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Copyright 2006 – Biz/ed Oligopoly.

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1 Copyright 2006 – Biz/ed Oligopoly

2 Copyright 2006 – Biz/ed Oligopoly Competition between the few –May be a large number of firms in the industry but the industry is dominated by a small number of very large producers Concentration Ratio – the proportion of total market sales (share) held by the top 3,4,5, etc firms: –A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry

3 Copyright 2006 – Biz/ed Oligopoly Several models of oligopolistic behaviour. Features of an oligopolistic market structure: –The market is dominated by a small number of large firms –High barriers to entry –Behaviour of firms affected by what they believe their rivals might do – interdependence of firms. This leads to strategic behaviour –Goods could be homogenous or highly differentiated

4 Copyright 2006 – Biz/ed The Concentration ratio Percentage of output produced by the largest firms in an industry. Can be calculated for any given number of firms: CR 4, CR 6, CR 8 … Provides an indication of the degree of competition in an industry: the higher the CR, the lower the degree of competition. In general, an industry with CR 4 >=40% is considered to be oligopolistic.

5 Copyright 2006 – Biz/ed It has some weaknesses: 1.Underestimates degree of competition when firms face competition from imports. 2.Provides no indication of importance of firms in global market. 3.Does not account for competition from other industries: case of substitutes such as metals (aluminium and copper). 4.The sizes of the largest firms are not considered. Consider CR 3 =90% 30%30%30% 60%15%15%

6 Copyright 2006 – Biz/ed The Herfindahl index is a better measure of the degree of market power in an industry, as it attaches a larger weight to firms with a large size. It is calculated taking the squares of each percentage share.

7 Copyright 2006 – Biz/ed Some other features –Potential for collusion. Oligopolistic firms face the incentive to collude (cooperate) with other firms to reduce competition: this reduces uncertainties and increases total profits. –Branding and brand loyalty may be a potent source of competitive advantage –Non-price competition may be prevalent

8 Copyright 2006 – Biz/ed Oligopoly Example: Music sales – The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this ‘independents’ group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers. Market Share of the Music Industry 2002. Source IFPI:

9 Copyright 2006 – Biz/ed Oligopoly (Barriers to entry) Economies of scale Product differentiation and brand loyalty Ownership of or control over key factors of production Legal protection Threat of mergers or takeovers Aggressive tactics, keeping a loss Intimidation

10 Copyright 2006 – Biz/ed Oligopoly (Collusion) Two types of oligopoly (collusive and non- collusive Collusive oligopoly :- formal collusion (cartel) often illegal - tacit collusion (dominant firm price leadership and barometric firm price leadership)

11 Copyright 2006 – Biz/ed Collusive oligopoly: cartels A cartel is a formal agreement between firms in an industry to take actions to limit competition in order to increase profits. –Limiting the quantity to be produced –Restrictions on non-price competition –Dividing the market –Agreeing to set up barriers to entry

12 Copyright 2006 – Biz/ed Collusive oligopoly: cartels The goal is to maximize industry profits: the cartel behaves as a monopoly. The OPEC (13 oil-producing countries) assigns an output level to each member

13 Copyright 2006 – Biz/ed Collusive oligopoly: Cartels Obstacles to forming and maintaining cartels: Incentive to cheat. If a firm secretly lowers the price, can increase its profits at the expense of other firms. Cost differences. Since firms have different cost curves, some will have larger profits than others. Agreeing on a price and allocating the output among the firms becomes more difficult. Firms face different demand curves, due to product differentiation and market shares.

14 Copyright 2006 – Biz/ed Number of firms. Possibility of a price war, when a firm’s price cat is matched by other firms’ price cuts. Recessions: firms have stronger incentives to reduce prices. Potential entry may drive the price down and lower cartel’s profits. The creation of high barriers is essential for the long-run survival of the cartel. Lack of a dominant firm. Its presence facilitates reaching agreement (Saudi Arabia is the dominant member of the OPEC).

15 Copyright 2006 – Biz/ed Collusive oligopoly: tacit collusion Cooperation that is implicit or understood, without formal agreement. One type is price leadership: a dominant firm in the industry sets the price and initiates any price changes. The remaining firms become price-takers and accept the price set by the leader. Price changes tend to be infrequent and they are initiated by the leader when major demand or cost changes occur.

16 Copyright 2006 – Biz/ed Obstacles: 1.Cost differences 2.Not following the leader, which might imply losing sales and market share if the leader initiates a price increase. 3.Incentive to cheat 4.Potential entrants 5.It may or may not be illegal

17 Copyright 2006 – Biz/ed Another example are informal agreements where firms agree to a rule for co-ordinating prices, such as limit pricing: firms agree to set a price lower than the profit-maximizing price. Firms may sacrifice some profit in order to avoid attracting new firms into the industry.

18 Copyright 2006 – Biz/ed Oligopoly: Game Theory Temptation to cheat Game theory illustrates the characteristics of mutual interdependence, strategic behaviour and conflicting incentives (incentive to cheat once firms agree to cooperate). It is not a branch of mathematics, but a discipline in itself. It is used as a tool in microeconomics but also in computer science, artificial intelligence, biology and logic. The concept of Nash equilibrium (developed by John Nash, who received the Nobel Prize in economics together with two other game theorists), although very popular is not very realistic.

19 Copyright 2006 – Biz/ed The prisoner's dilemma is the story of two criminals who have been arrested for a heinous crime and are being interrogated separately. Each knows that if neither of them talks, the case against them is weak and they will be convicted and punished for lesser charges. If this happens, each will get one year in prison. If both confess, each will get 20 years in prison. If only one confesses and testifies against the other, the one who did not cooperate with the police will get a life sentence and the one who did cooperate will get parole. The table below illustrates the structure of payoffs.

20 Copyright 2006 – Biz/ed Prisoner’s dilemma

21 Copyright 2006 – Biz/ed If they agree to not confess, they get one year in prison. But each prisoner, knowing that the other one will not confess, has the incentive to cheat, ie, confess and get parole. The Nash equilibrium is both confess, as they then face no incentive to deviate. However, they become worse off!

22 Copyright 2006 – Biz/ed Incentive to cheat: OPEC

23 Copyright 2006 – Biz/ed Player A realises that by breaking the agreement (and charge a lower price, it can earn 4 while B earns only 1). It also knows that player B can break the agreement so it will end up making 1 instead of 3. Player B thinks along the same lines. They are both likely to break the agreement, ending up making 2 both. This is the Nash equilibrium, in which both become worse off but none has any incentive to deviate.

24 Copyright 2006 – Biz/ed Non-collusive oligopoly: The Kinked demand curve The Kinked demand curve is a model developed to explain price rigidities of oligopolistic firms that do not collude. Firms do not make any agreements with each other on how to fix prices. Their price behavior is influenced by the expectations of how rival firms will react to a price change. Consider three firms, each producing 100 units and selling at 5.

25 Copyright 2006 – Biz/ed Price Quantity D = elastic D = Inelastic £5 100 Kinked D Curve Assume the firm is charging a price of £5 and producing an output of 100. If it chose to raise price above £5, its rivals would not follow suit and the firm effectively faces an elastic demand curve for its product (consumers would buy from the cheaper rivals). The % change in demand would be greater than the % change in price and TR would fall. Total Revenue A Total Revenue B If the firm seeks to lower its price to gain a competitive advantage, its rivals will follow suit. Any gains it makes will quickly be lost and the % change in demand will be smaller than the % reduction in price – total revenue would again fall as the firm now faces a relatively inelastic demand curve. Total Revenue B Total Revenue A

26 Copyright 2006 – Biz/ed The firm therefore, effectively faces a ‘kinked demand curve’ forcing it to maintain a stable or rigid pricing structure. Oligopolistic firms may overcome this by engaging in non- price competition. The principle of the kinked demand curve rests on the principle that: a.If a firm raises its price, its rivals will not follow suit b.If a firm lowers its price, its rivals will all do the same

27 Copyright 2006 – Biz/ed This model illustrates: Firms that do not collude are forced to take into account the actions of their rivals. Even though firms do not collude, there is still price stability. Firms are reluctant to change prices because of the likely actions of their rivals. Firms do not compete with each other on the basis of price.

28 Copyright 2006 – Biz/ed Non-price competition Oligopolistic firms try to avoid price competition, as this may trigger price wars, which result in lower profits for all firms. They do engage in intense non-price competition, in order to increase market share by methods such as product development, advertising and branding. This may also increase barriers to entry.

29 Copyright 2006 – Biz/ed Non-price competition is very important in oligopoly because: 1.Availability of financial resources that firms can devote to R&D and advertising and branding. 2.New products do not only may increase sales and profits but they also increase monopoly power and make demand less elastic. 3.Product differentiation may increase profits without creating risks for immediate retaliation by rivals, as it takes time and resources to develop a new product.

30 Copyright 2006 – Biz/ed ZmEiyTo0&feature=related ZmEiyTo0&feature=related os2fzIJ0&feature=player_embedded os2fzIJ0&feature=player_embedded 31yT/Murder+Numbers+Scenes+Whoe ver+Talks+First/Murder+By+Numbers

31 Copyright 2006 – Biz/ed Hotelling model of spatial competition: _8 _8

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