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CHAPTER 14 Oligopoly 1. The meaning of oligopoly, and why it occurs

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1 CHAPTER 14 Oligopoly 1. The meaning of oligopoly, and why it occurs
2. Why oligopolists have an incentive to act in ways that reduce their combined profit, and why they can benefit from collusion 3. How our understanding of oligopoly can be enhanced by using game theory, especially the concept of the prisoners’ dilemma 4. How repeated interactions among oligopolists can help them achieve tacit collusion 5. How oligopoly works in practice, under the legal constraints of antitrust policy CHAPTER 14 Oligopoly

2 The Prevalence of Oligopoly
In addition to perfect competition and monopoly, oligopoly and monopolistic competition are also important types of market structure. They are forms of imperfect competition. Oligopoly is a common market structure. It arises from the same forces that lead to monopoly, except in a weaker form. It is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.

3 ECONOMICS IN ACTION Is It An Oligopoly or Not? To get a better picture of market structure, economists often use a measure called the Herfindahl–Hirschman Index, or HHI. The HHI for an industry is the square of each firm’s share of market sales summed over the firms in the industry. For example, if an industry contains only 3 firms and their market shares are 60%, 25%, and 15%, then the HHI for the industry is: HHI = = 4,450 According to Justice Department guidelines, an HHI below 1,000 indicates a strongly competitive market, between 1,000 and 1,800 indicates a somewhat competitive market, and above 1,800 indicates an oligopoly. In an industry with an HHI above 1,000, a merger that results in a significant increase in the HHI will receive special scrutiny and is likely to be disallowed. Note: However, as recent events have shown, defining an industry can be tricky. In 2007, Whole Foods and Wild Oats, two purveyors of high-end organic foods, proposed a merger. The Justice Department disallowed it, claiming it would substantially reduce competition and defining the industry as consisting of only natural food groceries. However, this was appealed to a federal court, which found the merger allowable since regular supermarkets now carried organic foods as well, arguing that they would provide sufficient competition after the merger. The Justice Department has appealed and, as of the time of writing, the case is still undecided.

4 Some Oligopolistic Industries

5 Understanding Oligopoly
Some of the key issues in oligopoly can be understood by looking at the simplest case, a duopoly. An oligopoly consisting of only two firms is a duopoly. Each firm is a duopolist. With only two firms in the industry, each would realize that by producing more, it would drive down the market price. So each firm would, like a monopolist, realize that profits would be higher if it limited its production. So how much will the two firms produce? One possibility is that the two companies will engage in collusion. Sellers engage in collusion when they cooperate to raise each others’ profits. The strongest form of collusion is a cartel, an agreement by several producers to obey output restrictions to increase their joint profits. They may also engage in non-cooperative behavior, ignoring the effects of their actions on each others’ profits.

6 Understanding Oligopoly
By acting as if they were a single monopolist, oligopolists can maximize their combined profits. So, there is an incentive to form a cartel. However, each firm has an incentive to cheat—to produce more than it is supposed to under the cartel agreement. So, there are two principal outcomes: successful collusion or behaving noncooperatively by cheating. When firms ignore the effects of their actions on each others’ profits, they engage in noncooperative behavior. It is likely to be easier to achieve informal collusion when firms in an industry face capacity constraints. Competing in Prices vs. Competing in Quantities Firms may decide to engage in quantity competition or price competition. The basic insight of the quantity competition (or the Cournot model) is that when firms are restricted in how much they can produce, it is easier for them to avoid excessive competition and to “divvy up” the market, thereby pricing above marginal cost and earning profits. It is easier for them to achieve an outcome that looks like collusion without a formal agreement.

7 Competing in Prices vs. Competing in Quantities
The logic behind the price competition (or the Bertrand model) is that when firms produce perfect substitutes and have sufficient capacity to satisfy demand when price is equal to marginal cost, then each firm will be compelled to engage in competition by undercutting its rival’s price until the price reaches marginal cost—that is, perfect competition. GLOBAL COMPARISON Europe Levels the Playing Field for Coke and Pepsi In the United States, Coke and Pepsi have maintained relatively similar market shares: 44% versus 32% in 2004. In that same year, (thanks to the exclusivity deals that Coke regularly signed with shops, bars, and restaurants across Europe), Coke’s market shares in Europe were several times Pepsi’s, as you can see in the following graph—that is, until European regulators finally made their move, also in 2004. Not surprisingly, Pepsi applauded the change in European policy toward exclusive dealing.

8 Coke and Pepsi Market Shares
GLOBAL COMPARISON Europe Levels the Playing Field for Coke and Pepsi France Belgium Germany United States 75% 50 25 Coke and Pepsi Market Shares 68% 5% 6% 32% 60% 51% 44% Coke Pepsi

9 ECONOMICS IN ACTION The Great Vitamin Conspiracy
In the late 1990s, some of the world’s largest drug companies agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspiracy began in 1989 when the Swiss company Roche and the German company BASF began secret talks about setting prices and dividing up markets for bulk vitamins sold mainly to other companies. How could it have happened? The main answer probably lies in different national traditions about how to treat oligopolists. The United States has a long tradition of taking tough legal action against price-fixing. European governments, however, have historically been much less stringent. From Previous Edition

10 ECONOMICS IN ACTION The Prisoners’ Dilemma
To prove collusion, there must be some evidence of conversations or written agreements. Such evidence has emerged in our chocolate case. According to the Canadian press, 13 Cadbury executives voluntarily provided information to the courts about contacts between the companies, including a 2005 episode in which a Nestle executive handed over a brown envelope containing details about a forthcoming price hike to a Cadbury employee. And, according to affidavits submitted to a Canadian court, top executives at Hershey, Mars, and Nestle met secretly in coffee shops, in restaurants, and at conventions to set prices. The Prisoners’ Dilemma When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. The reward received by a player in a game—such as the profit earned by an oligopolist—is that player’s payoff. A payoff matrix shows how the payoff to each of the participants in a two-player game depends on the actions of both. Such a matrix helps us analyze interdependence.

11 A Payoff Matrix Ajinomoto Produce 30 million pounds
Ajinomoto makes $180 million profit. Ajinomoto makes $200 million profit. Produce 30 million pounds ADM makes $180 million profit ADM makes $150 million profit ADM A Payoff Matrix Two firms, ADM and Ajinomoto, must decide how much lysine to produce. The profits of the two firms are interdependent: each firm’s profit depends not only on its own decision but also on the other’s decision. Each row represents an action by ADM, each column one by Ajinomoto. Both firms will be better off if they both choose the lower output; but it is in each firm’s individual interest to choose the higher output. Ajinomoto makes $160 million profit. Ajinomoto makes $150 million profit. Produce 40 million pounds ADM makes $200 million profit ADM makes $160million profit

12 The Prisoners’ Dilemma
Economists use game theory to study firms’ behavior when there is interdependence between their payoffs. The game can be represented with a payoff matrix. Depending on the payoffs, a player may or may not have a dominant strategy. When each firm has an incentive to cheat, but both are worse off if both cheat, the situation is known as a prisoners’ dilemma. The game is based on two premises: 1) Each player has an incentive to choose an action that benefits itself at the other player’s expense. 2) When both players act in this way, both are worse off than if they had acted cooperatively.

13 The Prisoners’ Dilemma
Louise Don’t confess Confess Louise gets 5-year sentence. Louise gets 2-year sentence. Don’t confess Thelma gets 5-year sentence. Thelma gets 20-year sentence. Thelma Louise gets 20-year sentence. Louise gets 15-year sentence. The Prisoners’ Dilemma Each of two prisoners, held in separate cells, is offered a deal by the police—a light sentence if she confesses and implicates her accomplice but her accomplice does not do the same, a heavy sentence if she does not confess but her accomplice does, and so on. It is in the joint interest of both prisoners not to confess; it is in each one’s individual interest to confess. Confess Thelma gets 2-year sentence. Thelma gets 15-year sentence.

14 The Prisoners’ Dilemma
An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. Depending on the payoffs, a player may or may not have a dominant strategy. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players. Overcoming the Prisoners’ Dilemma Repeated Interaction and Tacit Collusion Players who don’t take their interdependence into account arrive at a Nash, or non-cooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners’ dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion.

15 Overcoming the Prisoners’ Dilemma
Repeated Interaction and Tacit Collusion Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusion.

16 How Repeated Interaction Can Support Collusion
Ajinomoto Tit for tat Always cheat Ajinomoto makes $180 million profit each year. Ajinomoto makes $200 million profit 1st year, $160 profit each later year. Tit for tat ADM makes $150 million profit 1st year, $160 million profit each later year. ADM makes $180 million profit each year. ADM Ajinomoto makes $150 million profit 1st year, $160 million profit each later year. Ajinomoto makes $160 million profit each year. Figure Caption: Figure 14-3: How Repeated Interaction Can Support Collusion A strategy of “tit for tat” involves playing cooperatively at first, then following the other player’s move. This rewards good behavior and punishes bad behavior. If the other player cheats, playing “tit for tat” will lead to only a short-term loss in comparison to playing “always cheat.” But if the other player plays “tit for tat,” also playing “tit for tat” leads to a long-term gain. So a firm that expects other firms to play “tit for tat” may well choose to do the same, leading to successful tacit collusion. Always cheat ADM makes $200 million profit 1st year, $160 million profit each later year. ADM makes $160 million profit each year.

17 The Kinked Demand Curve
An oligopolist who believes she will lose a substantial number of sales if she reduces output and increases her price, but will gain only a few additional sales if she increases output and lowers her price away from the tacit collusion outcome, faces a kinked demand curve—very flat above the kink and very steep below the kink. It illustrates how tacit collusion can make an oligopolist unresponsive to changes in marginal cost within a certain range when those changes are unique to her.

18 The Kinked Demand Curve
Price, cost marginal revenue W Tacit collusion outcome MC 1 P * MC 2 X 1. Any marginal cost in this region Y Figure Caption: Figure 14-4: The Kinked Demand Curve This oligopolist believes that her demand curve is kinked at the tacit collusion price and quantity levels, P* and Q*. That is, she believes that if she increases her output and lowers her price, her rivals will retaliate, increasing their output and lowering their prices as well, leading to only a small gain in sales. So her demand curve is very steep to the right of Q*. But the oligopolist believes that if she lowers her output and raises her price, her rivals will refuse to reciprocate and will steal a substantial number of her customers, leading to a large fall in sales. So her demand curve is very flat to the left of Q*. The kink in the demand curve leads to the break XY in the marginal revenue curve. As shown by the marginal cost curves, MC1 and MC2, any marginal cost curve that lies within the break leads the oligopolist to produce the same output level, Q*. So starting at the tacit collusion outcome, changes in marginal cost within a certain range will leave the firm’s output unchanged. But large changes in marginal cost—changes that cause the marginal cost curve to cut the marginal revenue curve in the segment WX or the segment YZ—will lead to changes in output. MR D Q * Z Quantity 2. … corresponds to this level of output

19 FOR INQUIRING MINDS Prisoners of the Arms Race
Between World War II and the late 1980s, the United States and the Soviet Union were locked in a struggle that never broke out into open war. During this Cold War, both countries spent huge sums on arms, sums that were a significant drain on the U.S. economy and eventually proved a crippling burden for the Soviet Union, whose underlying economic base was much weaker. Both nations would have been better off if they had both spent less on arms. Yet the arms race continued for 40 years. Why? As political scientists were quick to notice, one way to explain the arms race was to suppose that the two countries were locked in a classic prisoners’ dilemma. Each government would have liked to achieve decisive military superiority, and each feared military inferiority. But both would have preferred a stalemate with low military spending to one with high spending. However, each government rationally chose to engage in high spending.

20 FOR INQUIRING MINDS Prisoners of the Arms Race
If its rival did not spend heavily, its own high spending would lead to military superiority; not spending heavily would lead to inferiority if the other government continued its arms buildup. So, the countries were trapped. The answer to this trap could have been an agreement not to spend as much; indeed, the two sides tried repeatedly to negotiate limits on some kinds of weapons. But these agreements weren’t very effective. In the end the issue was resolved as heavy military spending hastened the collapse of the Soviet Union in 1991.

21 The Ups and Downs of Oil Cartels

22 Oligopoly in Practice Oligopolies operate under legal restrictions in the form of antitrust policy. Antitrust policies are efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors, including: large numbers of firms complex products and pricing scheme bargaining power of buyers conflicts of interest among firms

23 Contrasting Approaches to Anti-Trust Regulation
GLOBAL COMPARISON The European Union is believed to be stricter in imposing antitrust actions than the United States. Companies prefer the American system and the accompanying figure clarifies why. In recent years, on average, fines for unfair competition have been higher in the European Union than in the United States. Contrasting Approaches to Anti-Trust Regulation

24 Product Differentiation and Price Leadership
When collusion breaks down, there is a price war. To limit competition, oligopolists often engage in product differentiation, which is an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry. When products are differentiated, it is sometimes possible for an industry to achieve tacit collusion through price leadership. Oligopolists often avoid competing directly on price, engaging in nonprice competition through advertising and other means instead. In price leadership, one firm sets its price first, and other firms then follow. Firms that have a tacit understanding not to compete on price often engage in intense non-price competition, using advertising and other means to try to increase their sales.

25 ECONOMICS IN ACTION Price Wars of Christmas
The toy aisles of American retailers have often been the scene of cut-throat competition. During the 2011 Christmas shopping season, Target priced the latest Elmo doll at 89 cents less than Walmart (for those with a coupon), and $6 less than Toys “R” Us. So extreme is the price cutting that since 2003 three toy retailers—KB Toys, FAO Schwartz, and Zany Brainy—have been forced into bankruptcy. What is happening? The turmoil can be traced back to trouble in the toy industry itself as well as to changes in toy retailing–in the form of Internet sales. Besides the Internet, there have also been new entrants into the toy business: Walmart and Target have expanded their number of stores and have been aggressive price - cutters. The result is much like a story of tacit collusion sustained by repeated interaction run in reverse: because the overall industry is in a state of decline and there are new entrants, the future payoff from collusion is shrinking. The predictable outcome is a price war.

26 ECONOMICS IN ACTION Price Wars of Christmas
Since retailers depend on holiday sales for nearly half of their annual sales, the holidays are a time of particularly intense price-cutting. Traditionally, the biggest shopping day of the year has been the day after Thanksgiving. But in an effort to expand sales and undercut rivals, retailers—particularly Walmart—have now begun their price-cutting earlier in the fall.

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