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Oligopoly Hall and Lieberman, 3 rd edition, Thomson South- Western, Chapter 10.

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Presentation on theme: "Oligopoly Hall and Lieberman, 3 rd edition, Thomson South- Western, Chapter 10."— Presentation transcript:

1 Oligopoly Hall and Lieberman, 3 rd edition, Thomson South- Western, Chapter 10

2 2 Overview Oligopoly market characteristics Measure of market structure Barriers in oligopoly market Game theory approach to duopoly Cooperative collusion Cheating Future of oligopoly

3 3 Oligopoly When just a few large firms dominate a market –So that actions of each one have an important impact on the others –In such a market, each firm recognizes its strategic interdependence with others An oligopoly is a market dominated by a small number of strategically interdependent firms

4 4 Number of Firms Oligopoly requires that a few firms dominate the market –How few? At some point, number of firms is large enough — and interdependence weak enough — that oligopoly becomes a poor description –Monopolistic competition would fit better –No absolute number at which oligopoly ends and monopolistic competition begins

5 5 Market Domination Strategic interdependence requires that a few firms dominate the market –Their share of market is large As combined market share shrinks, strategic interdependence becomes weaker Oligopoly is a matter of degree –Not an absolute classification

6 6 Economies of Scale: Natural Oligopolies When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market –only a few large firms survive since small firms can ’ t compete –Market becomes an (natural) oligopoly –Remember, MES is defined as the lowest level of output at which it can achieve minimum cost per unit The output level at which the LRATC first hits bottom

7 7 Figure 1: Natural Oligopoly E H F 25,000 Units per Month 100,000 0 80 $200 Dollars D Market LRATC Typical Firm

8 8 Reputation as a Barrier Established oligopolists are likely to have favorable reputations Investors decision: enter or not? –Critical thing: is it worthy to take the risk of being a new firm in such market? –If expected profit is greater than the initial loss, enter –If initial loss is too big, stay out.

9 9 Strategic Barriers Strategies designed to keep out potential competitors, for example: –Maintain excess production capacity as a signal –Make special deals with distributors to receive best shelf space in retail stores –Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product

10 10 Legal Barriers Patents and copyrights — which can be responsible for monopoly — can also create oligopolies Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination

11 11 Measures of Market Structure Concentration ratios: Aggregated market share of the largest N firms in the industry Range: 0-100% 4 Firm Concentration ratio: Market share controlled by the largest 4 firms

12 12 Data based on the 2002 Economic Census. Measured Industry Concentration in Manufacturing D: Not disclosed Second and third columns: Percentage in value added in the industry Last column: Herfindahl index from the 50 largest firms

13 13 Data based on the 2002 Economic Census. Measured Industry Concentration in Manufacturing D: Not disclosed

14 14 Oligopoly vs. Other Market Structures Oligopoly presents the greatest challenge to economists –essence of oligopoly is strategic interdependence –economists have had to modify the tools used to analyze other market structures and to develop entirely new tools as well One approach — game theory — has yielded rich insights into oligopoly behavior

15 15 The Game Theory Approach Game theory approach –An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves –Elements Players Strategies Payoffs –Pay off matrix –Game tree

16 16 Game Theory Approach Some situations to which game theory can be applied: – firms competing for business – political candidates competing for votes –animals fighting over prey – bidders competing in an auction – legislators' voting behavior under pressure from interest groups

17 17 Game Theory – Short History John Von Neumann (1903-1957) “ Theory of Games and Economic Behavior ” with Oskar Morgenstern This book established game theory as a field “ An introduction to game theory ” by Martin J. Osborne. Oxford University Press, 2002

18 18 Game Theory – Short History John F. Nash, Jr.(1928- ) One of the contributions is the introduction of the equilibrium notion now known as Nash equilibrium 1994 Nobel prize winner in economics with the game theorists John Harsanyi and Reinhard Selten “ An introduction to game theory ” by Martin J. Osborne. Oxford University Press, 2002

19 19 The Prisoner’s Dilemma Simple example to explain why a technique for obtaining confessions, commonly used by police, is so often successful Payoff matrix –Players: Rose and Colin –Payoffs: number in the matrix –Strategies: Confess (C) / not confess (NC) for either of the players

20 20 Figure 2: The Prisoner’s Dilemma How to read the matrix? –Players:{Rose, Colin} –Strategies:{C, NC} –Payoffs What will Rose do? What will Colin do? Rose Colin CNC C-20, -20-3, -30 NC-30, -3-5, -5

21 21 The Prisoner’s Dilemma A dominant strategy: the player ’ s best strategy regardless of the other player ’ s strategy –Rose ’ s dominant strategy is “ confess ” regardless of Colin ’ s choice –So is Colin

22 22 Nash Equilibrium Outcome of this game is an example of a Nash equilibrium –Exists when each player is taking the best action — given best actions taken by other players –Under the Nash Equilibrium, no players want to deviate

23 23 Figure 3: Figure 3: Working on a joint project Elements –Players:{you, your friend} –Strategies:{work hard, Goof off} –Payoffs What is the Nash Equilibrium? Friend You WG W 2, 20, 3 G3, 01, 1

24 24 Figure 4: Figure 4: Battle of Sex Elements –Players:{Mr. R and Mrs. R} –Strategies:{ go shopping, watch a baseball game} –Payoffs What is the Nash Equilibrium? Mr. R Mrs. R SB S 2, 10, 0 B 1, 2

25 25 Figure 5: Figure 5: Duopoly Elements –Players:{Firm A, Firm B} –Strategies:{ Low price, High price} –Payoffs What is the Nash Equilibrium? Firm A Firm B LH L10, 1040, -5 H-5, 4020, 20

26 26 Simple Oligopoly Games - Duopoly Duopoly - oligopoly market with only two sellers Assume that Firm A and B must make their decisions independently –Without knowing in advance what the other will do A ’ s dominant strategy is to charge a low price –So is B ’ s dominant strategy –Outcome is a Nash equilibrium (Low, Low)

27 27 Example: Price Competition for Duopoly Duopoly firms A & B have the same cost structure, produce the undifferentiated goods. Suppose the MC and ATC is constant, equal to c. If the two firms are going to set price to maximize their profit, what is the Nash equilibrium?

28 28 Oligopoly Games in the Real World Typically more than two strategies Usually more than two players In some games, one or more players may not have a dominant strategy –A game with two players will have a Nash equilibrium as long as at least one player has a dominant strategy –When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

29 29 Oligopoly Games in the Real World -- Static v.s. Dynamic We ’ ve limited the players to one play of the game –In reality, for gas stations and almost all other oligopolies, there is repeated play Where both players select a strategy Observe the outcome of the trial Play the game again and again, as long as they remain rivals

30 30 Oligopoly Games in the Real World -- Cooperation in the long run One possible result of repeated trials is cooperative behavior –Results may be very different from equilibrium in a game played only once –Explicit collusion Simplest Managers meet face-to-face to decide how to set prices –Tacit collusion No formal discussion

31 31 Explicit Collusion Most extreme form is creation of a cartel –Group of firms that tries to maximize total profits of the group as a whole –OPEC However, it is not commonly observed. Why? –Usually illegal in U.S.A., EU & most of developed countries –Penalties, if the oligopolists are caught, can be severe But oligopolists can collude in other, implicit ways

32 32 Tacit Collusion Two most common forms –Tit for tat A game-theoretic strategy of doing to another player this period what he has done to you in previous period –Price Leadership One firm — the price leader — sets its price and other sellers copy that price

33 33 Tacit Collusion - Tit For Tat –Prominent in airline industry –However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion –Oligopolist will sometimes go further Attempting to punish a firm that threatens to destroy tacit cooperation –Lead to price wars

34 34 Tacit Collusion – Price Leadership No formal agreement Rather the decisions come about because firms realize — without formal discussion — that system benefits all of them

35 35 The Limits to Collusion Oligopoly power — even with collusion — has its limits –demand constraints –collusion — even when it is tacit — may be illegal –collusion is limited by powerful incentives to cheat on any agreement

36 36 The Incentive to Cheat Will firm stick to the collusion? Maybe, and maybe not –Problem — each player may conclude that he can do even better by cheating, Figure 5 –Two players would be back to non-cooperative outcome based on their dominant strategies –May be in each player ’ s interest to cheat occasionally Analyzing this sort of behavior requires some rather sophisticated game theory models –Economists are actively engaged in building them

37 37 When is Cheating Likely? While no firm wants to completely destroy a collusive agreement by cheating –Since this would mean a return to the noncooperative equilibrium wherein each firm earns lower profit –Some firms may be willing to risk destroying agreement if benefits are great enough –Cheating is most likely to occur when there is Difficulty observing other firms ’ prices Unstable market demand Large number of sellers

38 38 The Future of Oligopoly Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure Prediction has not come true –Today, there are hundreds and thousands of ongoing businesses in United States Possible reasons –Antitrust law –Globalization of markets –Technological change

39 39 Antitrust Legislation and Enforcement Three types of actions –Preventing collusive agreements among firms Such as price-fixing agreements –Breaking up or limiting activities of large firms — oligopolists and monopolists — whose market dominance harms consumers –Preventing mergers that would lead to harmful market domination While thrust of these policies is to preserve competition –Type of competition preserved — and zeal with which policies are applied — can shift

40 40 The Globalization of Markets Globalization introduces competition –By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods While consumers in each nation may have access to more firms, these may be larger and more powerful firms –Creating greater likelihood of strategic interaction and danger of collusion

41 41 Technological Change Technological change works – To increase competition by creating new substitute goods –To reduce barriers to entry –To increase size of market However, technologies on the other hand –encourage oligopoly by actually increasing MES of typical firm Result could be strategic interaction, or collusion, among large national players –Thereby encouraging formation of oligopolies

42 42 The Four Market Structures: A Postscript Different market structures –Perfect competition –Monopoly –Monopolistic competition –Oligopoly Market structure models help us organize and understand apparent chaos of real- world markets

43 43 Summary on four types of market

44 44 Summary Oligopoly market characteristics –Small number of large strategically interdependent firms –No free entry or exit –Either differentiated or standardized products Measure of market structure Barriers to enter the oligopoly market –Favorable reputation / legal / strategy / substantial economy of scale Game theory approach to duopoly –Dominant strategy –Nash equilibrium –Prisoner ’ s dilemma Repeated game: cooperative collusion –Explicit : Cartel –Implicit : Tit – for – Tat ; Price leadership Cheating Future of oligopoly depends on –Antitrust legislation / globalization of market / technological change

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