2 Oligopoly Markets Interdependence of firms’ profits Distinguishing feature of oligopolyArises when number of firms in market is small enough that every firms’ price & output decisions affect demand & marginal revenue conditions of every other firm in market
3 Features of oligopoly Fewness of sellers Seller interdependence Feasibility of coordinated action among ostensibly independent firms
4 Seller interdependence If Kroger offers deep discounts on soft drinks, will Wal-Mart follow suit?Verizon carries unused minutes over the to next month—implications for AT&T, et. al.?If AA discounts fares on its Chicago to NY service, will United follow?If Regions charges swipe fees, how will rival banks react?How will Duracell react to an aggressive marketing campaign by EverReady?Alcoa’s decision to add production capacity is conditioned upon the investment plans of rival aluminum producers.
5 Measures of seller concentration The concentration ratio is the percentage of total market sales accounted for by an absolute number of the largest firms in the market.The four-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top four firms in the market.The eight-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top eight firms in the market.
6 Concentration Ratios: Very Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers
7 Concentration Ratios: Less Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers
8 Game Theory and Competitive Strategy Selecting a course of action in a situation in which rival players are selecting strategies that suit their interests is the basic problem of game theory.
9 1. Players and their actions A situation of competitive rivalry must involve two or more players whose choice of actions affect each other.A “player” can be a firm, an interest group or coalition, a military leader, government official.Games generally consider only one kind of action—e.g., number of daily departures, fares, in-flight services, schedules, advertising, technology, choice of hubs, ordering planes, expanding terminals, use of computerized reservations systems, mergers and acquisitions, and human resource decisions.
10 2. Outcomes and PayoffsThe firm’s action, together with the actions of its rivals, determine its payoffIn the standard “business” game, the payoff can be in the form of profit, market share, ratings points,In war games, the payoff might be measured in enemy killed or territory seized.In political games, payoffs may be measured in votes or campaign contributions.
11 3. Underlying “rules”The rules of the game define the range of possible outcomes and payoffsFor example, collusion to fix prices or a merger among direct rivals in a concentrated market structure may be against the rules.Another set a rules specifies whether players move sequentially or simultaneously, who moves first, and what does each player know about the other players’ preference and prior to actions?
12 Strategic Decisions Strategic behavior Game theory Actions taken by firms to plan for & react to competition from rival firmsGame theoryUseful guidelines on behavior for strategic situations involving interdependenceSimultaneous DecisionsOccur when managers must make individual decisions without knowing their rivals’ decisions
13 Dominant StrategiesAlways provide best outcome no matter what decisions rivals makeWhen one exists, the rational decision maker always follows its dominant strategyPredict rivals will follow their dominant strategies, if they existDominant strategy equilibriumExists when all decision makers have dominant strategies
14 Prisoner’s dilemmaBill and Jane have been charged with bank robbery. But lacking a confession,the DA can only get a “reckless endangerment” charge to stick. So the police play one suspect off against the other.
15 Let’s make a dealOK, Bill. Confess, give evidence on Jane, and you get a reduced sentence of one year in prison.
17 Prisoners’ Dilemma All rivals have dominant strategies In dominant strategy equilibrium, all are worse off than if they had cooperated in making their decisions
18 Prisoners’ Dilemma (Table 13.1) BillDon’t confessConfessJaneA2 years, 2 yearsB12 years, 1 yearC1 year, 12 yearsD6 years, 6 yearsBJJB
19 Principle: When a firm does not have a dominant strategy but at least one of its rivals does have a dominant strategy, the firm can predict that its rivals will follow their dominant strategies. Thus the problem for the firm is to select the strategy that gives the highest payoff conditional upon rival pursuing their dominant strategies.
20 Dominated StrategyA strategy is dominated if, regardless of what any other players do, the strategy earns a player a smaller payoff than some other strategy. Hence, a strategy is dominated if it is always better to play some other strategy, regardless of what opponents may do. If a player has a dominant strategy than all others are dominated, but the converse is not always true.
21 Dominated StrategiesNever the best strategy, so never would be chosen & should be eliminatedSuccessive elimination of dominated strategies should continue until none remainSearch for dominant strategies first, then dominated strategiesWhen neither form of strategic dominance exists, employ a different concept for making simultaneous decisions
22 Successive Elimination of Dominated Strategies (Table 13.3) Pizza PricingPalace’s priceHigh ($10)Medium ($8)Low ($6)Castle’s priceHigh($10)A$1,000, $1,000B$900, $1,100C$500, $1,200Medium($8)D$1,100, $400E$800, $800F$450, $500Low($6)G$1,200, $300H$500, $350I$400, $400CCPPCPPayoffs in dollars of profit per week
23 Successive Elimination of Dominated Strategies (Table 13.3) Unique SolutionReduced Payoff TablePalace’s priceMedium ($8)Low ($6)Castle’s priceHigh($10)B$900, $1,100C$500, $1,200Low($6)H$500, $350I$400, $400CCPPPayoffs in dollars of profit per week
24 Castle does not have a dominant strategy. But Palace does Castle does not have a dominant strategy. But Palace does. Castle should select its best strategy, given Castle will pursue its dominant strategy
25 Making Mutually Best Decisions For all firms in an oligopoly to be predicting correctly each others’ decisions:All firms must be choosing individually best actions given the predicted actions of their rivals, which they can then believe are correctly predictedStrategically astute managers look for mutually best decisions
26 Nash EquilibriumSet of actions or decisions for which all managers are choosing their best actions given the actions they expect their rivals to chooseStrategic stabilityNo single firm can unilaterally make a different decision & do better
27 Nash decisions are likely to chosen because Nash sets of decisions are mutually best and thus, “strategically stable.” No player can do better by unilaterally changing its decision. Non-Nash decisions are unlikely to be chosen because at least one player can improve its payoff by changing its decision.Beautiful Mind
28 Super Bowl Advertising: A Unique (Non-Cooperative) Nash Equilibrium Note: No dominant or dominated strategiesPepsi’s budgetLowMediumHighCoke’s budgetA$60, $45B$57.5, $50C$45, $35D$50, $35E$65, $30F$30, $25G$45, $10H$60, $20I$50, $40CPPCCPPayoffs in millions of dollars of semiannual profit
29 Why is High-High Stable? Suppose Coke and Pepsi cooperate—Both choose “low” and maximize joint profit.Pepsi can do better by unilaterally selecting “medium.”In some cells, both Coke and Pepsi can increase their payoffs by changing strategies—Consider cell F, for example.
30 Nash EquilibriumWhen a unique Nash equilibrium set of decisions existsRivals can be expected to make the decisions leading to the Nash equilibriumWith multiple Nash equilibria, no way to predict the likely outcomeAll dominant strategy equilibria are also Nash equilibriaNash equilibria can occur without dominant or dominated strategies
31 Best-Response CurvesAnalyze & explain simultaneous decisions when choices are continuous (not discrete)Indicate the best decision based on the decision the firm expects its rival will makeUsually the profit-maximizing decisionNash equilibrium occurs where firms’ best-response curves intersect
32 Deriving Best-Response Curve for Arrow Airlines (Figure 13.1) Arrow Airline’s price and marginal revenuePanel A : Arrow believes PB = $100Bravo Airway’s quantityArrow Airline’s pricePanel B: Two points on Arrow’s best-response curveBravo Airway’s price
34 Sequential DecisionsOne firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decisionThe best decision a manager makes today depends on how rivals respond tomorrow
35 Game TreeShows firms decisions as nodes with branches extending from the nodesOne branch for each action that can be taken at the nodeSequence of decisions proceeds from left to right until final payoffs are reachedRoll-back method (or backward induction)Method of finding Nash solution by looking ahead to future decisions to reason back to the current best decision
36 Sequential Pizza Pricing Panel B – Roll-back solutionPanel A – Game tree
37 First-Mover & Second-Mover Advantages First-mover advantageIf letting rivals know what you are doing by going first in a sequential decision increases your payoffSecond-mover advantageIf reacting to a decision already made by a rival increases your payoffDetermine whether the order of decision making can be confer an advantageApply roll-back method to game trees for each possible sequence of decisions
38 Cellular Service in Brazil MotorolaSonyAnnual cost of analog$250$400Annual cost of digital$350$325Use of incompatible technologies would reduce the market demand for cellular service.Motorola would obviously prefer analog; Sony digital.Brazilian government has imposed a price ceiling—technology is the decision variable.
39 First-Mover Advantage in Technology Choice Motorola’s technologyAnalogDigitalSony’s technologyA$10, $13.75B$8, $9C$9.50, $11D$11.875, $11.25SMSMPanel A – Simultaneous technology decision
40 To determine if a first mover advantage exists, construct a decision tree and then “roll back.”
41 First-Mover Advantage in Technology Choice Panel B – Motorola secures a first-mover advantage
42 Strategic Moves & Commitments Actions used to put rivals at a disadvantageThree typesCommitmentsThreatsPromisesOnly credible strategic moves matterManagers announce or demonstrate to rivals that they will bind themselves to take a particular action or make a specific decisionNo matter what action is taken by rivals
43 Credible MovesThere is no doubt the strategic move will be carried out because it is in the best interest of the player making the move to carry it out.
44 The NBA Players Association made the decision to decertify its union and bring an anti-trust suit against the NBA owners. Whether this amounts to a credible strategic move is open to debate.
45 Threats & Promises Conditional statements Threats Promises Explicit or tacit“If you take action A, I will take action B, which is undesirable or costly to you.”Promises“If you take action A, I will take action B, which is desirable or rewarding to you.”
46 Cooperation in Repeated Strategic Decisions Cooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (noncooperative) Nash equilibrium
47 Cheating Making noncooperative decisions One-time prisoners’ dilemmas Does not imply that firms have made any agreement to cooperateOne-time prisoners’ dilemmasCooperation is not strategically stableNo future consequences from cheating, so both firms expect the other to cheatCheating is best response for each
48 Pricing Dilemma for AMD & Intel AMD’s priceHighLowIntel’s priceA:$5, $2.5B:$2, $3C:$6, $0.5D:$3, $1CooperationAMD cheatsIntel cheatsANoncooperationIIAPayoffs in millions of dollars of profit per week
49 Punishment for Cheating With repeated decisions, cheaters can be punishedWhen credible threats of punishment in later rounds of decision making existStrategically astute managers can sometimes achieve cooperation in prisoners’ dilemmas
50 In a one-time game, there is no opportunity to punish cheaters In a one-time game, there is no opportunity to punish cheaters. In repeated games, cheaters can be punished.Cooperation in one-time games is unstable.
51 Deciding to Cooperate Cooperate Cheat When present value of costs of cheating exceeds present value of benefits of cheatingAchieved in an oligopoly market when all firms decide not to cheatCheatWhen present value of benefits of cheating exceeds present value of costs of cheating
52 Retaliation for Cheating Legal sanctions or fines levied against cheaters are illegal in most countries.Cheaters are usually “punished” when rival firms push the game back to non-cooperative (Nash) equilibrium.
53 Deciding to Cooperate Where Bi = πCheat – πCooperate for i = 1,…, N Where Cj = πCooperate – πNash for j = 1,…, P
54 A Firm’s Benefits & Costs of Cheating (Figure 13.5)
55 Trigger Strategies A rival’s cheating “triggers” punishment phase Tit-for-tat strategyPunishes after an episode of cheating & returns to cooperation if cheating endsGrim strategyPunishment continues forever, even if cheaters return to cooperation
56 Facilitating Practices Legal tactics designed to make cooperation more likelyFour tacticsPrice matchingSale-price guaranteesPublic pricingPrice leadership
57 Price MatchingFirm publicly announces that it will match any lower prices by rivalsUsually in advertisementsDiscourages noncooperative price-cuttingEliminates benefit to other firms from cutting prices
58 Sale-Price Guarantees Firm promises customers who buy an item today that they are entitled to receive any sale price the firm might offer in some stipulated future periodPrimary purpose is to make it costly for firms to cut prices
59 Public PricingPublic prices facilitate quick detection of noncooperative price cutsTimely & authenticExample: Shared computerized reservation systems in the airline industry.Early detectionReduces PV of benefits of cheatingIncreases PV of costs of cheatingReduces likelihood of noncooperative price cuts
60 Price LeadershipPrice leader sets its price at a level it believes will maximize total industry profitRest of firms cooperate by setting same priceDoes not require explicit agreementGenerally lawful means of facilitating cooperative pricing
61 Cartels Most extreme form of cooperative oligopoly Explicit collusive agreement to drive up prices by restricting total market outputIllegal in U.S., Canada, Mexico, Germany, & European Union
62 CartelsPricing schemes usually strategically unstable & difficult to maintainStrong incentive to cheat by lowering priceWhen undetected, price cuts occur along very elastic single-firm demand curveLure of much greater revenues for any one firm that cuts priceCartel members secretly cut prices causing price to fall sharply along a much steeper demand curve
63 Intel’s Incentive to Cheat (Figure 13.6) Along dIntel, Intel can increase its sales and its market share.Along DIntel, Intel can increase its sales but not its market share.
64 Tacit CollusionFar less extreme form of cooperation among oligopoly firmsCooperation occurs without any explicit agreement or any other facilitating practices
65 Strategic Entry Deterrence Established firm(s) makes strategic moves designed to discourage or prevent entry of new firm(s) into a marketTwo types of strategic movesLimit pricingCapacity expansion
66 Limit PricingEstablished firm(s) commits to setting price below profit-maximizing level to prevent entryUnder certain circumstances, an oligopolist (or monopolist), may make a credible commitment to charge a lower price forever
67 The key is making a credible commitment to a “low” post-entry price Star CoffeeThe key is making a credible commitment to a “low” post-entry priceManager of Star Coffee
68 Limit Pricing: Entry Deterred P* is the π-maximizing pricePL is the maximum-entry forestalling price.
69 Limit Pricing: Entry Occurs PN is the Nash price
71 Star CoffeeThe problem is that, if I am unable to make a credible commitment to permanently low prices, the manager of the Burned Bean knows I have an incentive to shift to the Nash price post-entry. Thus entry will not be deterred.Manager of Star Coffee
72 Capacity ExpansionEstablished firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacityWhen increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of productionRequires established firm to cut its price to sell extra output