Transcript Principles of Economics Third Edition by Fred Gottheil

Chapter 12
Price and Output
Determination Under
Oligopoly
© 2002 South-Western
Economic Principles
• The concentration ratio and the
Herfindahl-Hirschman Index
(HHI)
• Balanced and unbalanced
oligopoly
• Horizontal, vertical and
conglomerate mergers
2
Economic Principles
• Cartels
• Game theory
• Price leadership
• Kinked demand
• Brand multiplication
• Price discrimination
3
Oligopoly and
Concentration Ratios
For a vast number of US
manufacturing industries, the
competition among firms in the
industry is essentially competition
among the few – oligopoly.
4
Oligopoly and
Concentration Ratios
An industry may consist of many
firms, but if only a few of the
many dominate the industry, then
the industry is oligopolistic.
5
Oligopoly and
Concentration Ratios
Concentration ratio
A measure of market power. It is
the ratio of total sales of the
leading firms in an industry
(usually four) to the industry’s
total sales.
6
Oligopoly and
Concentration Ratios
A criterion for determining whether
an industry is an oligopoly:
If the leading four firms in an
industry account for 40 percent or
more of total industry sales, then an
industry is likely to be an oligopoly.
7
Oligopoly and
Concentration Ratios
Herfindahl-Hirschman index
A measure of industry
concentration, calculated as the
sum of the squares of the market
shares held by each of the firms
in the industry.
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EXHIBIT 1
CONCENTRATION RATIOS—PERCENTAGE
OF TOTAL INDUSTRY SALES PRODUCED BY
THE LEADING FOUR FIRMS, AND HHI
Source: U.S. Bureau of the Census, 1992 Concentration Ratios in Manufacturing, 1996.
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Exhibit 1: Concentration Ratios –
Percentage of Total Industry Sales
Produced by the Leading Four Firms,
and HHI: 1992
How many industries in Exhibit 1
have market shares greater than
50 percent at the four-firm level?
• Eleven of the fifteen industries.
10
EXHIBIT 2
DISTRIBUTION OF MANUFACTURING
INDUSTRIES BY FOUR-FIRM SALES
CONCENTRATION
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin
Company, Adapted with permission. Data refer to 1982.
11
Exhibit 2: Distribution of
Manufacturing Industries by FourFirm Sales Concentration: 1982
How many industries had fourfirms controlling 40-59 percent of
the industry sales in 1982?
• 120 out of 448 total industries had four
firms controlling 40-59 percent of the total
industry sales.
12
Oligopoly and Concentration
Ratios
Contrary to many people’s
intuition, there is no convincing
evidence that the share of
industry sales controlled by the
four leading firms in the US
manufacturing economy is
growing.
13
EXHIBIT 3
PERCENTAGE OF TOTAL INDUSTRIAL
SALES PRODUCED BY INDUSTRIES WITH
FOUR-FIRM SALES CONCENTRATION RATIOS
OF 50 PERCENT OR MORE: 1895–1982
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright
© 1990 by Houghton Mifflin Company, Adapted with permission.
14
Exhibit 3: Percentage of Total Industrial
Sales Produced by Industries with FourFirm Sales Concentration Ratios of 50
Percent or More: 1895-1982
What is the trend in the
percentage of industrial sales
produced by the largest four
firms since 1963?
• There is a downward trend in the
percentage of industrial sales by the
largest four firms from 1963 to 1982.
15
Oligopoly and Concentration
Ratios
Market power
A firm’s ability to select and
control market price and output.
16
Oligopoly and Concentration
Ratios
Unbalanced oligopoly
An oligopoly in which the sales of
the leading firms are distributed
unevenly among them.
17
Oligopoly and Concentration
Ratios
Balanced oligopoly
An oligopoly in which the sales of
the leading firms are distributed
fairly evenly among them.
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EXHIBIT 4
BALANCED AND UNBALANCED OLIGOPOLY
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Exhibit 4: Balanced and
Unbalanced Oligopoly
1. What percentage of their
industry’s total sales do the
leading four firms in Industry A
and B control?
• The leading four firms in both industry A
and B control 80 percent of their
industry’s sales.
20
Exhibit 4: Balanced and
Unbalanced Oligopoly
2. Why is industry B considered
an unbalanced oligopoly?
• The largest firm in industry B controls
50 percent of the industry’s sales. It’s
market share is greater than the other
three leading industries combined and
more than four times greater than the next
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largest firm’s sales share.
Oligopoly and Concentration
Ratios
• The dominance of oligopolies in
industry is not unique to the US.
• The concentration ratios for US
industries are similar to other
modern industrialized economies.
22
EXHIBIT 5
PRODUCTION CONCENTRATION RATIOS IN
JAPANESE MANUFACTURING INDUSTRIES BY
LEADING AND FIVE LEADING FIRMS: 1991
Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano Memorial Society, p. 162.
23
Exhibit 5: Production Concentration Ratios
in Japanese Manufacturing Industries by
Leading and Five Leading Firms: 1991
In how many Japanese industries
do the five leading firms have
greater than a 90 percent
production concentration ratio?
• Four industries – beer, nylon, glass, and
tires and tubes – are controlled by the five
leading firms at a concentration of 90
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percent or greater.
Concentrating the
Concentration
An oligopoly can build market
power in two ways:
• Reinvesting its profit and painstakingly
expanding its production capacity.
• Merging with and/or acquiring other
firms.
25
Concentrating the
Concentration
There are three reasons why firms merge:
1. To exercise greater market control.
2. To increase control over the supplies of
their inputs or the buyers of their goods.
3. To expand and diversify their asset
holdings.
26
Concentrating the
Concentration
There are three types of mergers:
1. Horizontal merger.
2. Vertical merger.
3. Conglomerate merger.
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EXHIBIT 6
THE GROWTH OF MERGERS
28
Exhibit 6: The Growth of
Mergers
Complete this sentence: On the
whole, the number of mergers per
year in the US has ____ between
1890 and 1990.
i. Increased.
ii. Remained the same.
iii. Decreased.
29
Exhibit 6: The Growth of
Mergers
Complete this sentence: On the
whole, the number of mergers per
year in the US has ____ between
1890 and 1990.
i. Increased.
30
Concentrating the
Concentration
Horizontal merger
A merger between firms
producing the same good in the
same industry.
31
Concentrating the
Concentration
A number of high-profile horizontal
mergers occurred in the 1990s.
• Boeing and McDonnell Douglas in the
aircraft industry.
• Staples and Office Depot in the office
supply industry.
• Union Pacific and Southern Pacific Rail
in the railroad industry.
32
Concentrating the
Concentration
Vertical merger
A merger between firms that
have a supplier-purchaser
relationship.
33
Concentrating the
Concentration
An example of vertical merging is
that of Anheuser-Busch.
The firm has acquired malt
plants, yeast plants, a cornprocessing plant, beer can
factories, and a railway that ships
freight by rail and truck.
34
Concentrating the
Concentration
Conglomerate merger
A merger between firms in
unrelated industries.
35
Concentrating the
Concentration
The conglomerate merger is the
most common type of merger.
36
Concentrating the
Concentration
• One reason for conglomerate mergers is
the desire to diversify operations.
• While horizontal and vertical mergers
strengthen the firm’s position within the
industry, the fate of the firm rests on the
health of the industry.
• Acquiring unrelated firms insures the
conglomerate against catastrophe if one
industry faces severe problems.
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Concentrating the
Concentration
Cartel
A group of firms that collude to
limit competition in a market by
negotiating and accepting agreedupon price and market shares.
38
Concentrating the
Concentration
Collusion
The practice of firms to negotiate
price and market share decision
that limit competition in a
market.
39
Concentrating the
Concentration
Cartels are an example of a
merger in which firms don’t have
to actually buy each other’s
assets, yet they enjoy the benefits
of having market power.
40
Concentrating the
Concentration
• While cartels are illegal in the United
States, it is difficult to prove collusion.
• Some cartels are disguised. Agricultural
cooperatives in regions of the US behave
like cartels.
• Some governments encourage cartels to
form in their countries. OPEC is one
example.
41
Concentrating the
Concentration
Many studies support the
contention that price and
concentration ratios move in the
same direction – an increase in
one is associated with an increase
in the other.
42
EXHIBIT 7
RELATIONSHIP BETWEEN THE
CONCENTRATION RATIO AND PRICE
43
Exhibit 7: Relationship
Between the Concentration
Ratio and Price
Where on the curve in Exhibit 7
does the concentration ratio have
the strongest effect on price?
• The effect is the strongest in the
middle of the S-shaped curve.
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Theories of Oligopoly
Pricing
Game theory
A theory of strategy ascribed to
the firms’ behavior in oligopoly.
The firms’ behavior is mutually
interdependent.
45
Theories of Oligopoly
Pricing
In monopoly, monopolistic
competition and perfect
competition, firms react only to
the demand and cost structures
they face. Prices tend toward
equilibrium.
46
Theories of Oligopoly
Pricing
In oligopoly, firms are
continually second guessing how
the competition will respond to
price decision they make. Prices
are subject to fits of change.
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EXHIBIT 8
FIRM PROFIT, GENERATED BY HIGH AND
LOW PRICING
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EXHIBIT 9
PAYOFF MATRIX
49
Exhibit 9: Firm Profit,
Generated by High and Low
Pricing
How does total profit change as Dell
and Compaq change their prices?
• When both firms price high, total
profit is 20. When one firm prices
high and the other prices low, total
profit is 18. When both firms price
low, total profit is 12.
50
Theories of Oligopoly
Pricing
Price leadership
A firm whose price decisions are
tacitly accepted and followed by
other firms in the industry. The
theory explains pricing in
unbalanced oligopolies.
51
EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF
GODFATHER OLIGOPOLY
52
Exhibit 10: Price and Output
Under Conditions of Godfather
Oligopoly
How is the price of chocolate
determined in Exhibit 9?
• Hershey is the “godfather” in the
chocolate business. Hershey produces
where its MR=MC. That is, 5 tons of
chocolate at $5 per pound. The other
firms in the chocolate industry accept
the $5 per pound price.
53
Theories of Oligopoly
Pricing
Kinked demand curve
The demand curve facing a firm in
oligopoly; the curve is more elastic
when the firm raises price than
when it lowers price.
54
EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND
CURVE
55
Exhibit 11: Constructing an
Oligopolist’s Demand Curve
1. If Lipton were to raise its price
above $0.80 per box, what would
its competitors do, according to the
curve in panel b?
• Lipton’s competitors would not follow
suit. Lipton’s demand curve above $0.80
(NK) is relatively elastic.
56
Exhibit 11: Constructing an
Oligopolist’s Demand Curve
2. If Lipton were to lower its price
below $0.80 per box, then what
would its competitors do?
• Lipton’s competitors would feel
compelled to follow suit. Lipton’s demand
curve below $0.80 (YK) is relatively
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inelastic.
EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH
KINKED DEMAND CURVES
58
Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
The marginal revenue curve
associated with a kinked demand
curve is:
i. Continuous.
ii. Discontinuous.
59
Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
The marginal revenue curve
associated with a kinked demand
curve is:
ii. Discontinuous.
60
Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
As long as the MC curve crosses
the gap created by the
discontinuity in the MR curve,
price will remain unchanged, as
shown in panel b.
61
Exhibit 12: Price Rigidity in
Oligopolies with Kinked
Demand Curves
If the MC curve cuts the MR curve
above the gap, output will decrease
and price will increase. This
scenario is depicted in panel c.
62
Oligopoly and Brand
Multiplication
Brand multiplication
Variations on essentially one good
that a firm produces in order to
increase its market share.
63
Oligopoly and Brand
Multiplication
• A firm’s market share =
(number of brands) x (brand
market share).
• As the number of brands in the
industry increases, market share
per brand diminishes.
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Why Oligopolists Sometimes
Discriminate
Price discrimination
The practice of offering a
specific good or service at
different prices to different
segments of the market.
65
Why Oligopolists Sometimes
Discriminate
• Oligopolists sometimes
segment the market in order to
charge consumers what they
are willing to pay for a good or
service.
• Differences in airline ticket
prices are a good example.
66
EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED
AIRLINES ROUND-TRIP FLIGHT BETWEEN
LOS ANGELES AND NEW YORK
67
Exhibit 13: Demand Schedule for a
United Airlines Round-Trip Flight
Between LA and NY
If United chose not to segment
its market in Exhibit 12, what
would be its total revenue?
• The maximum total revenue for
United would be achieved at a ticket
price of $318 each, for a total of
$119,250.
68
EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A
UNITED AIRLINES ROUND-TRIP FLIGHT
BETWEEN LOS ANGELES AND NEW YORK
69
Exhibit 14: Demand by Market
Segment for a United Airlines
Round-Trip Flight Between LA
and NY
What is United’s total revenue
when it segments its market
into a multiple-fare system?
• United’s total revenue is $210,635.
This is an increase of $91,385 over the
unsegmented market.
70
Why Oligopolists Sometimes
Discriminate
• Price discrimination exists in
virtually every market.
• Some differences in price are
not clear cases of price
discrimination, however.
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Why Oligopolists Sometimes
Discriminate
• For example, many would argue
that upper balcony seats are not
the same as front row seats at a
concert. If the goods are different,
then it is not necessarily price
discrimination to charge more for
the front row seats.
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Cartel Pricing
• A cartel determines price by
acting as if it is a monopoly.
• Price and quantity are
determined using the MR=MC
rule.
73
EXHIBIT 15 CARTEL PRICING AND OUTPUT ALLOCATIONS
74
Exhibit 15: Cartel Pricing
and Output Allocations
Why is there an incentive for
cartels to “cheat” and produce
greater quantities than they are
assigned?
• The price and output decisions made
by the cartel are determined by the
MR=MC rule.
75
Exhibit 15: Cartel Pricing
and Output Allocations
Why is there an incentive for
cartels to “cheat” and produce
greater quantities than they are
assigned?
• The price and quantity assigned to
individual firms within the cartel may
not coincide with where the firm would
maximize profit using its own MR and
MC curves.
76
Exhibit 15: Cartel Pricing
and Output Allocations
Why is there an incentive for
cartels to “cheat” and produce
greater quantities than they are
assigned?
• There is an incentive for the firm to
try to secretly increase quantity and
thereby increase its own profit.
77