
total= Quantity
B’s
= 1,600
= 80Profit
and price
= $40
Most Likely
Outcome: A’s Strategies Both Cheat
Produce 30 units
Cheat
Best strategy
B’s Strategies
If A Sells 30 Units as
If A
Cheats
and sells A’s Profit = 2,000
Produce 30 A’s
Profit
= 1,800
agreed…
If
B
Cheats
and
sells
40
units….
40
units,
units
B’s Profit = 1,800
B’s
Profit
=
1,500 is
B’s
best
strategy
A’s best strategy
is the
one that
brings the largest payoff.
B’s best
strategy
is the
the one that brings
one that brings the
the largest payoff.
Cheat
A’s Profit
=
1,500
A’s
Profit = 1,600
largest payoff.
If BProfit
Sells=30
Units as agreed…
B’s
2,000
B’s Profit = 1,600
A’s best strategy is the one that brings the largest payoff.
Best strategy
The best strategy for both firms is to cheat under both scenarios:
if the other firm cheats as well as if the other firm abides by the
agreement
Determining Industry
Structure
Economists use one of two methods to
measure industry structure:
The concentration ratio.
The Herfindahl index.
Concentration Ratio
Is the value of sales by the top firms of an
industry stated as a percentage of total
industry sales.
The most commonly used concentration ratio
is the four-firm concentration ratio.
The higher the ratio, the closer to an
oligopolistic or monopolistic type of market
structure.
The Herfindahl Index
An index of market concentration calculated
by adding the squared value of the individual
market shares of all firms in the industry.
The Herfindahl index gives higher weights
(than those given by the concentration ratio)
to the largest firms in the industry because it
squares market shares.
The Herfindahl Index
The Herfindahl Index is used as a rule
of thumb by the Justice Department to
determine whether a merger be allowed
to take place.
If the index is less than 1,000, the industry
is considered competitive thus allowing the
merger to take place.
An Example
The weight assigned
Firm firm
Market
to the largest
is Share
twice that of the next
A
50%
largest firm
Four Firm Concentration
Ratio: 84.
50 + 25 + 5 + 4 =
HHI :3,230
2
2
2
2
50 + 25 + 5 + 5(4 ) =
2,500 + 625 + 25 + 5(16)
The HHI index reflects more
accurately the true distribution of
power in the industry.
B
25%
C
5%
F
4%
G
4%
H
4%
The weight
D assigned to
4%the
largest firm is four
Etimes that 4%
of the
next largest firm
Herfindahl-Hirschman Index (HHI)
Largest index for a monopoly:
2
Market share =100%
HHI: 100 = 10,000
For an industry with 2 firms:
Market share = 100%/2=50% each
2
HHI: 2(50 )=5,000
For a competitive industry with 10,000 firms:
Market share =100%/10,000=0.01%
2
HHI: 10,000(0.01 )= 1
The More Concentrated the
Industry,
The larger the HerfindahlHirschman Index (HHI)
Concentration Ratios and the
Herfindahl Index
Industry
Four-firm
concentration
ratio
Herfindahl
index
Meat products
Breakfast cereal
Book printing
Greeting card publishing
Soap and detergent
Men’s footwear
Electronic computer
Burial caskets
35
82
32
66
60
50
45
74
393
2,445
364
1,619
1,306
857
728
2,965
Medicinal Chemicals
Cars
Breakfast Cereal
Cigarettes
Men/Boy Shirts
Ice Cream
Largest 4
HHI
76 %
3,000
84 %
2,676
85 %
2,253
93 %
?
28 %
315
24 %
293
The Larger the HHI
Index
Industry
The larger market share
concentrated in a few firms
1992
Value of
Shipments
Questions to Prepare
Define the following terms and provide an example.
a. monopolistic competition
b. oligopoly
c. cartel
d. oligopolistic interdependence
e. excess capacity
f. price leadership
g. kinked demand curve
h. contestable market
2.
What is the value of the HHI index and the four firm
concentration ratio when there are
a.
20,000 firms all with equal market shares
b.
Ten firms all with equal market shares
c.
2 firms with equal market share and
d.
One firm?
1.
In what way is monopolistic competition more like
competition, and in what way is it more like monopoly?
4.
Explain how short-run and long-run equilibrium
in monopolistic competition differ. Use graphs to
illustrate your answer. Be sure that your graphs are
completely and correctly labeled.
5.
Here is an excerpt form an editorial praising
capitalism in The Economist: "It is competition that
delivers choice, holds prices down, encourages
invention and service, and (through all these things)
delivers economic growth." To what type of competition
does the writer refer? Is it the sort of competition that
economists study? Explain..
3.
1.
Oligopolist A cuts price in an attempt to enlarge his share of the market. His
competitors retaliate with identical price cuts. In this case, oligopolist A will move from
point A to which point? ________
2.
Oligopolist A cuts price in an attempt to enlarge his share of the market. His
competitors fail to retaliate with price cuts. In this case, oligopolist A will move from point
A to which point? ________
3.
Demand curve CAD represents a market in which oligopolists will match the price
changes of rivals and demand curve EAB represents a market in which oligopolists will
ignore the price changes of rivals. According to the kinked demand model, the relevant
demand curve will be: ________
4.
According to economic theory, the kink in the demand curve will occur at point
_____
Determine the competitive
solution for this duopoly
A Does not cheat
A Cheats
A +$200,000
A $75,000
B Does not
cheat
B $75,000
B – $75,000
A – $75,000
A0
B Cheats
B +$200,000
B0
1. What is the value of the HHI index and the four firm concentration
ratio when there are
a.
20,000 firms all with equal market shares
b. Ten firms all with equal market shares
c.
2 firms with equal market share and
d. One firm?
2.
Explain how short-run and long-run equilibrium in
monopolistic competition differ. Use graphs to illustrate your answer.
Be sure that your graphs are completely and correctly labeled.
3. Find price, output and
profit/loss for this MC producer.
Explain in detail what would
happen in the long run.
Perfectly
competitive firm
Monopoly
Monopolistic Competition
Oligopoly
Is Entry/Exit into the market free or
restricted?
How does the firm choose the output
level?
Does the firms charge one price? Or
does it price discriminate?
Shape of Demand faced by the firm
Are producers price takers or price
setters?
Is MR greater than, less than or equal
to Price? WHY?
Do producers want to maximize profit
or do they produce for some other
reason?
Do producers react to prices? In other
words: is there a Supply curve in this
market?
Is the price charged greater than,
smaller than or equal to MC?
Can firm(s) make profit in the short
run?
Can firm(s) make profit in the long
run?
Can firm(s) incur a loss in the short
run?
Can firm(s) incur a loss in the long run?
55
© 2000 Claudia Garcia - Szekely
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Barriers to Exit: Sunk Costs
An example