Transcript The Study of Economics

CHAPTER 14
Oligopoly
1. The meaning of oligopoly, and why it occurs
2. Why oligopolists have an incentive to act in ways
that reduce their combined profit, and why they
can benefit from collusion
3. How our understanding of oligopoly can be
enhanced by using game theory, especially the
concept of the prisoners’ dilemma
4. How repeated interactions among oligopolists
can help them achieve tacit collusion
5. How oligopoly works in practice, under the legal
constraints of antitrust policy
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The Prevalence of Oligopoly
 In addition to perfect competition and monopoly, oligopoly and
monopolistic competition are also important types of market structure.
 They are forms of imperfect competition.
 Oligopoly is a common market structure.
 It arises from the same forces that lead to monopoly, except in a
weaker form.
 It is an industry with only a small number of producers.
 A producer in such an industry is known as an oligopolist.
 When no one firm has a monopoly, but producers nonetheless realize
that they can affect market prices, an industry is characterized by
imperfect competition.
ECONOMICS IN ACTION
Is It An Oligopoly or Not?
To get a better picture of market structure, economists often use a measure
called the Herfindahl–Hirschman Index, or HHI.
 The HHI for an industry is the square of each firm’s share of market sales
summed over the firms in the industry.
 For example, if an industry contains only 3 firms and their market shares are
60%, 25%, and 15%, then the HHI for the industry is:
HHI = 602 + 252 + 152 = 4,450
 According to Justice Department guidelines, an HHI below 1,000 indicates a
strongly competitive market, between 1,000 and 1,800 indicates a somewhat
competitive market, and above 1,800 indicates an oligopoly.
 In an industry with an HHI above 1,000, a merger that results in a significant
increase in the HHI will receive special scrutiny and is likely to be disallowed.
Note: However, as recent events have shown, defining an industry can be tricky. In 2007, Whole
Foods and Wild Oats, two purveyors of high-end organic foods, proposed a merger. The Justice
Department disallowed it, claiming it would substantially reduce competition and defining the
industry as consisting of only natural food groceries.
•
However, this was appealed to a federal court, which found the merger allowable since regular
supermarkets now carried organic foods as well, arguing that they would provide sufficient
competition after the merger. The Justice Department has appealed and, as of the time of
writing, the case is still undecided.
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Some Oligopolistic Industries
Understanding Oligopoly
 Some of the key issues in oligopoly can be understood by looking at the
simplest case, a duopoly.
 An oligopoly consisting of only two firms is a duopoly. Each firm is a
duopolist.
 With only two firms in the industry, each would realize that by
producing more, it would drive down the market price.
• So each firm would, like a monopolist, realize that profits would be
higher if it limited its production.
 So how much will the two firms produce?
 One possibility is that the two companies will engage in collusion.
Sellers engage in collusion when they cooperate to raise each others’
profits.
 The strongest form of collusion is a cartel, an agreement by several
producers to obey output restrictions to increase their joint profits.
 They may also engage in non-cooperative behavior, ignoring the effects
of their actions on each others’ profits.
Understanding Oligopoly
 By acting as if they were a single monopolist, oligopolists can maximize their
combined profits.
 So, there is an incentive to form a cartel.
 However, each firm has an incentive to cheat—to produce more than it is
supposed to under the cartel agreement.
 So, there are two principal outcomes: successful collusion or behaving
noncooperatively by cheating.
 When firms ignore the effects of their actions on each others’ profits, they
engage in noncooperative behavior.
 It is likely to be easier to achieve informal collusion when firms in an
industry face capacity constraints.
Competing in Prices vs. Competing in Quantities
 Firms may decide to engage in quantity competition or price competition.
 The basic insight of the quantity competition (or the Cournot model) is that
when firms are restricted in how much they can produce, it is easier for them to
avoid excessive competition and to “divvy up” the market, thereby pricing above
marginal cost and earning profits.
 It is easier for them to achieve an outcome that looks like collusion without a
formal agreement.
Competing in Prices vs. Competing in Quantities
 The logic behind the price competition (or the Bertrand model) is that when
firms produce perfect substitutes and have sufficient capacity to satisfy demand
when price is equal to marginal cost, then each firm will be compelled to engage
in competition by undercutting its rival’s price until the price reaches marginal
cost—that is, perfect competition.
GLOBAL COMPARISON
Europe Levels the Playing Field for Coke and Pepsi
 In the United States, Coke and Pepsi have maintained relatively similar
market shares: 44% versus 32% in 2004.
 In that same year, (thanks to the exclusivity deals that Coke regularly
signed with shops, bars, and restaurants across Europe), Coke’s market
shares in Europe were several times Pepsi’s, as you can see in the
following graph—that is, until European regulators finally made their
move, also in 2004.
 Not surprisingly, Pepsi applauded the change in European policy toward
exclusive dealing.
GLOBAL COMPARISON
Europe Levels the Playing Field for Coke and Pepsi
Coke and Pepsi
Market Shares
Coke
75%
Pepsi
68%
60%
51%
50
44%
32%
25
5%
6%
5%
Belgium
France
Germany
0
United States
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ECONOMICS IN ACTION
The Great Vitamin Conspiracy
 In the late 1990s, some of the world’s largest drug companies agreed to
pay billions of dollars in damages to customers after being convicted of
a huge conspiracy to rig the world vitamin market.
 The conspiracy began in 1989 when the Swiss company Roche and the
German company BASF began secret talks about setting prices and
dividing up markets for bulk vitamins sold mainly to other companies.
 How could it have happened? The main answer probably lies in
different national traditions about how to treat oligopolists.
 The United States has a long tradition of taking tough legal action
against price-fixing. European governments, however, have historically
been much less stringent.
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ECONOMICS IN ACTION
 To prove collusion, there must be some evidence of conversations or written
agreements.
 Such evidence has emerged in our chocolate case.
 According to the Canadian press, 13 Cadbury executives voluntarily
provided information to the courts about contacts between the
companies, including a 2005 episode in which a Nestle executive handed
over a brown envelope containing details about a forthcoming price hike to
a Cadbury employee.
 And, according to affidavits submitted to a Canadian court, top executives at
Hershey, Mars, and Nestle met secretly in coffee shops, in restaurants, and at
conventions to set prices.
The Prisoners’ Dilemma
 When the decisions of two or more firms significantly affect each others’
profits, they are in a situation of interdependence.
 The study of behavior in situations of interdependence is known as game
theory.
 The reward received by a player in a game—such as the profit earned by an
oligopolist—is that player’s payoff.
• A payoff matrix shows how the payoff to each of the participants in a two-player
game depends on the actions of both. Such a matrix helps us analyze
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interdependence.
A Payoff Matrix
Ajinomoto
Produce 30 million
pounds
Ajinomoto makes $180
million profit.
Produce 40 million
pounds
Ajinomoto makes $200
million profit.
Produce 30
million
pounds
ADM
ADM makes $180
million profit
Ajinomoto makes $160
million profit.
ADM makes $150
million profit
Ajinomoto makes $150
million profit.
Produce 40
million
pounds
ADM makes $200
million profit
ADM makes
$160million profit
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The Prisoners’ Dilemma
 Economists use game theory to study firms’ behavior when there is
interdependence between their payoffs.
 The game can be represented with a payoff matrix.
 Depending on the payoffs, a player may or may not have a dominant
strategy.
 When each firm has an incentive to cheat, but both are worse off if both
cheat, the situation is known as a prisoners’ dilemma.
 The game is based on two premises:
1) Each player has an incentive to choose an action that benefits itself
at the other player’s expense.
2) When both players act in this way, both are worse off than if they
had acted cooperatively.
The Prisoners’ Dilemma
Louise
Don’t confess
Louise gets 5-year
sentence.
Confess
Louise gets 2-year
sentence.
Don’t
confess
Thelma
Thelma gets 5-year
sentence.
Louise gets 20-year
sentence.
Thelma gets 20-year
sentence.
Louise gets 15-year
sentence.
Confess
Thelma gets 2-year
sentence.
Thelma gets 15-year
sentence.
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The Prisoners’ Dilemma
 An action is a dominant strategy when it is a player’s best action
regardless of the action taken by the other player. Depending on the
payoffs, a player may or may not have a dominant strategy.
 A Nash equilibrium, also known as a noncooperative equilibrium, is
the result when each player in a game chooses the action that
maximizes his or her payoff given the actions of other players, ignoring
the effects of his or her action on the payoffs received by those other
players.
Overcoming the Prisoners’ Dilemma
Repeated Interaction and Tacit Collusion
 Players who don’t take their interdependence into account arrive at a
Nash, or non-cooperative, equilibrium.
 But if a game is played repeatedly, players may engage in strategic
behavior, sacrificing short-run profit to influence future behavior.
 In repeated prisoners’ dilemma games, tit for tat is often a good
strategy, leading to successful tacit collusion.
Overcoming the Prisoners’ Dilemma
Repeated Interaction and Tacit Collusion
 Tit for tat involves playing cooperatively at first, then doing whatever the
other player did in the previous period.
 When firms limit production and raise prices in a way that raises each
others’ profits, even though they have not made any formal agreement,
they are engaged in tacit collusion.
How Repeated Interaction Can Support Collusion
Ajinomoto
Tit for tat
Ajinomoto makes $180 million
profit each year.
Always cheat
Ajinomoto makes $200
million profit 1st year,
$160 profit each later
year.
Tit for tat
ADM
ADM makes $180
million profit each year.
Ajinomoto makes $150
million profit 1st year,
$160 million profit each
later year.
ADM makes $150
million profit 1st year,
$160 million profit each
later year.
Ajinomoto makes $160 million
profit each year.
Always cheat
ADM makes $200
million profit 1st
year, $160 million
profit each later
year.
ADM makes $160
million profit each year.
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The Kinked Demand Curve
 An oligopolist who believes she will lose a substantial number of sales
if she reduces output and increases her price, but will gain only a few
additional sales if she increases output and lowers her price away from
the tacit collusion outcome, faces a kinked demand curve—very flat
above the kink and very steep below the kink.
 It illustrates how tacit collusion can make an oligopolist unresponsive
to changes in marginal cost within a certain range when those changes
are unique to her.
The Kinked Demand Curve
Price, cost
marginal
revenue
W
Tacit collusion
outcome
MC
P*
1
MC
2
X
1. Any marginal
cost in this
region
Y
MR
D
Q*
Z
Quantity
2. … corresponds to this level of
output
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FOR INQUIRING MINDS
Prisoners of the Arms Race
 Between World War II and the late 1980s, the United States and the
Soviet Union were locked in a struggle that never broke out into open
war. During this Cold War, both countries spent huge sums on arms,
sums that were a significant drain on the U.S. economy and eventually
proved a crippling burden for the Soviet Union, whose underlying
economic base was much weaker.
 Both nations would have been better off if they had both spent less on
arms. Yet the arms race continued for 40 years. Why?
 As political scientists were quick to notice, one way to explain the arms
race was to suppose that the two countries were locked in a classic
prisoners’ dilemma.
 Each government would have liked to achieve decisive military
superiority, and each feared military inferiority.
 But both would have preferred a stalemate with low military spending
to one with high spending.
 However, each government rationally chose to engage in high
spending.
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FOR INQUIRING MINDS
Prisoners of the Arms Race
 If its rival did not spend heavily, its own high spending would lead to
military superiority; not spending heavily would lead to inferiority if the
other government continued its arms buildup.
 So, the countries were trapped.
 The answer to this trap could have been an agreement not to spend as
much; indeed, the two sides tried repeatedly to negotiate limits on
some kinds of weapons.
 But these agreements weren’t very effective.
 In the end the issue was resolved as heavy military spending hastened
the collapse of the Soviet Union in 1991.
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The Ups and Downs of Oil Cartels
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Oligopoly in Practice
 Oligopolies operate under legal restrictions in the form of antitrust
policy.
 Antitrust policies are efforts undertaken by the government to prevent
oligopolistic industries from becoming or behaving like monopolies.
 But many succeed in achieving tacit collusion.
 Tacit collusion is limited by a number of factors, including:
 large numbers of firms
 complex products and pricing scheme
 bargaining power of buyers
 conflicts of interest among firms
GLOBAL COMPARISON
 The European Union is
believed to be stricter in
imposing antitrust actions
than the United States.
 Companies prefer the
American system and the
accompanying figure clarifies
why.
 In recent years, on average,
fines for unfair competition
have been higher in the
European Union than in the
United States.
Contrasting Approaches to Anti-Trust
Regulation
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Product Differentiation and Price Leadership
 When collusion breaks down, there is a price war.
 To limit competition, oligopolists often engage in product
differentiation, which is an attempt by a firm to convince buyers that its
product is different from the products of other firms in the industry.
 When products are differentiated, it is sometimes possible for an
industry to achieve tacit collusion through price leadership.
 Oligopolists often avoid competing directly on price, engaging in
nonprice competition through advertising and other means instead.
 In price leadership, one firm sets its price first, and other firms then
follow.
 Firms that have a tacit understanding not to compete on price often
engage in intense non-price competition, using advertising and other
means to try to increase their sales.
ECONOMICS IN ACTION
Price Wars of Christmas
 The toy aisles of American retailers have often been the scene of cutthroat competition.
 During the 2011 Christmas shopping season, Target priced the latest
Elmo doll at 89 cents less than Walmart (for those with a coupon),
and $6 less than Toys “R” Us. So extreme is the price cutting that
since 2003 three toy retailers—KB Toys, FAO Schwartz, and Zany
Brainy—have been forced into bankruptcy.
 What is happening? The turmoil can be traced back to trouble in the toy
industry itself as well as to changes in toy retailing–in the form of
Internet sales.
 Besides the Internet, there have also been new entrants into the toy
business: Walmart and Target have expanded their number of stores and
have been aggressive price - cutters.
 The result is much like a story of tacit collusion sustained by repeated interaction
run in reverse: because the overall industry is in a state of decline and there are
new entrants, the future payoff from collusion is shrinking.
 The predictable outcome is a price war.
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ECONOMICS IN ACTION
Price Wars of Christmas
 Since retailers depend on holiday sales for nearly half of their annual
sales, the holidays are a time of particularly intense price-cutting.
 Traditionally, the biggest shopping day of the year has been the day
after Thanksgiving.
 But in an effort to expand sales and undercut rivals, retailers—
particularly Walmart—have now begun their price-cutting earlier in
the fall.
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