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Oligopoly Few Firms in the Industry Strategic Decision Making The number of firms in an industry play a role in determining whether firms explicitly.

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Presentation on theme: "Oligopoly Few Firms in the Industry Strategic Decision Making The number of firms in an industry play a role in determining whether firms explicitly."— Presentation transcript:

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2 Oligopoly Few Firms in the Industry

3 Strategic 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.

4 Oligopoly: 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.

5 Oligopoly The 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.

6 Characteristics Few firms each large enough to influence market price Products may be differentiated or homogeneous The behavior of each firm depends on the behavior of the others Entry/exit barriers exist.

7 Examples of Oligopolies Tennis Balls: Wilson, Penn, Dunlop and Spalding. Cars: GM, Ford, DaimlerChrysler Cereal: 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 Martin Grocery stores(Ralphs, Trader Joe’s)

8 OPEC The 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).

9 Models of Oligopoly Behavior No single general model of oligopoly behavior exists. Three models of oligopoly behavior are: The cartel (Collusion) model The 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)

10 The Cartel Model A 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 profit For this they must assign output quotas to member firms

11 Implicit 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.

12 Illegal but done … Explicit Price Collusion OPEC Implicit Price Collusion: Firms just happen to charge the same price but did not meet to discuss it. Airlines, Car Manufacturers.

13 The Collusion Model Suppose there are only two firms Producing identical products Face identical demand Have identical cost structures

14 The Sum of the Firms’ Demand = Market Demand Market Demand One Firm’s Demand P0P0 Each Firm’s Demand = Half Market Demand

15 The Sum of the Firms’ Demands = Market Demand Market Demand d each firm mr each firm The Sum of the MR lines for both firms = d each firm d A + d B = Market Demand MR

16 Collusion: The two firms agree to behave as One Monopolist MR D MC PoPo QoQo Together these two firms will sell Q o each firm selling half.

17 Oligopoly Collusion Solution is Inefficient MR D MC PoPo QoQo Q pc P pc The efficient solution is the perfectly competitive Price and Output combination (P pc, Q pc ) Oligopolies restrict output and charge higher prices (P o, Q o )

18 Enforcement of Cartel agreements is difficult Antitrust Laws make collusive agreements illegal There is a strong incentive to cheat.

19 The Incentive to Cheat the Agreement Assume: MC = 10 Profit Maximizing Output for Cartel at: MC = MR Each firm sells 30 units and charges Price = $60

20 Each firm should produce 30 units Total sold = 60 units Price =$60 Each firm’s Total Revenue = $3600/2 = 1,800

21 To maximize Profit, both firms will cheat. If one firm sells 30 and the other “cheats” selling 40, total units for sale = 70 and the price will then drop to $50 Total revenues for the cheating firm would be 50 x 40 = 2,000 If each firm sells 30 units, revenue for each firm = 1800 Total revenues for the cheated firm would be 50 x 30 = 1,500 Each firm can increase profits by cheating the agreement.

22 Both firms will bring 40 units for sale Total Sold = 80 units Price = $40 Firm’s Total Revenue = $3200/2=1,600

23 Prices 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.

24 The 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 prices We also observed that when prices did change, they were large in magnitude.

25 Kinked Demand Model of Oligopoly A firm realizes that its price drops are more likely to be matched by rivals than its price increases

26 The Kinked Demand Model of Oligopoly We assume that firms follow the following strategy: If I increase my price My competition will not increase their price and I would lose sales. If I decrease my price My competition will also decrease their price and I would gain very few if any additional sales.

27 The Kinked Demand Model If I increase my price say by 10%, no one follows and I lose sales If I decrease my price by 10%, everyone follows and I gain little or nothing at all! Quantity demanded drops by 20% Quantity demanded increases 5% Q0Q0 P1P1 D0D0 Q1Q1 P0P0 P0P0 D0D0 Q0Q0 Q1Q1 P1P1 Demand is more elastic above P 0 Demand is less elastic below P 0

28 P0P0 D0D0 Q0Q0 MR 0 MR 1 D1D1 Above P 0 demand is more elastic Above P 0 MR looks like this Below P 0 demand is less elastic Below P 0 MR looks like this Ignore the lower part of D 0 and MR 0 Ignore the upper part of D 1 and MR 1 Note: this Kink in demand, translates into a gap in the MR line

29 The Kinked Demand Model For prices above the current price P0P0 D Demand is more elastic For prices below the current price Q0Q0 MR Marginal Revenue is flatter Demand is less elastic Marginal Revenue is steeper

30 Why are prices sticky under oligopoly? D Q0Q0 MR MR = MC MC 0 MC 1 MC 2 MR = MC 0 P0P0 MR = MC 1 P 1 = P2P2 Q1Q1 If Costs increase within the MR gap… Price does not change Price changes only when MC shifts out of the MR gap

31 1.Oligopolist 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? ________ 2.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? ________ 3.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: ________ 4.According to economic theory, the kink in the demand curve will occur at point _____

32 The 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?

33 Why is “free entry” relevant? The threat that other firms will enter is sufficient to deter the single firm from making profits which would attract entry Threat 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.

34 Barriers to Exit When “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 use A nuclear power plant Or the firm must incur costs that are unavoidable once they have been committed at a particular moment in time The money that the telecoms spent to win mobile phone licenses at auction in Exiting the industry requires that the firm lose its investment

35 The 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.

36 Comparing 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.

37 Profit 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.

38 Strategic 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.

39 Price Wars Price 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.

40 Game 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.

41 Prisoner’s Dilemma Two 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?

42 Prisoner’s Dilemma Prisoner B Stays Silent Prisoner B confess Prisoner A Stays Silent Each serves 6 months Prisoner A: 10 years Prisoner B: goes free Prisoner A Confess Prisoner A: goes free Prisoner B: 10 years Each 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."

43 Prisoner’s Dilemma and a Duopoly Example All possible courses of action are represented in a table called A payoff matrix: a table that contains the outcomes of a strategic game under various circumstances.

44 Using Game Theory to Determine Oligopoly Outcome

45 To 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) or Cheat the agreement (Q =40) Determine the payoffs to each firm for each choice action: Revenues = 1,800 for both firms if they cooperate Revenue Cheating Firm = 2,000 Revenue Cheated Firm = 1,800

46 Payoff Matrix A’s Profit = 1,600 (40 x $40 = 1,600) B’s Profit = 1,600 A’s Profit = 1,500 (30 x $50 = 1,500) B’s Profit = 2,000 (40 x $50 = 2,000) Cheat (Produce 40 units) A’s Profit = 2,000 (40 x $50 = 2,000) B’s Profit = 1,500 (30 x $50 = 1,500) A’s Profit = 1,800 (30 x $60 = 1,800) B’s Profit = 1,800 Produce 30 units Cheat ( Produce 40 units) Produce 30 units Firm A’s Strategies Firm B’s Strategies If both firms sell 30 units, total Quantity = 60 and price = $60 If both firms sell 40 units, total Quantity = 80 and price = $40 If A sells 40, and B sells 30, total Quantity = 70 and price = $50 If A sells 30, and B sells 40, total Quantity = 70 and price = $50 P = 60P = 50 P = 40

47 Most Likely Outcome: A’s Profit = 1,600 B’s Profit = 1,600 A’s Profit = 1,500 B’s Profit = 2,000 Cheat A’s Profit = 2,000 B’s Profit = 1,500 A’s Profit = 1,800 B’s Profit = 1,800 Produce 30 units CheatProduce 30 units A’s Strategies B’s Strategies If B Sells 30 Units as agreed… A’s best strategy is the one that brings the largest payoff. If B Cheats and sells 40 units…. A’s best strategy is the one that brings the largest payoff. If A Cheats and sells 40 units, B’s best strategy is the one that brings the largest payoff. The 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 Both Cheat Best strategy If A Sells 30 Units as agreed… B’s best strategy is the one that brings the largest payoff. Best strategy

48 Determining Industry Structure Economists use one of two methods to measure industry structure: The concentration ratio. The Herfindahl index.

49 Concentration Ratio Is 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.

50 The Herfindahl Index An 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.

51 The Herfindahl Index The 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.

52 An Example FirmMarket Share A50% B25% C5% D4% E F G H The weight assigned to the largest firm is four times that of the next largest firm Four Firm Concentration Ratio: = HHI :3, (4 2 ) = 2, (16) The HHI index reflects more accurately the true distribution of power in the industry. The weight assigned to the largest firm is twice that of the next largest firm

53 Herfindahl-Hirschman Index (HHI) Largest index for a monopoly: Market share =100% HHI: = 10,000 For an industry with 2 firms: Market share = 100%/2=50% each HHI: 2(50 2 )=5,000 For a competitive industry with 10,000 firms: Market share =100%/10,000=0.01% HHI: 10,000( )= 1

54 The More Concentrated the Industry, The larger the Herfindahl- Hirschman Index (HHI)

55 Concentration Ratios and the Herfindahl Index

56 Percentage of 1992 Value of Shipments 3,00076 %Medicinal Chemicals 2,67684 %Cars 2,25385 %Breakfast Cereal ?93 %Cigarettes %Men/Boy Shirts %Ice Cream The larger market share concentrated in a few firms The Larger the HHI Index HHILargest 4Industry

57 Questions to Prepare 1. Define the following terms and provide an example. a. monopolistic competition b. oligopoly c. cartel d. oligopolistic interdependence e. excess capacity f. price leadership g. kinked demand curve h. contestable market 2. What is the value of the HHI index and the four firm concentration ratio when there are a. 20,000 firms all with equal market shares b. Ten firms all with equal market shares c. 2 firms with equal market share and d. One firm?

58 3. In what way is monopolistic competition more like competition, and in what way is it more like monopoly? 4. 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. 5. 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..

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60 B Cheats B Does not cheat A Does not cheatA Cheats B +$200,000 B 0 A 0 A +$200,000 B $75,000 A $75,000 A – $75,000 B – $75,000 Determine the competitive solution for this duopoly

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62 1.What is the value of the HHI index and the four firm concentration ratio when there are a. 20,000 firms all with equal market shares b. Ten firms all with equal market shares c. 2 firms with equal market share and d. One firm? 2.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.

63 © 2000 Claudia Garcia - Szekely 62


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