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Chapter 13 Oligopoly and Monopolistic Competition.

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1 Chapter 13 Oligopoly and Monopolistic Competition

2 Key issues 1. market structure 2.game theory 3.cooperative oligopoly models (cartels) 4.Cournot model of noncooperative oligopoly 5. Stackelberg model of noncooperative oligopoly 6.monopolistic competition 7.Bertrand model of noncooperative oligopoly

3 Market structures markets differ according to number of firms in market ease of entry and exit ability of firms to differentiate their products

4 Oligopoly small group of firms in a market with substantial barriers to entry because relatively few firms compete in such a market, each firm faces a downward-sloping demand curve each firm can set its price: p > MC market failure: inefficient (too little) consumption each affects rival firms typical oligopolists differentiate their products

5 Monopolistic competition small or moderate number of firms free entry  = 0 p = AC usually products differentiated

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7 Strategies and games oligopolistic or monopolistically competitive firm use a strategy: battle plan of actions (such as setting a price or quantity) it will take to compete with other firms oligopolies engage in a game: any competition between players (such as firms) in which strategic behavior plays a major role

8 Game theory set of tools used by economists, political scientists, military analysts, and others to analyze decision making by players (such as firms) who use strategies these analytic tools can be used to analyze oligopolistic games poker coin-matching games tic-tac-toe elections nuclear war

9 Firm's objective obtain largest possible profit (or payoff) at game’s end typically, one firm's gain comes at expense of other firms each firm's profit depends on actions taken by all firms

10 Nash equilibrium set of strategies is a Nash equilibrium if, holding strategies of all other players (firms) constant, no player (firm) can obtain a higher payoff (profit) by choosing a different strategy in a Nash equilibrium, no firm wants to change its strategy because each firm is using its best response: strategy that maximizes its profit given its beliefs about its rivals' strategies

11 Duopoly consider single-period, duopoly, quantity- setting game duopoly: an oligopoly with two ("duo") firms

12 Airlines Example American Airlines and United Airlines compete for customers on flights between Chicago and Los Angeles

13 Notation Q = total number of passengers flown by both firms; sum of: q A = passengers on American Airlines q U = passengers on United Airlines

14 Firms act simultaneously each firm selects a strategy that maximizes its profit given what it believes other firm will do firms are playing a noncooperative game of imperfect information: each firm must choose an action before observing rivals’ simultaneous actions

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16 Dominant strategy a strategy that strictly dominates all other strategies regardless of which actions rivals’ chose in this Table 13.2 game, each firm has a dominant strategy firm chooses its dominant strategy where a firm has a dominant strategy, its belief about its rival's behavior is irrelevant

17 Noncooperative game firms do not cooperate in a single-period game In Nash equilibrium (q A = q U = 64), each firm earns $4.1 million (< $4.6 million it would make if firms restricted their outputs to q A = q U = 48) sum of firms' profits is not maximized in this simultaneous choice, one-period game

18 Why don't firms cooperate? don't cooperate due to a lack of trust: each firm can profitably use low-output strategy only if it trusts other firm! each firm has a substantial profit incentive to cheat on a collusive agreement

19 Prisoners' dilemma game all players have dominant strategies that lead to a profit (or other payoff) that is inferior to what they could achieve if they cooperated and played alternative strategies

20 Collusion in repeated games in a single-period prisoners' dilemma game, firms produce more than they would if they colluded why, then, are cartels frequently observed? collusion is more likely in a multiperiod game: single-period game played repeatedly punishment: not possible in a single-period game but possible in a multiperiod game

21 Supergame if a single-period game is played repeatedly, firms engage in a supergame: players’ strategies in this period may depend on rivals' actions in previous periods in a repeated game, firm can influence its rival's behavior by signaling threatening to punish

22 Threat suppose American announces to United that it will use the following two-part strategy: American produces smaller quantity each period as long as United does the same if United produces larger quantity in period t, then American will produce larger quantity in period t + 1and all subsequent periods thus, if firms play same game indefinitely, they should find it easier to collude

23 Know number of periods suppose firms know that they are going to play game for T periods period T is like a single-period game, and all firms cheat hence T-1 period is last interesting period by same reasoning, they cheat in that period, etc. cheating is less likely to occur if end period is unknown or there is no end

24 Insurance price wars from , life insurance companies' prices were high and unchanging in 1995, prices dropped 25% or more

25 Explanations for price war 1. insurers knew that new “Triple X” regulations were expected to go into effect in 1996 regulations required insurers to raise reserves on term policies to cover future claims were expected to boost rates on new policies by as much as 50% companies cut rates to attract new customers before higher rates took effect 2. formal or informal agreement to keep prices high fell apart as end of original game approached

26 Cooperative oligopoly models Adam Smith: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices"

27 Cartels fail luckily for consumers, cartels often fail because each firm in a cartel has an incentive to cheat on the cartel agreement by producing extra output governments forbid them

28 Historic cartels in late nineteenth century, cartels (trusts) were legal and common in the United States oil railroads sugar tobacco steel J.D. Rockefeller

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31 Laws against cartels in response to trusts' high prices, Congress passed Sherman Antitrust Act in 1890 Federal Trade Commission Act of 1914 these laws prohibit firms from explicitly agreeing to take actions that reduce competition, such as jointly setting price these anti-cartel laws are called antitrust laws in U.S. competition policies in most other countries

32 Europe over the last dozen years, the European Commission has been pursuing competition cases under laws that are similar to U.S. antitrust laws recently the EC, the DOJ, and the FTC have become increasingly aggressive, prosecuting many more cases following the U.S., which uses both civil and criminal penalties, the British government introduced legislation in 2002 to criminalize certain cartel-related conduct EU uses only civil penalties, but its fines have increased dramatically, as have U.S. fines

33 Corporate Leniency Program in 1993, DOJ introduced a new Corporate Leniency Program that guarantees that participants in cartels who blow the whistle will receive immunity from federal prosecution as a consequence, DOJ has caught, prosecuted, and fined several gigantic cartels (e.g. Vitamins) on Valentine’s Day, 2002, EC adopted a similar policy

34 Sotheby’s and Christie’s Sotheby’s (established in 1744) and Christie’s (1776) are the two largest and most prestigious auction houses in the world they control 90% of the $4 billion worldwide auction market for most of the last two and a half centuries, they thrived starting at least by 1993, when faced with poor business conditions, they started to collude, according to the U.S. Department of Justice (DOJ)

35 Auctions (cont.) DOJ started investigating in 1997, but gained the necessary evidence in 2000, when Christie’s approached both DOJ and European Commission with proof that it had conspired with Sotheby’s to fix prices Christie’s applied for leniency under the U.S. antitrust laws, effectively “shopping” its rival

36 Auctions (cont.) DOJ charged that the pair held meetings between top-level executives exchanged confidential lists of super-rich clients agreed to limit which customers received lower commissions charged identical commission rates (a sliding scale up to 20%) to other sellers who had little negotiation power Sotheby’s paid a $45 million fine the two auction houses agreed to pay more than $512 million to former clients to settle lawsuits

37 Auctions (cont.) A. Alfred Taubman, Sotheby’s former chairman and who still held a 21% share of stock and controlled 63% of its voting rights, was sentenced for price fixing to a year in prison and fined $7.5 million in 2002 Christie’s former chairman, Sir Anthony Tennant, lives in England has refused to come to the United States to face trial however, days before Taubman’s conviction, the European Commission brought charges against both auction houses

38 Why some cartels persist 1. tacit collusion 2. international cartels (OPEC) and cartels within certain countries operate legally 3. illegal cartel believes it can avoid detection or punishment will be small

39 Why cartels form members of cartel believe they can raise their profits by coordinating their actions

40 Why can cartels raise profits? if a competitive firm is maximizing its profit, why should joining a cartel increase its profit? competitive firm is already choosing output to maximize its profit however, it ignores effect that changing its output level has on other firms' profits cartel takes into account how changes in one firm's output affect cartel profits

41 Why cartels fail cartels fail if noncartel members can supply consumers with large quantities of goods (example: copper) each member of a cartel has an incentive to cheat on cartel agreement

42 Figure 13.1 Competition Versus Cartel Price,p, $ per unit (a) Firm q c q*q m Quantity,q, Units per year S MR Market demand AC MC p m MC m p c p m e m e c m p c Price,p, $ per unit (b) Market Q m Q c Quantity,Q, Units per year

43 Solved problem initially, all identical firms in a market collude if some of these firms leave the cartel and act like price takers, how are consumers affected?

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45 Maintaining cartels to maintain cartel, firms must detect cheating punish violators keep its illegal behavior hidden from governments

46 Detection and enforcement inspect each other's books (e.g., most-favored nation clauses) governments report bids on government contracts divide market by region or by customers mercury cartel ( ) allocated U.S. to Spain and Europe to Italy use industry organizations to detect cheating offer "low price" guarantees

47 Insurance price wars life insurance companies' prices are normally stable and high however, in 1995, companies dropped their prices substantially: 25% or more the previous price war , when term insurance rates went from $4 to $1 per thousand dollars of coverage for a 35-year- old for a 10-year plan

48 Cause of price war theory 1: sparked by new insurance regulations insurers knew in advance when these new regulations (Triple X) were expected to go into effect new regulations required insurers raise reserves on term policies to cover future claims; were expected to boost rates by as much as 50% companies were cutting rates to attract new customers before the higher rates took effect

49 Alternative theory theory 2 (not necessarily incompatible view): a formal or informal agreement to keep prices high fell apart as the end of the original game approached

50 Government created cartels American, European, and other governments established a cartel in 1944 that fixed prices for international airline flights and prevented competition baseball teams exempted from some U.S. antitrust laws since 1922 Bud Selig, baseball's commissioner: “[The baseball] antitrust exemption is protection for the fans.” automobiles

51 Automobile cartel Reagan admin. negotiated 1981 voluntary export restraints (VER): Japanese auto manufacturers would reduce their auto exports to U.S. Why would Japanese manufacturers “voluntarily” reduce their exports? to avoid government quotas to act like a cartel: reducing sales to collusive level when U.S. allowed VER agreements to lapse in 1985, Japanese government wanted to continue to restrict exports

52 Auto cartel effects stock market value of Japanese auto industry increased during VER period by $6.6 billion VERs raised price of American cars by 5.4% between 1981 and 1983 U.S. consumers lost $6.9 billion ($1984) due to these export restrictions using VER is foolish foreign and domestic auto manufacturers capture “cartel” profits from higher prices tariffs better for U.S.

53 Entry and cartel success barriers to entry help cartel: limit competition cartels with large number of firms rare (except professional associations) Dept. of Justice price-fixing cases only 6.5% involved 50 or more conspirators average number of firms was % involved 6 or fewer firms cartels often fall apart after entry (mercury)

54 Bail bonds Connecticut sets a maximum fee bail-bond businesses can charge for posting a given- size bond how close price in a city is to legal maximum depends on number of firms

55 Town # of active firms % of maximum allowed fee Plainville, Stamford, Wallingford 199 Meriden, New London298 Norwalk354 New Haven864 Bridgeport1078

56 Mergers if antitrust or competition laws prevent firms from colluding, they may try to merge U.S. laws restrict ability of firms to merge if effect would be anticompetitive

57 Some mergers raise efficiency efficiency due to greater scale sharing trade secrets closing duplicative retail outlets Chase and Chemical banks merged in 1995: closed or combined 7 branches in Manhattan located within 2 blocks of another branch

58 Airline mergers government did not contest most airline mergers prices increased on routes served by firms that merged relative to those on routes without mergers

59 Soft drinks 1986 merger proposals Coke, largest producer of carbonated soft drinks (38.6% of sales), tried to buy third largest, Dr Pepper (7.1%) Pepsi, second largest producer (27.4%), tried to acquire fourth largest firm, Seven-Up Co. (6.3%) had these proposed mergers taken place, Coke's market share would have risen to 45.7% and Pepsi's to 33.7% combined share would have risen from 66.0% to 79.4%

60 FTC intervenes Federal Trade Commission (FTC) opposed mergers, arguing that merger would increase market shares of big firms make entry of new firms more difficult raise costs of other companies doing business in this market ease "collusion among participants in the relevant markets"

61 Relevant market definition Coca-Cola: all beverages including tap water Federal Judge Gesell: carbonated soft drinks (based on cross-elasticities of demand)

62 Outcome after Coke and Pepsi mergers blocked by FTC in 1986 Dr Pepper Co. sold for $416 million to investor group ($54 million less than Coke offered) Seven-Up Co. sold for $240 million to another investment group ($140 million less than Pepsico's bid) lower values to others than to Coke and Pepsi is consistent with FTC's view that Coke and Pepsi would have gained market power through these mergers

63 Eventually Dr Pepper and Seven-Up merged by 1995: Dr Pepper/Seven-Up: 11.5% of carbonated beverages market Cadbury: 5.5% [Schweppes, Canada Dry, Crush, Sunkist, and A&W (root beer) brands] Cadbury bought Dr Pepper/Seven-Up (17% of soft- drink market, and half non-cola part) Coke: 41%, Pepsi: 32% mergers increased share of top 3 firms FTC's actions limited share of top 2 firms

64 Noncooperative oligopoly many models of noncooperative oligopoly behavior firms choose quantities Cournot model Stackelberg model firms set prices: Bertrand model

65 Cournot Augustin Cournot introduced first formal model of oligopoly in 1838 oligopoly firms choose how much to produce at same time as in prisoners' dilemma game, firms are playing noncooperative game of imperfect information each firm chooses its output level before knowing what other firm will choose firms may choose any output level they want

66 Basic model duopoly: 2 firms (no other firms can enter) firms sell identical products market that lasts only 1 period (product or service cannot be stored and sold later)

67 Cournot model of airline market duopoly: United Airlines (UA) and American Airlines (AA) fly passengers between Chicago and Los Angeles no possible entry (limited landing rights at both airports)

68 Cournot equilibrium Nash equilibrium where firms choose quantities set of quantities sold by firms such that, holding quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity

69 Figure 13.2a American Airlines’ Profit-Maximizing Output p, $ per passenger MC MR D (a) Monopoly q A, Thousand American Airlines passengers per quarter

70 Figure 13.2b American Airlines’ Profit-Maximizing Output MR r D r D p, $ per passenger MC (b) Duopoly q A, Thousand American Airlines passengers per quarter q U =

71 Figure 13.3 American and United’s Best-Response Curves q U, Thousand United passengers per quarter United ’ s best-response curve Cournot equilibrium American’s best-response curve q A, Thousand American passengers per quarter

72 Figure 13.4a Duopoly Equilibria Price-taking equilibrium q U, Thousand United passengers per quarter United’s best-response curve Cournot equilibrium Cartel equilibrium Stackelberg equilibrium Contract curve American’s best-response curve (a) Equilibrium Quantities q A, Thousand American passengers per quarter

73 Figure 13.4b Duopoly Equilibria  U, $ million profit of United Airlines Cournot profits Price-taking profits Profit possibility frontier Cartel profits Stackelberg profits American monopoly profit (b) Equilibrium Profits  A, $ million profit of American Airlines

74 Algebraic approach estimate of linear market demand function is Q(p) = 339 – p linear residual demand facing AA is q A = Q(p) – q U = (339 – p) – q U  p = q A - q U slope of residual demand curve is  p/  q A = -1, so slope of MR r = -2 MR r = q A - q U

75 Calculus linear residual demand facing AA is p = q A – q U so AA’s revenue is R = 339q A - q A 2 - q U q A so AA’s marginal revenue (using the Cournot assumption) is MR r = dR/dq A = 339 – 2q A - q U

76 AA Maximizes profit MR r = q A - q U = 147 = MC  best-response function q A = 96 - ½ q U

77 Cournot equilibrium intersection of best-response functions q A = 96 - ½ q U q U = 96 - ½ q A solve by substituting q A = 96 - ½(96 - ½ q A )  q A = 64 Q = q A + q U = 128 p = 339 – Q = $211

78 Solved problem Math version of Solved Problem 13.1 in text. Government charges American Airlines and United Airlines a specific tax of  per passenger on the Los Angeles-Chicago route. What is the new equilibrium number of passengers that each airline flies? What's the equilibrium number if the tax is $30?

79 Answer determine how the firms' best-response functions change due to the tax: AA sets its MR r equal to its MC (including the tax) MR r = q A - q U =  = MC rearranging, AA’s best-response function is q A = 96 -  /2 - q U /2 similarly, UA's best-response function is q U = 96 -  /2 - q A /2

80 Answer (cont.) solve for the equilibrium quantities in terms of  : substitute UA's best-response function into AA's and rearrange: q A = (2/3)(96 –  /2) = 64 –  /3 substitute for q a in UA's best-response function: q U = 64 –  /3

81 Answer (cont.) solve for the equilibrium quantities where  = $30: q A = q U = 64 – [1/3]  = 54

82 European cigarette tax incidence As with a monopoly, an oligopoly may pass through less or more than 100% of a tax to consumers Delipalla and O’Donnell’s (2001) estimate degree of pass- through to consumers from a specific tax on cigarettes: less than 100% in the Netherlands (67%), Belgium (79%), and Germany (82%) about 100% in Denmark, the United Kingdom, Portugal, and Ireland extremely high in Italy (359%), France (604%), and Luxembourg (700%)

83 Cournot equilibrium varies with number of firms typical Cournot firm maximizes its profit MR = p(1 + 1/[n  ]) = MC n  is elasticity of residual demand curve facing each firm  is market elasticity of demand n is number of firms Lerner index:

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85 Air ticket prices and rivalry markup of price over marginal cost is much greater on routes in which one airline carries most of the passengers than on other routes a single firm is the only carrier or the dominate carrier on 58% of all U.S. domestic routes monopoly serves 18% of all routes duopolies 19% three firms 16% four firms 13% five or more firms 35%

86 Air ticket prices (cont.) although nearly two-thirds of all routes have three or more carriers, one or two firms dominate virtually all routes dominant firm: has at least 60% of ticket sales by value but is not a monopoly dominant pair if they collectively have at least 60% of the market but neither firm is a dominant firm and three or more firms fly this route all but 0.1% of routes have a monopoly (18%), a dominant firm (40%), or a dominant pair (42%)

87 Air ticket prices (cont.) (average price includes “free” frequent flier tickets and other below-cost tickets) ticket price is 2.1 x MC on average across all U.S. routes and market structures 3.3 x MC for monopolies 3.1 x MC for dominant firms 1.2 x MC for dominant pairs if there is a dominant pair, whether there are 4 or 5 firms, price is between 1.3 x MC for a 4-firm route and 1.4 x for a route with 5 or more firms

88 Stackelberg model Cournot model: both firms make their output decisions simultaneously Heinrich von Stackelberg's model: firms act sequentially leader firm sets its output first then its rival (follower) sets its output

89 Figure 13.5 Stackelberg Game Tree American (4.6, 4.6) (3.8, 5.1) (2.3, 4.6) 48 Leader’s decisionFollower’s decisionProfits(  A,  U ) (5.1, 3.8) (4.1, 4.1) (2.0, 3.1) (4.6, 2.3) (3.1, 2.0) (0, 0) 96 United

90 Figure 13.6 Stackelberg Equilibrium q U, Thousand United passengers per quarter q A, Thousand American passengers per quarter q U = q A = 96 MR r D r D MC p, $ per passenger (a) Residual Demand American Faces q A, Thousand American passengers per quarter q U = q A = 96Q = 144 United ’ s best-response curve (b) United’s Best-Response Curve

91 Question when firms move simultaneously, why doesn't AA announce it will produce Stackelberg-leader output, so as to induce UA to produce the Stackelberg follower's output level?

92 Answer when firms move simultaneously, UA doesn't view AA's warning that it will produce a large quantity as a credible threat: not in AA’s best interest to produce large quantity because AA cannot be sure that UA believes threat and reduce its output, AA produces Cournot level when one firm moves first, its threat to produce large quantity is credible because it has already committed to producing large quantity

93 Monopolistic competition market structure in which firms have market power are price setters firms enter if there is a profit opportunity (  = 0) monopolistically competitive equilibrium: MR = MC p = AC (demand curve tangent to AC curve)

94 Figure 13.8 Monopolistically Competitive Equilibrium p, $ per unit q, Units per yearq p MR r D r MC AC p = MR r = MC

95 Figure 13.9a Monopolistic Competition Among Airlines p, $ per passenger q, Thousand passengers per quarter (a) Two Firms in the Market AC MC MR r for 2 firms  = $1.8 million D r for 2 firms if F = $2.3 million

96 Figure 13.9b Monopolistic Competition Among Airlines p, $ per passenger q, Thousand passengers per quarter (b) Three Firms in the Market AC MC MR r for 3 firms D r

97 Number of firms number of firms in equilibrium is smaller, greater economies of scale less market demand at each price fewer monopolistically competitive firms, less elastic is each firm’s residual demand curve at equilibrium higher fixed cost

98 Fixed cost and number of firms fixed costs determine number of firms AC = F/q smallest quantity at which AC curve reaches its minimum called full capacity, or minimum efficient scale monopolistically competitive equilibrium in downward-sloping section of AC curve, so monopolistically competitive firm operates at less than full capacity in LR

99 Bertrand firms set price instead of quantity changes equilibrium (unlike monopoly, choice of quantity vs. price matters)

100 Figure Bertrand Equilibrium with Identical Products p 2, Price of Firm 2, $ per unit Firm 2 ’s best-response curve Firm 1 ’ s best-response curve 45° line e p 1, Price of Firm 1, $ per unit

101 Figure Bertrand Equilibrium with Differentiated Products p c, Price of Coke, $ per unit Pepsi’s best-response curve (MC p = $5)Coke’s best-response curve (MC c = $14.50) Coke’s best-response curve (MC c = $5) p p, Price of Pepsi, $ per unit e 1 e 2

102 1. Market structure prices, profits, and quantities in a market equilibrium depend on the market's structure all firms maximize profit by setting MR = MC oligopolies and monopolistically competitive firms are price setters: face downward-sloping demand curves oligopoly: entry blocked monopolistic competition: free entry

103 2. Game theory set of tools used to analyze conflict and cooperation between firms each firm forms a strategy or battle plan of the actions to compete with other firms firms' set of strategies is a Nash equilibrium if, holding the strategies of all other firms constant, no firm can obtain a higher profit by choosing a different strategy

104 3. Cooperative oligopoly models with collusion, firms collectively produce monopoly output and earn monopoly profit each individual firm has an incentive to cheat on a cartel arrangement so as to raise its own profit even higher

105 4. Cournot model of noncooperative oligopoly if oligopoly firms act independently, market output and firms' profits lie between competitive and monopoly levels Cournot model: each oligopoly firm sets its output simultaneously Cournot (Nash) equilibrium: each firm produces its best-response output given rivals’ outputs as number of Cournot firms increases, Cournot equilibrium price, quantity, and profits approach price-taking levels

106 5. Stackelberg model of noncooperative oligopoly Stackelberg leader chooses its output first then its rivals - Stackelberg followers – choose outputs leader produces more and earns a higher profit than followers

107 6. Monopolistic competition monopolistically competitive firms are price setters: MR= MC, so p > MC there's free entry: p = AC


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