Presentation on theme: "Few Firms in the Industry"— Presentation transcript:
1Few Firms in the Industry OligopolyFew Firms in the Industry
2Strategic Decision Making The number of firms in an industry play a role in determining whether firms explicitly take other firms’ actions into account.A monopolistically competitive firm does not take into account rival firms’ responses to its decisions.In oligopoly each firm takes account of a rival’s expected response to a decision.
3Oligopoly: Competition has a face and a name. Oligopoly is an intermediate market structure between PC and Monopoly.Firms might compete (non-cooperative oligopoly) or cooperate (cooperative oligopoly)Whereas firms in an oligopoly are price makers, their control over the price is determined by the level of coordination among them.There are often significant barriers to entry and exit.
4OligopolyThe distinguishing characteristic of an oligopoly is that there are a few mutually interdependent firms that produce either identical products (homogeneous oligopoly) or heterogeneous products (differentiated oligopoly).Mutual interdependence means that each firm must take into account the expected reaction of other firms.
5Characteristics Few firms each large enough to influence market price Products may be differentiated or homogeneousThe behavior of each firm depends on the behavior of the othersEntry/exit barriers exist.
6Examples of Oligopolies Tennis Balls: Wilson, Penn, Dunlop and Spalding.Cars: GM, Ford, DaimlerChryslerCereal: Quaker, Ralston Food, Kellogg, Post and General Mills.Airlines: American and Delta with US Airways, Northwest and TWA struggling along.Aircraft: Boeing (McDonnell Douglas) and Lockheed MartinGrocery stores(Ralphs, Trader Joe’s)
7The Most Famous Oligopoly OPECThe Organization of Petroleum Exporting Countries:Africa (Algeria, Libya and Nigeria)Asia (Indonesia)Middle East (Iran, Iraq, Kuwait, Qatar, Saudi Arabia and the United Arab Emirates)Latin America (Venezuela).
8Models of Oligopoly Behavior No single general model of oligopoly behavior exists. Three models of oligopoly behavior are:The cartel (Collusion) modelThe group behaves as ONE (monopoly)The contestable market model.The group behaves as PC market.The Kinked Demand Model (for the special oligopoly case of Duopoly)
9The Cartel ModelA cartel is a combination of firms acting as a single firm.In the cartel model, an oligopoly sets price as a monopoly.If the cartel can limit the entry of other firms, they can increase their profits.Restrict output to maximize profitFor this they must assign output quotas to member firms
10Implicit Price Collusion Formal collusion is illegal in the U.S. while informal collusion is inevitable.Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another.Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.
11Illegal but done … Explicit Price Collusion OPECImplicit Price Collusion: Firms just happen to charge the same price but did not meet to discuss it.Airlines, Car Manufacturers.
12The Collusion Model Suppose there are only two firms Producing identical productsFace identical demandHave identical cost structures
13The Sum of the Firms’ Demand = Market Demand Each Firm’s Demand= Half MarketDemandOne Firm’sDemandP0Market Demand10002000
14The Sum of the Firms’ Demands = Market Demand The Sum of the MR lines for both firms = deach firmdA+ dB = Market DemandMarket Demanddeach firmMRmreach firm
15Collusion: The two firms agree to behave as One Monopolist Together these two firms will sell Qo each firm selling half.PoMCDMRQo
16Oligopoly Collusion Solution is Inefficient The efficient solution is the perfectly competitive Price and Output combination (Ppc, Qpc)MCPoOligopolies restrict output and charge higher prices (Po, Q o)PpcDMRQoQpc
17Enforcement of Cartel agreements is difficult Antitrust Laws make collusive agreements illegalThere is a strong incentive to cheat.
18The Incentive to Cheat the Agreement Assume: MC = 10Each firm sells 30 units and charges Price = $60Profit Maximizing Output for Cartel at: MC = MR
19Each firm should produce 30 units Total sold = 60 unitsPrice =$60Each firm’s Total Revenue = $3600/2 = 1,800
20To maximize Profit, both firms will cheat. If each firm sells 30 units, revenue for each firm = 1800If one firm sells 30 and the other “cheats” selling 40, total units for sale = 70 and the price will then drop to $50To maximize Profit, both firms will cheat.Total revenues for the cheating firm would be 50 x 40 = 2,000Total revenues for the cheated firm would be 50 x 30 = 1,500Each firm can increase profits by cheating the agreement.
21Both firms will bring 40 units for sale Total Sold = 80 unitsPrice = $40Firm’s Total Revenue = $3200/2=1,600
22Prices are more stable in oligopoly than in any other market structure When prices are stable we say prices are “sticky” – difficult to move-.Informal collusion is an important reason why prices are sticky in oligopoly.Another is the kinked demand explanation.
23The Kinked Demand Model Developed to explain why prices in oligopoly markets tend to be sticky.We observed that changes in costs were only rarely met by changes in oligopoly pricesWe also observed that when prices did change, they were large in magnitude.
24Kinked Demand Model of Oligopoly A firm realizes that its price drops are more likely to be matched by rivals than its price increases
25The Kinked Demand Model of Oligopoly We assume that firms follow the following strategy:My competition will not increase their price and Iwould lose sales.If I increase my priceMy competition will also decrease their price and Iwould gain very few if any additional sales.If I decrease my price
26The Kinked Demand Model Quantity demanded drops by 20%P0D0Q0Q1P1If I increase my pricesay by 10%, no one follows and I lose salesDemand is more elastic above P0If I decrease my priceby 10%, everyone follows and I gain little or nothing at all!Q0P1D0Q1P0Quantity demanded increases 5%Demand is less elastic below P0
27Note: this Kink in demand, translates into a gap in the MR line Above P0 demand is more elasticAbove P0 MR looks like thisBelow P0 demand is less elasticBelow P0 MR looks like thisP0Ignore the lower part of D0 and MR0Ignore the upper part of D1 and MR1Note: this Kink in demand, translates into a gap in the MR lineD1D0Q0MR0MR1
28The Kinked Demand Model Demand is more elasticFor prices above the current priceP0Marginal Revenue is flatterMRDDemand is less elasticFor prices below the current priceMarginal Revenue is steeperQ0MR
29Why are prices sticky under oligopoly? MC2Why are prices sticky under oligopoly?DQ0MRMC1P2MC0P1 =P0Price changes only when MC shifts out of the MR gapMR = MCMR = MC1MR = MC0If Costs increase within the MR gap…Price does not changeQ1
30Oligopolist A cuts price in an attempt to enlarge his share of the market. His competitors retaliate with identical price cuts. In this case, oligopolist A will move from point A to which point? ________Oligopolist A cuts price in an attempt to enlarge his share of the market. His competitors fail to retaliate with price cuts. In this case, oligopolist A will move from point A to which point? ________Demand curve CAD represents a market in which oligopolists will match the price changes of rivals and demand curve EAB represents a market in which oligopolists will ignore the price changes of rivals. According to the kinked demand model, the relevant demand curve will be: ________According to economic theory, the kink in the demand curve will occur at point _____
31The Contestable Market Model A contestable market is defined as one into which there are no barriers to entry or exit.Entry is free and exit is costless.In this case we predict that even in a market with only one firm, that firm will make zero profits, just as in a perfectly competitive market. WHY?
32Why is “free entry” relevant? The threat that other firms will enter is sufficient to deter the single firm from making profits which would attract entryThreat of entry is enough to deter the firm from raising prices above the ATC.This is true even if even with high fixed costs of entry as long as these costs are recoverable (say airplanes, cars, buildings, etc which can be resold).If the single firm set price to make a positive profit, a firm has little to lose by entering because it can always recover its investment.
33Barriers to ExitWhen “barriers to exit” exist, exiting the industry is not costless because there are ‘sunk costs’This is the case to enter, a firm would have to purchase assets with no alternative useA nuclear power plantOr the firm must incur costs that are unavoidable once they have been committed at a particular moment in timeThe money that the telecoms spent to win mobile phone licenses at auction in 2000.Exiting the industry requires that the firm lose its investment
34The Contestable Market Model In the contestable market model, an oligopoly with no barriers to entry or exit sets a competitive price (= ATC) in order to eliminate any incentive for new firms to enter the market.The threat from outside competition limits oligopolies from acting as a cartel (setting monopoly prices).The newcomer may not want to cooperate with the other firms.
35Comparing the Contestable Market and Cartel Models The stronger the ability of Oligopolists to collude and prevent entry, the closer the oligopoly price would be to monopoly pricing.The weaker the ability to collude is, the more competitive the oligopoly price is.Most Oligopoly markets lie between these two extremes.
36Profit Maximization under Oligopoly Much is uncertain: there is NO Single model to predict output and price under oligopoly…An oligopoly's plan is a contingency or strategic plan:As in chess: A firm plans a strategy based on what it believes the opponent will do in response to price moves.Strategic interactions have a variety of potential outcomes rather than a single outcome.
37Strategic Pricing and Oligopoly Both the cartel and contestable market models use strategic pricing decisions where firms set their price based on the expected reactions of other firms.
38Price WarsPrice wars are the result of strategic pricing decisions gone wild.A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business.
39Game Theory and Strategic Decision Making Most oligopolistic strategic decision making is carried out with explicit or implicit use of game theory.Game theory is the application of economic principles to interdependent situations.
40Prisoner’s DilemmaTwo suspects are arrested. The police have insufficient evidence for a conviction so they put the prisoners in separate rooms to prevent them from talking to each other. They are offered the following deal: If you confess you go free and your partner receives a 10-year sentence. If neither confess, both get six months in jail for a minor charge. If both confess, each receives a five-year sentence. How should the prisoners act?
41Prisoner’s DilemmaPrisoner B Stays SilentPrisoner B confessPrisoner A Stays SilentEach serves 6 monthsPrisoner A: 10 years Prisoner B: goes freePrisoner A ConfessPrisoner A: goes free Prisoner B: 10 yearsEach serves 5 years"No matter what he does, I personally am better off confessing than staying silent. Therefore, for my own sake, I should confess."
42Prisoner’s Dilemma and a Duopoly Example All possible courses of action are represented in a table calledA payoff matrix: a table that contains the outcomes of a strategic game under various circumstances.
43Using Game Theory to Determine Oligopoly Outcome
44To set up the oligopoly decision as a game you need to: Define the possible actions for each firm:Abide by the quota agreement (Q=30) orCheat the agreement (Q =40)Determine the payoffs to each firm for each choice action:Revenues = 1,800 for both firms if they cooperateRevenue Cheating Firm = 2,000Revenue Cheated Firm = 1,800
45Payoff Matrix Firm A’s Strategies Produce 30 units Cheat ( Produce 40 units)P = 50P = 50P = 60P = 40Produce 30 unitsA’s Profit = 1,800(30 x $60 = 1,800)B’s Profit = 1,800If both firms sell 30 units, total Quantity = 60 and price = $60A’s Profit = 2,000(40 x $50 = 2,000)B’s Profit = 1,500(30 x $50 = 1,500)If A sells 40, and B sells 30, total Quantity = 70 and price = $50Firm B’s StrategiesCheat (Produce 40 units)A’s Profit = 1,500(30 x $50 = 1,500)B’s Profit = 2,000(40 x $50 = 2,000)If A sells 30, and B sells 40, total Quantity = 70 and price = $50A’s Profit = 1,600(40 x $40 = 1,600)B’s Profit = 1,600If both firms sell 40 units, total Quantity = 80 and price = $40
46Most Likely Outcome: Both Cheat A’s Profit = 1,600 B’s Profit = 1,600 Produce 30 unitsA’s StrategiesB’s StrategiesIf A Cheats and sells 40 units,B’s best strategy is the one that brings the largest payoff.If A Sells 30 Units as agreed…B’s best strategy is the one that brings the largest payoff.Best strategyIf B Cheats and sells 40 units….A’s best strategy is the one that brings the largest payoff.If B Sells 30 Units as agreed…A’s best strategy is the one that brings the largest payoff.Best strategyThe best strategy for both firms is to cheat under both scenarios: if the other firm cheats as well as if the other firm abides by the agreement
47Determining Industry Structure Economists use one of two methods to measure industry structure:The concentration ratio.The Herfindahl index.
48Concentration RatioIs the value of sales by the top firms of an industry stated as a percentage of total industry sales.The most commonly used concentration ratio is the four-firm concentration ratio.The higher the ratio, the closer to an oligopolistic or monopolistic type of market structure.
49The Herfindahl IndexAn index of market concentration calculated by adding the squared value of the individual market shares of all firms in the industry.The Herfindahl index gives higher weights (than those given by the concentration ratio) to the largest firms in the industry because it squares market shares.
50The Herfindahl IndexThe Herfindahl Index is used as a rule of thumb by the Justice Department to determine whether a merger be allowed to take place.If the index is less than 1,000, the industry is considered competitive thus allowing the merger to take place.
51An Example Four Firm Concentration Ratio: 84. 50 + 25 + 5 + 4 = The weight assigned to the largest firm is twice that of the next largest firmAn ExampleFirmMarket ShareA50%B25%C5%D4%EFGHFour Firm Concentration Ratio: 84.=HHI :3,230(42) =2, (16)The weight assigned to the largest firm is four times that of the next largest firmThe 4- firm concentration ratio gives the largest company twice the weight of the next size firm.Whereas with the HHI the dominant firm’s weight is almost 4 times that of the next largest firm. The HHI gives greater weight to the firms with relatively high market power than does the 4-firm concentration ratio.The laThe HHI index reflects more accurately the true distribution of power in the industry.
52Herfindahl-Hirschman Index (HHI) Largest index for a monopoly:Market share =100% HHI: 1002= 10,000For an industry with 2 firms:Market share = 100%/2=50% eachHHI: 2(502)=5,000For a competitive industry with 10,000 firms:Market share =100%/10,000=0.01%HHI: 10,000(0.012)= 1
53The More Concentrated the Industry, The larger the Herfindahl-Hirschman Index (HHI)
55Percentage of 1992 Value of Shipments The larger market share concentrated in a few firmsHHILargest 4IndustryThe Larger the HHI Index3,00076 %Medicinal Chemicals2,67684 %Cars2,25385 %Breakfast Cereal?93 %Cigarettes31528 %Men/Boy Shirts29324 %Ice Cream
56Questions to PrepareDefine the following terms and provide an example.monopolistic competitionoligopolycarteloligopolistic interdependenceexcess capacityprice leadershipkinked demand curvecontestable marketWhat is the value of the HHI index and the four firm concentration ratio when there are 20,000 firms all with equal market sharesTen firms all with equal market shares2 firms with equal market share andOne firm?
57In what way is monopolistic competition more like competition, and in what way is it more like monopoly?Explain how short-run and long-run equilibrium in monopolistic competition differ. Use graphs to illustrate your answer. Be sure that your graphs are completely and correctly labeled.Here is an excerpt form an editorial praising capitalism in The Economist: "It is competition that delivers choice, holds prices down, encourages invention and service, and (through all these things) delivers economic growth." To what type of competition does the writer refer? Is it the sort of competition that economists study? Explain..
61What is the value of the HHI index and the four firm concentration ratio when there are 20,000 firms all with equal market sharesTen firms all with equal market shares2 firms with equal market share andOne firm?Explain how short-run and long-run equilibrium in monopolistic competition differ. Use graphs to illustrate your answer. Be sure that your graphs are completely and correctly labeled.3. Find price, output and profit/loss for this MC producer. Explain in detail what would happen in the long run.