2 Recall that there is an entire spectrum of market structures Perfect CompetitionMany firms, each with zero market shareP = MCProfits = 0 (Firm’s earn a reasonable rate of return on invested capital)NO STRATEGIC INTERACTION!MonopolyOne firm, with 100% market shareP > MCProfits > 0 (Firm’s earn excessive rates of return on invested capital)NO STRATEGIC INTERACTION!
3 Most industries, however, don’t fit the assumptions of either perfect competition or monopoly. We call these industries oligopoliesOligopolyRelatively few firms, each with positive market shareSTRATEGIES MATTER!!!Mobile Phones (2011)Nokia: 22.8% Samsung: 16.3% LG: 5.7% Apple: 4.6% ZTE:3.0% Others: 47.6%US Beer (2010)Anheuser-Busch: 49% Miller/Coors: 29% Crown Imports: 5% Heineken USA: 4% Pabst: 3%Music Recording (2005)Universal/Polygram: 31% Sony: 26% Warner: 25% Independent Labels: 18%
4 The key difference in oligopoly markets is that price/sales decisions can’t be made independently of your competitor’s decisionsYour Price (-)MonopolyOligopolyYour N Competitors Prices (+)Oligopoly markets rely crucially on the interactions between firms which is why we need game theory to analyze them!
5 Market shares are not constant over time in these industries! Airlines (1992)Airlines (2002)AmericanAmericanUnitedUnitedDeltaDeltaNorthwestNorthwestContinentalContinentalUS AirSWestWhile the absolute ordering didn’t change, all the airlines lost market share to Southwest.
6 Another trend is consolidation Retail Gasoline (1992)Retail Gasoline (2001)ShellExxon/MobilChevronShellTexacoBP/Amoco/ArcoExxonAmocoChev/TexacoMobilTotal/Fina/ElfBPConoco/PhillipsCitgoMarathonSunPhillips
7 Confess Don’t Confess -4 -4 0 -8 -8 0 -1 -1 Recall the prisoners dilemma game…ClydeConfessDon’t ConfessJakeThe prisoner’s dilemma game is used to describe circumstances where competition forces sub-optimal outcomes
8 Price Fixing and Collusion Prior to 1993, the record fine in the United States for price fixing was $2M. Recently, that record has been shattered!DefendantProductYearFineF. Hoffman-LarocheVitamins1999$500MBASF$225MSGL CarbonGraphite Electrodes$135MUCAR International1998$110MArcher Daniels MidlandLysine & Citric Acid1997$100MHaarman & ReimerCitric Acid$50MHeereMacMarine Construction$49MIn other words…Cartels happen!
9 Each has a marginal cost of $80. Suppose that we have two firms in the market. They face the following demand curve…Each has a marginal cost of $80.Firm 1’s outputFirm 2’s outputIf these firms formed a cartel, they would operate jointly as a monopolist.Each firm agrees to sell 20 units at $240 each.Each firm makes $3200 in profits
10 Firm 1 cheats and earns more profits! However, given that firm 2 is producing 20 units, what should firm 1 do?Firm 1’s outputFirm 2’s outputFirm 1 cheats and earns more profits!
12 Cooperate Cheat $3200 $3200 $2400 $3600 $3600 $2400 $2400 $2400 Cartels - The Prisoner’s DilemmaThe problem facing the cartel members is a perfect example of the prisoner’s dilemma !ClydeCooperateCheat$ $3200$ $3600$ $2400$ $2400JakeCheating is a dominant strategy!
13 Cartel FormationWhile it is clearly in each firm’s best interest to join the cartel, there are a couple problems:With the high monopoly markup, each firm has the incentive to cheat and overproduce. If every firm cheats, the price falls and the cartel breaks downCartels are generally illegal which makes enforcement difficult!Note that as the number of cartel members increases the benefits increase, but more members makes enforcement even more difficult!
14 Perhaps cartels can be maintained because the members are interacting over time – this brings is a possible punishment for cheating.ClydeCooperateCheat$ $3200$ $3600$ $2400$ $2400JakeJake“I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!”12345TimeMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic Decision
15 Clyde should cooperate, right? Cheat$ $3200$ $3600$ $2400$ $2400“I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!”JakeCooperate:$3200$3200$3200$3200$3200$3200Clyde12345TimeMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionCheat:$3600$2400$2400$2400$2400$2400Cooperate: $19,200Cheat: $15,600Clyde should cooperate, right?
16 We need to use backward induction to solve this. JakeClyde12345TimeMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionCooperateCheat$ $3200$ $3600$ $2400$ $2400Regardless of what took place the first four time periods, what will happen in period 5?What should Clyde do here?
17 We need to use backward induction to solve this. JakeClyde12345TimeMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionCheatCooperateCheat$ $3200$ $3600$ $2400$ $2400Given what happens in period 5, what should happen in period 4?What should Clyde do here?
18 We need to use backward induction to solve this. JakeClyde12345TimeMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionMake Strategic DecisionCheatCheatCheatCheatCheatCooperateCheat$ $3200$ $3600$ $2400$ $2400Knowing the future prevents credible promises/threats!
19 Where is collusion most likely to occur? High profit potentialInelastic Demand (Few close substitutes, Necessities)Cartel members control most of the marketEntry Restrictions (Natural or Artificial)Low cooperation/monitoring costsSmall Number of Firms with a high degree of market concentrationSimilar production costsLittle product differentiation
20 High Price Low Price $12 $12 $5 $14 $14 $5 $6 $6 Price Matching: A form of collusion?High PriceLow Price$12 $12$5 $14$14 $5$6 $6Price Matching Removes the off-diagonal possibilities. This allows (High Price, High Price) to be an equilibrium!!
21 The Stag Hunt - Airline Price Wars Suppose that American and Delta face the given demand for flights to NYC and that the unit cost for the trip is $200. If they charge the same fare, they split the market$500$220AmericanP = $500P = $220$9,000$3,600$0$1,80060180What will the equilibrium be?Delta
22 The Airline Price Wars P = $500 P = $220 $9,000 $3,600 $0 $1,800 If American follows a strategy of charging $500 all the time, Delta’s best response is to also charge $500 all the timeIf American follows a strategy of charging $220 all the time, Delta’s best response is to also charge $220 all the timeAmericanP = $500P = $220$9,000$3,600$0$1,800This game has multiple equilibria and the result depends critically on each company’s beliefs about the other company’s strategyDelta
23 The Airline Price Wars: Mixed Strategy Equilibria Suppose American charges $500 with probabilityCharges $220 with probabilityCharge $500:AmericanCharge $220:P = $500P = $220$9,000$3,600$0$1,800Delta(6%)(19%)(19%)(56%)(75%)(25%)
24 Continuous Choice Games Consider the following example. We have two competing firms in the marketplace.These two firms are selling identical products.Each firm has constant marginal costs of production.What are these firms using as their strategic choice variable? Price or quantity?Are these firms making their decisions simultaneously or is there a sequence to the decisions?
25 Cournot Competition: Quantity is the strategic choice variable There are two firms in an industry – both facing an aggregate (inverse) demand curve given byDTotal Industry ProductionBoth firms have constant marginal costs equal to $20
26 Consider the following scenario…We call this Cournot competition Two manufacturers choose a production targetTwo manufacturers earn profits based off the market pricePSQ1P*Profit = P*Q1 - TCDQQ1 + Q2A centralized market determines the market price based on available supply and current demandQ2Profit = P*Q2 - TC
27 For example…suppose both firms have a constant marginal cost of $20 Two manufacturers choose a production targetTwo manufacturers earn profits based off the market pricePSQ1 = 1$60Profit = 60*1 – 20 = $40DQ3A centralized market determines the market price based on available supply and current demandQ2 = 2Profit = 60*2 – 40 = $80
28 From firm one’s perspective, the demand curve is given by Treated as a constant by Firm OneSolving Firm One’s Profit Maximization…
29 In Game Theory Lingo, this is Firm One’s Best Response Function To Firm 2 If firm 2 drops out, firm one is a monopolist!
39 Recall, we had an aggregate demand and a constant marginal cost of production. CS = (.5)(120 – 70)(2.5) = $62.5Monopoly$120$62.5$70DWhat would it be worth to consumers to add another firm to the industry?2.5
40 Recall, we had an aggregate demand and a constant marginal cost of production. CS = (.5)(120 – 53)(3.33) = $112Two Firms$112$53D3.33
41 Suppose we increase the number of firms…say, to 3 Demand facing firm 1 is given by (MC = 20)The strategies look very similar!
42 With three firms in the market… CS = (.5)(120 – 45)(3.75) = $140Three Firms$140$45D3.75
43 Expanding the number of firms in an oligopoly – Cournot Competition N = Number of firmsNote that as the number of firms increases:Output approaches the perfectly competitive level of productionPrice approaches marginal cost.
49 Market Concentration and Profitability Industry DemandThe Lerner index for Firm i is related to Firm i’s market share and the elasticity of industry demandThe Average Lerner index for the industry is related to the HHI and the elasticity of industry demand
51 The previous analysis (Cournot Competition) considered quantity as the strategic variable. Bertrand competition uses price as the strategic variable.Should it matter?P*DQ*Just as before, we have an industry demand curve and two competing duopolies – both with marginal cost equal to $20.Industry Output
52 Firm level demand curves look very different when we change strategic variables Bertrand CaseQuantity StrategyIf you are underpriced, you lose the whole marketAt equal prices, you split the marketIf you are the low price you capture the whole marketDD
53 Price competition creates a discontinuity in each firm’s demand curve – this, in turn creates a discontinuity in profitsAs in the cournot case, we need to find firm one’s best response (i.e. profit maximizing response) to every possible price set by firm 2.
54 Firm One’s Best Response Function Case #1: Firm 2 sets a price above the pure monopoly price:Case #2: Firm 2 sets a price between the monopoly price and marginal costCase #3: Firm 2 sets a price below marginal costCase #4: Firm 2 sets a price equal to marginal costWhat’s the Nash equilibrium of this game?
55 2 FirmsMonopolyPerfect CompetitionHowever, the Bertrand equilibrium makes some very restricting assumptions…Firms are producing identical products (i.e. perfect substitutes)Firms are not capacity constrained
56 An example…capacity constraints Consider two theatres located side by side. Each theatre’s marginal cost is constant at $10. Both face an aggregate demand for movies equal toEach theatre has the capacity to handle 2,000 customers per day.What will the equilibrium be in this case?
57 If both firms set a price equal to $10 (Marginal cost), then market demand is 5,400 (well above total capacity = 2,000)Note: The Bertrand Equilibrium (P = MC) relies on each firm having the ability to make a credible threat:“If you set a price above marginal cost, I will undercut you and steal all your customers!”At a price of $33, market demand is 4,000 and both firms operate at capacity. Now, how do we choose capacity? Back to Cournot competition!
58 With competition in price, the key is to create product variety somehow! Suppose that we have two firms. Again, marginal costs are $20. The two firms produce imperfect substitutes.Example:D
59 Recall Firm 1 has a marginal cost of $20 Each firm needs to choose price to maximize profits conditional on the other firm’s choice of price.Firm 1 profit maximizes by choice of priceFirm 2 sets a price of $50Firm 1’s strategyD$30Firm 1 responds with $55
60 With equal costs, both firms set the same price and split the market evenly
62 Suppose that Firm two‘s costs increase. What happens in each case? BertrandWith higher marginal costs, firm 2’s profit margins shrink. To bring profit margins back up, firm two raises its priceFirm 2$30
63 Suppose that Firm two‘s costs increase. What happens in each case? With higher marginal costs, firm 2’s profit margins shrink. To bring profit margins back up, firm two raises its priceFirm 1A higher price from firm two sends customers to firm 1. This allows firm 1 to raise price as well and maintain market share!Firm 2
64 Bertrand Cournot Firm 1 Firm 1 Firm 2 Firm 2 Cournot (Quantity Competition): Competition is for market shareFirm One responds to firm 2’s cost increases by expanding production and increasing market share – prices are fairly stable and market shares fluctuateBest response strategies are strategic substitutesBertrand (Price Competition): Competition is for profit marginFirm One responds to firm 2’s cost increases by increasing price and maintaining market share – prices fluctuate and market shares are fairly stable.Best response strategies are strategic complementsBertrandCournotFirm 1Firm 1Firm 2Firm 2
65 Stackelberg leadership – Incumbent/Entrant type games In the previous example, firms made price/quantity decisions simultaneously. Suppose we relax that and allow one firm to choose first.Both firms have a marginal cost equal to $20Firm 1 chooses its output firstFirm 2 chooses its output secondMarket Price is determined
66 Firm 2 has observed Firm 1’s output decision and faces the residual demand curve: Firm 2’s strategy
67 Knowing Firm 2’s response, Firm 1 can now maximize its profits: Firm 1 produces the monopoly output!
69 Sequential Bertrand Competition We could also sequence events using price competition.Both firms have a marginal cost equal to $20Firm 1 chooses its price firstFirm 2 chooses its price secondMarket sales are determined
70 Recall Firm 1 has a marginal cost of $20 From earlier, we know the strategy of firm 2. Plug this into firm one’s profits…Now we can maximize profits with respect to firm one’s price.
72 Cournot vs. Bertrand: Stackelberg Games Cournot (Quantity Competition):Firm One has a first mover advantage – it gains market share and earns higher profits. Firm B loses market share and earns lower profitsTotal industry output increases (price decreases)Bertrand (Price Competition):Firm Two has a second mover advantage – it charges a lower price (relative to firm one), gains market share and increases profits.Overall, production drops, prices rise, and both firms increase profits.
73 Predatory Pricing: A pricing strategy that makes sense only if it drives a competitor out of business.Suppose that a Cournot competitor decides to exploit the first mover advantage to drive its competitor out of business…Both firms have a marginal cost equal to $20, each also has a fixed cost equal to $5Firm 1 chooses its output firstFirm 2 chooses its output secondMarket Price is determined
74 Knowing Firm 2’s response, We can adjust the demand curve: This demand curve incorporates firm two’s behavior.
75 Now, we want to create firm 2’s profits: MC = $20, FC = $5
76 We want to find the level of production by firm 1 that lowers Firm 2’s profits to zero…
77 Now, we can calculate profits… Note: This was by design!Firm one sacrifices some profits today to stay a monopoly!
78 A merger is generally a dominant strategy!! There have been numerous cases involving predatory pricing throughout history.Standard OilAmerican Sugar Refining CompanyMogul Steamship CompanyWall MartAT&TToyotaAmerican AirlinesThere are two good reasons why we would most likely not see predatory pricing in practiceIt is difficult to make a credible threat (Remember the Chain Store Paradox)!A merger is generally a dominant strategy!!
79 The Bottom Line with Predatory Pricing… There have been numerous cases over the years alleging predatory pricing. However, from a practical standpoint we need to ask three questions:Can predatory pricing be a rational strategy?Can we distinguish predatory pricing from competitive pricing?If we find evidence for predatory pricing, what do we do about it?
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