Transcript Oligopoly - Micro Economics

Oligopoly
Chapter 25
Market Structure
Most firms possess some market power.
Degrees of 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.
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.
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 Differentiate
d
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
or
differentiated
Determinants of Market Power
The determinants of market power
include:
Number of producers.
Size of each firm.
Barriers to entry.
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.
The concentration ratio is a measure of
market power that relates the size of firms
to the size of the market.
Concentration Ratio
The concentration ratio is the
proportion of total industry output
produced by the largest firms (usually the
four largest).
Firm Size
Market power isn’t necessarily associated
with firm size.
A small firm could possess a lot of power
in a relatively small market.
Measurement Problems
Many smaller firms acting in unison can
achieve market power.
Concentration ratios do not convey the
extent to which market power may be
concentrated in a local market.
Oligopoly Behavior
Market structure affects market behavior
and outcomes.
Assume that the computer market has
three oligopolists.
Initial Equilibrium
Initial conditions and market shares of
each firms are described in the following
slides.
Market share - The percentage of total
market output produced by a single firm.
Price (per computer)
Initial Conditions in Computer
Market
$1000
Market demand
Industry output
0
20,000
Quantity Demanded (computers per month)
Initial Market Shares of
Microcomputer Producers
Producer
Output
Market Share
Universal Electronics
8,000
40.0%
World Computers
6,500
32.5%
International
Semiconductor
5,500
27.5%
20,000
100.0%
Total industry output
The Battle for Market Shares
In an oligopoly, increased sales on the
part of one firm will be noticed
immediately by the other firms.
Increased Sales at the
Prevailing Market Price
Increases in the market share of one
oligopolist necessarily reduce the shares
of the remaining oligopolists.
Increased Sales at Reduced
Prices
Lowering price may expand total market
sales and increase the sales of an
individual firm without affecting the sales
of its competitors.
There simply isn’t any way that a firm can
do so without causing alarms to go off in
the industry.
Retaliation
Oligopolists respond to aggressive
marketing by competitors.
Step up marketing efforts.
Cut prices on their product(s).
Retaliation
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.
Retaliation
An attempt by one oligopolist to increase
its market share by cutting prices will
lead to a general reduction in the market
price.
• This is why oligopolists avoid price
competition and instead pursue nonprice
competition.
Price (per computer)
Rivalry for Market Shares
$1000
900
F
G
Market
demand
0
20,000
25,000
Quantity Demanded (computers per month)
The Kinked Demand Curve
Close interdependence – and the
limitations it imposes on price and output
decisions – is a characteristic of
oligopoly.
Rivals’ Response to Price
Reductions
The degree to which sales increase when
the price is reduced depends on the
response of rival oligopolists.
We expect oligopolists to match any price
reductions by rival oligopolists.
Rivals’ Response to Price
Increases
Rival oligopolists may not match price
increases in order to gain market share.
The Kinked Demand Curve
Confronting an Oligopolist
The shape of the demand curve facing an
oligopolist 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 (per computer)
The Kinked Demand Curve
Confronting an Oligopolist
Demand curve facing
oligopolist if rivals match
price changes
$1100
1000
900
B
D
C
Demand curve facing
oligopolist if rivals
match price cuts but
not price hikes
0
M
A
Demand curve
facing oligopolist if
rivals don't match
price changes
8000
QUANTITY DEMANDED (computers per month)
Game Theory
Each oligopolist has to consider the
potential responses of rivals when
formulating price or output strategies.
The payoff to an oligopolist’s price cut
depends on how its rivals respond.
Game Theory
Game theory is the study of decision
making in situations where strategic
interaction (moves and countermoves)
between rivals occurs.
Game Theory
Each oligopolist is uncertain about its
rival’s behavior.
– The collective interests of the oligopoly are
protected if no one cuts the market price.
– But an individual oligopolist could lose if it
holds the line on price when rivals reduce
price.
The Payoff Matrix
The payoff to an oligopolist’s price cut
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
Oligopolists may try to coordinate their
behavior in a way that maximizes
industry profits.
Price and Output
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 on a monopoly
price and agree to maintain it by limiting
production and allocating market shares.
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
Industry
marginal
cost
Profitmaximizing
price
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
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.
• There is 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
The kink in the demand curve
A
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)
Coordination Problems
There is an inherent conflict in the joint
and individual interests of oligopolists.
Each oligopolist wants industry profits to be
maximized.
Each oligopolist 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
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.
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.
Examples of 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.
Examples of Price Fixing
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.
Examples of Price Fixing
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
AOL-Time Warner and Universal Music
with fixing prices on the “Three Tenors”
CD.
Examples of Price Fixing
Laser Eye Surgery – The FTC charged
VISX and Summit Technology with pricefixing that raised the price of surgery by
$500 per eye.
Examples of Price Fixing
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.
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
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.
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.
Barriers to Entry
Above-normal profits cannot be
maintained over the long-run unless
barriers to entry exist.
Barriers to entry are obstacles that
make it difficult or impossible for wouldbe producers to enter a particular
market.
Patents
Patents prevent potential competitors
from setting up shop.
They either have to develop an
alternative method for producing a
product or receive permission from the
patent holder to use the patented process.
Distribution Control
The control of distribution outlets can be
accomplished through selective discounts,
long-term supply contracts, or expensive
gifts at Christmas.
Mergers and Acquisition
A firm can limit competition by acquiring
competitors through mergers and
acquisition.
Government Regulation
Patents are issued by the federal
government.
Licensing requirements imposed by
government limit competition.
Nonprice Competition
Advertising not only strengthens brand
loyalty, but also makes it expensive for
new producers to enter the market.
Training
Early market entry can create an
important barrier to later competition.
Customers of training-intensive products
(such as computer hardware and
software) become familiar with a
particular system.
Network Economies
The widespread use of a particular
product may heighten its value to
consumers, thereby making potential
substitutes less viable.
Antitrust Enforcement
Market power contributes to market
failure when it leads to resource
misallocations or greater inequity.
Market failure is an imperfection in the
market mechanism that prevents optimal
outcomes.
Industry Behavior
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
The Herfindahl-Hirshman index (HHI)
is a measure of industry concentration
that accounts for number of firms and
size of each.
The Herfindahl-Hirshman
Index
The Herfindahl-Hirshman Index of
market equals the sum of the squares of
the market shares of each firm in an
industry.
2
n
share of 


HHI =  firm i


i=1
2
2
share of   share of 
share of 




HHI =  firm 1
+
+    firm n

  firm 2 


2
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.
Oligopoly
End of Chapter 25