1. Oligopoly and Strategic Behavior
Chapter 27
Oligopoly and Strategic Behavior

2. Introduction
On a typical day, United Parcel Service will transport over 10 million packages. UPS and its main rival, FedEx Ground, earn more than three-fourths of total revenue earned in the ground delivery of packages.
How can an economic model explain the dominance of only two firms in one industry?

3. Learning Objectives
Outline the fundamental characteristics of oligopoly
Understand how to apply game theory to evaluate the pricing strategies of oligopolistic firms
Explain the kinked demand theory of oligopolistic price rigidity

4. Learning Objectives
Describe theories of how firms may deter market entry by potential rivals
Illustrate why network effects and market feedback can explain why some industries are oligopolies

5. Chapter Outline Oligopoly Strategic Behavior and Game Theory
Price Rigidity and the Kinked Demand Curve

6. Chapter Outline
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
Deterring Entry into an Industry
Network Effects
Comparing Market Structures

7. Did You Know That...
Intel is the predominant seller of microprocessor chips, with a global market share of 80 percent?
Industries such as this, with one predominant seller and several smaller competitors, are not monopolies.
They are described by the term oligopoly.

8. Oligopoly
Oligopoly
A market situation in which there are very few sellers
Each seller knows that the other sellers will react to its changes in prices and quantities

9. Oligopoly Characteristics of oligopoly Small number of firms
Interdependence
Strategic dependence

10. Oligopoly Strategic Dependence
A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry

11. Oligopoly Why oligopoly occurs Economies of scale Barriers to entry
Mergers
Vertical mergers
Horizontal mergers

12. Oligopoly Vertical Merger Horizontal Merger
The joining of a firm with another to which it sells an output or from which it buys an input
Horizontal Merger
The joining of firms that are producing or selling a similar product

13. Oligopoly Measuring industry concentration Concentration Ratio
The percentage of all sales contributed by the leading four or leading eight firms in an industry

14. Computing the Four-Firm Concentration Ratio
Annual Sales
Firm ($ Millions)
1 150
2 100
3 80
4 70
5 through 25 50
Total number
of firms in
Industry = 25
Total 450
Four-firm concentration ratio =
450
400
88.9% =
Table 27-1

15. E-Commerce Example: Concentration in the Search-Engine Industry
Internet search-engines collect revenue through advertisements posted on their websites.
To measure the concentration ratio in this industry, economists count the number of searches conducted on each site.

16. E-Commerce Example: Concentration in the Search-Engine Industry
The four most frequently used search- engines are Google, Yahoo, AOL Time Warner, and MSN.
The four-firm concentration ratio in this industry is 91 percent, indicating that it qualifies as an oligopoly.

17. Oligopoly, Inefficiency, and Resource Allocation
Oligopolistic firms have some degree of market power, which means each one can affect the market price.
This creates some inefficiency in resource allocation.
But to the extent that U.S. oligopolies must compete with firms from other countries, their market power is limited.

18. Strategic Behavior and Game Theory
Explaining the pricing and output behavior of oligopoly markets
Reaction Function
The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry

19. Strategic Behavior and Game Theory
A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly

20. Strategic Behavior and Game Theory
Cooperative Game
A game in which the players explicitly cooperate to make themselves better off
Noncooperative Game
A game in which the players neither negotiate nor cooperate in any way

21. Strategic Behavior and Game Theory
Zero-Sum Game
A game in which any gains within the group are exactly offset by equal losses by the end of the game

22. Strategic Behavior and Game Theory
Negative-Sum Game
A game in which players as a group lose at the end of the game
Positive-Sum Game
A game in which players as a group are better off at the end of the game

23. Strategic Behavior and Game Theory
Strategies in noncooperative games
Strategy
Any rule that is used to make a choice
Any potential choice that can be made by players in a game
Dominant Strategies
Strategies that always yield the highest benefit

24. Example: The Prisoner’s Dilemma
You and your partner rob a bank and get caught.

25. Prisoner’s Dilemma You are separated and given these options:
Both confess and get five years in jail
Neither confess and get two years
One confess and the other does not
Confessor goes free
One who does not confess gets ten years

26. Prisoner’s Dilemma
What would you do?
Remember
No cooperation

27. The Prisoners’ Dilemma Payoff Matrix
Figure 27-1

28. Strategic Behavior and Game Theory
Applying game theory to pricing strategies
Would you choose a high price or a low price?
Remember
No collusion

29. Strategic Behavior and Game Theory
Figure 27-2

30. Strategic Behavior and Game Theory
Opportunistic Behavior
Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains
An example might be writing a check that you know will bounce

31. Strategic Behavior and Game Theory
Opportunistic behavior
Implies a noncooperative game
Not realistic
We make repeat transactions

32. Strategic Behavior and Game Theory
Tit-for-Tat Strategic Behavior
In game theory, cooperation that continues so long as the other players continue to cooperate

33. Price Rigidity and the Kinked Demand Curve
Panel (a) d 2
MR2
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share d 1 MR 1 A q P
Price and Marginal Revenue per Unit
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
Quantity per Time Period
Figure 27-3, Panel (a)

34. Price Rigidity and the Kinked Demand Curve
Panel (b) d 2 1
The kinked demand curve indicates the possibility of price rigidity MR 2 1 A q P
Price and Marginal Revenue per Unit
Quantity per Time Period
Figure 27-3, Panel (b)

35. Price Rigidity and the Kinked Demand Curve2 1 MR 2 1 q P ' MC MC
Price, Marginal Revenue, and
Marginal Cost per Unit
MC"
Changes in cost do
not impact output
and prices as long as
MC remains in the
vertical portion of MR
Quantity per Time Period
Figure 27-4

36. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices
Price leadership behavior is apparent in the overnight package delivery industry

37. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
Price War
A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices

38. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
Markets where price wars are common
Cigarettes
Long-distance telephone companies
Airlines

39. Strategic Behavior with Implicit Collusion: A Model of Price Leadership
Markets where price wars are common
Diapers
Frozen foods
PC hardware and software

40. Example: A Price War in Diapers
In 2001, the makers of Huggies disposable diapers reduced the size of its packages by one diaper, but left the package price unchanged.
This increased the effective diaper price by 5 percent.

41. Example: A Price War in Diapers
The response from Pampers, the main competitor, was to cut prices by 15 percent.
Huggies soon followed with a price reduction, and a price war ensued.
As would be expected, there was a benefit to consumers as package prices fell and coupons were made widely available.

42. Deterring Entry Into an Industry
Entry Deterrence Strategy
Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm

43. Deterring Entry Into an Industry
Increasing entry cost
Threat of price wars
Government regulations
Environmental regulation
Safety standards

44. Deterring Entry Into an Industry
Limit-Pricing Strategies
A model that hypothesizes that a group of colluding sellers will set the highest common price they believe they can charge, without new firms seeking to enter the industry

45. Deterring Entry Into an Industry
Raising switching costs for customers
Examples
Non-compatible software
Non-transferability of college courses

46. Example: QWERTY and High Switching Costs
The QWERTY keyboard was designed to solve a mechanical problem of the tendency for typewriter keys to jam.
Now that the mechanical problem no longer exists, why does this keyboard layout persist?

47. Network Effects
A network effect is a situation in which a consumer’s inclination to use an item depends on how many others use it.
For example, the value of a fax machine increases as there are more fax machines in use.

48. Network Effects Positive Market Feedback Negative Market Feedback
Potential for a network effect to arise when an industry’s product catches on
Negative Market Feedback
The tendency for industry sales to spiral downward rapidly when the product falls out of favor

49. Network Effects and Industry Concentration
In an industry selling products subject to network effects, a small number of firms may be able to secure the bulk of the payoffs resulting from positive market feedback.
Oligopoly is likely to emerge as the prevailing market structure.

50. Comparing Market Structures
Long-Run
Number Unrestricted Ability Economic
Market of Entry and to Set Profits Product Nonprice
Structure Sellers Exit Price Possible Differentiation Competition Examples
Perfect Numerous Yes None No None None Agriculture, competition roofing nails
Monopolistic Many Yes Some No Considerable Yes Toothpaste competition toilet paper, soap, retail trade
Oligopoly Few Partial Some Yes Frequent Yes Recorded music, college textbooks
Pure One Not Consider- Yes None Yes Some electric monopoly for entry able (product is companies, unique) some local telephone companies
Table 27-3

51. Issues and Applications: Oligopoly in the Ground-Shipping Business
In the industry of shipping packages by ground, the four-firm concentration ratio in the U.S. is 100 percent.
The four firms are UPS, FedEx Ground, the U.S. Postal Service, and DHL.
Among these four firms, there is strategic dependence regarding both prices and delivery schedules.

52. Issues and Applications: Oligopoly in the Ground-Shipping Business
FedEx Ground is willing to deliver on Saturdays.
Each of the four delivery services employs computer technology to speed the pace of delivery and to allow customers to track packages in shipment.
This industry fits the definition of oligopoly, with four firms competing interdependently.

53. Summary Discussion of Learning Objectives
The fundamental characteristics of oligopoly
Economies of scale
Barriers to entry
Strategic dependence
Applying game theory to evaluate the pricing strategies of oligopolistic firms
Game theory looks at competition for payoffs
That depends on the strategies that others employ

54. Summary Discussion of Learning Objectives
The kinked demand theory of oligopolistic price rigidity
If a firm believes that rivals will follow price cuts but not price increases, it will be reluctant to change price.
How firms may deter market entry by potential rivals
Raise entry costs
Limit pricing
Switching policies

55. Summary Discussion of Learning Objectives
Why network effects and market feedback encourage oligopoly:
Network effects arise when a consumer’s demand for a good or service is affected by how many other consumers also use the item
Oligopoly can arise because a handful of firms may be able to capture all of the positive market feedback

56. Oligopoly and Strategic Behavior
End of Chapter 27
Oligopoly and Strategic Behavior