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1 Chapter 12 Principles of Economics by Fred M Gottheil Chapter 12 Price and Output Determination Under Oligopoly PowerPoint Slides prepared by Ken Long.

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Presentation on theme: "1 Chapter 12 Principles of Economics by Fred M Gottheil Chapter 12 Price and Output Determination Under Oligopoly PowerPoint Slides prepared by Ken Long."— Presentation transcript:

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2 1 Chapter 12 Principles of Economics by Fred M Gottheil Chapter 12 Price and Output Determination Under Oligopoly PowerPoint Slides prepared by Ken Long © ©1999 South-Western College Publishing

3 2 What is Oligopoly? A market structure consisting of only a few firms producing goods that are close substitutes © ©1999 South-Western College Publishing

4 3 What are some examples of Oligopoly? Automobiles Steel Soup Cereals © ©1999 South-Western College Publishing

5 4 What determines if a market is an Oligopoly? The concentration ratio can be used as a guide © ©1999 South-Western College Publishing

6 5 What concentration ratio constitutes an Oligopoly? There is no magic number, but if a large percentage of the sales are from the 4 largest firms, it’s an Oligopoly © ©1999 South-Western College Publishing

7 6 What is an example of a high concentration ratio? Out of 151 firms in the aircraft industry the leading 4 constitutes 79% of total sales © ©1999 South-Western College Publishing

8 7 For more information on industry concentration check out these web pages - /www/manumenu.htmlhttp://www.census.gov/econ /www/manumenu.html © ©1999 South-Western College Publishing

9 8 What is the Herfindahl- Hirschman Index (HHI)? A measure of industry concentration, calculated as the sum of the squares of the market shares held by each firm in the industry © ©1999 South-Western College Publishing

10 9 Calculation of the HHI HHI = s s ….. s n 2 where S i = the i th firms market share, n= number of firms in industry

11 10 Problems: For an industry with only 1 firm, (monopoly), what would be the HHI?

12 11 Suppose the industry has 10 equal size firms, what is the HHI? What if the industry has 100 equal size firms?

13 12 Answers: Monopoly, HHI = 10, equal size firms, HHI = 1, equal size firms, HHI = 100

14 13 How Oligopolistic is the U.S. Economy? Oligopoly is very much of a fact of life in the U.S. © ©1999 South-Western College Publishing

15 14 Is the U.S. becoming more Oligopolistic? Answer appears to be NO to this question. While there have been some periods of time when industries appeared to be getting more concentrated into fewer firms, there are other periods of history where just the opposite happened.

16 15 What is Market Power? A firm’s ability to select and control market price and output © ©1999 South-Western College Publishing

17 16 What is an Unbalanced Oligopoly? An oligopoly in which the sales of the leading firms are distributed unevenly among them © ©1999 South-Western College Publishing

18 17 What is a Balanced Oligopoly? An oligopoly in which the sales of the leading firms are distributed fairly evenly among them © ©1999 South-Western College Publishing

19 18 In which type is market power most concentrated? Unbalanced Oligopoly © ©1999 South-Western College Publishing

20 19 Why do Oligopolies exist? Mergers Economies of scale Reputation Strategic barriers Government barriers © ©1999 South-Western College Publishing

21 20 What is a Horizontal Merger? A merger between firms producing the same good in the same industry © ©1999 South-Western College Publishing

22 21 What is a Vertical Merger? A merger between firms that have a supplier - purchaser relationship © ©1999 South-Western College Publishing

23 22 What is a Conglomerate Merger? A merger between firms in unrelated industries © ©1999 South-Western College Publishing

24 23 For more information on mergers check out these sites: newsipos.htmlhttp://www.stocksmart.com/ newsipos.html © ©1999 South-Western College Publishing

25 24 Firms in Oligopoly are said to be Mutually Interdependent Firms realize the large impact that other firms behavior has on their profits Leads to many models of oligopoly, depending on how the firms deal with the mutual interdependence issue

26 25 One way to deal with the Mutual Interdependence problem is….. LET’S CHEAT!!!! THE COLLUSION SOLUTION!!!

27 26 What is Collusion? The practice of firms to negotiate price and market decisions that limit competition © ©1999 South-Western College Publishing

28 27 What is a Cartel? A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares © ©1999 South-Western College Publishing

29 28 One model of collusion that can be used is the cartel model Internationally, some cartels like OPEC exist Domestically, these would be illegal If the cartel can collude perfectly, would tend to charge the monopoly price

30 29 Ingredients for a successful cartel Control a large share of the market Inelastic and stable demand for the product Similar costs among cartel members Fairly homogenous product Few number of firms Ways of preventing cheating on the agreement

31 30 Check out the Opec Cartel

32 31 What is the relationship between market concentration and price? A high concentration ratio in an industry may translate into noncompetitive prices and behavior © ©1999 South-Western College Publishing

33 32 Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts but not price increases. Under this assumption, its as if each firm faces a “kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals quickly match price cuts.

34 33 Kinked Demand Curve P1P1 Starting price 33 D MR MR Gap Price Quantity Q1Q1

35 34 Graph explanation: Let P 1 and Q 1 be the existing price and quantity for this oligopoly firm: due to the assumptions of this model, the demand curve has a kink in it at this price and output. Because of the strange shape of the demand curve, the MR curve is discontinuous, or has a gap in it.

36 35 Kinked demand curve model is an attempt to explain rigid prices in oligopoly: That is, firms might not change price very often. Why? Firm is reluctant to raise price if its competitors do not, since it could lose sales to them, and little reason is seen to lower price if competitors quickly match the price cut, since little will be gained.

37 36 What does the kinked demand curve illustrate? There is a great deal of price stability and nonprice competition is important © ©1999 South-Western College Publishing

38 37 How do firms in an Oligopoly set price? Most often they practice price leadership © ©1999 South-Western College Publishing

39 38 Price leadership in Oligopoly One firm, the dominant firm, sets the price, others follow the leader Often the dominant firm is the low cost producer in the industry Is this a form of “tacit” collusion?

40 39 What is an example nonprice competition? Brand multiplication when there are variations on one good to increase market share © ©1999 South-Western College Publishing

41 40 Game Theory Approach to Oligopoly Is Oligopoly best analyzed as a strategic game like chess?

42 41 What is Game Theory? A theory of strategy ascribed to a firm’s behavior in oligopoly © ©1999 South-Western College Publishing

43 42 For more information about Game Theory - alroth.htmlhttp://www.pitt.edu/~alroth/ alroth.html © ©1999 South-Western College Publishing

44 Prisoner's Dilemma

45 44 If the 2 people could collude, would likely choose to not confess, but self interest may drive each to confess, hoping the other does not, end up both confessing, worse off for both—many similar situations perhaps for firms in oligopoly

46 Two firm game

47 46 What is a dominant strategy? A strategy that is best regardless of what the opposition does. For B, dominant strategy is to break the agreement, and also for A. Both firms avoid the worst case scenario in this manner.

48 47 What is a Nash equilibrium? (named for Mathematician John Nash…did you see the film “A Beautiful Mind?) A situation where neither firm can improve its payoff, given what the other firm is doing…in this example, breaking the agreement is the Nash equilibrium

49 48 Is there any way to get to box 1 where both firms are better off short of outright collusion? Possibility of a tit-for-tat strategy….somehow indicate to the other firm that although you want to hold the agreement, you will switch to match what the other firm does.

50 49 For a forum that induces the interactive Prisoner’s Dilemma check out - /~ann/pd.htmlhttp://serendip.brynmawr.edu /~ann/pd.html © ©1999 South-Western College Publishing

51 50 What is Price Discrimination? The practice of offering a specific good or service at different prices to different segments of the market © ©1999 South-Western College Publishing

52 51 Why would a firm want to price discriminate? Greater profits possible!!

53 52 Different types of Price Discrimination “Perfect” price discrimination: Charge each buyer the highest price they are willing to pay

54 53 More usual type of price discrimination Separate buyers into groups (based perhaps on age, sex, region of country, etc. Groups should have different elasticities of demand

55 54 Higher price to more inelastic group, lower to more elastic: must also be able to prevent resale of product

56 55 What is Oligopoly? What concentration ratio constitutes an Oligopoly?What concentration ratio constitutes an Oligopoly? What is an Unbalanced Oligopoly? What is a Balanced Oligopoly? What is Collusion? What is a Cartel?

57 56 What is the distinguishing feature of Oligopoly?What is the distinguishing feature of Oligopoly? How do firms in an Oligopoly set price?How do firms in an Oligopoly set price? What is Game Theory? What is the Prisoner’s Dilemma? What is Price Discrimination?

58 57 ENDEND © ©1999 South-Western College Publishing


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