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Oligopoly is a market structure featuring a small number of sellers that together account for a large fraction of market sales. Oligopoly is derived from the Greek work “olig” meaning “few” or “a small number.”

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Features of oligopoly Fewness of sellers Seller interdependence Feasibility of coordinated action among ostensibly independent firms

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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 (CR 4 ) measures the percent of total market sales accounted for by the top four firms in the market. The eight-firm concentration ratio (CR 4 ) measures the percent of total market sales accounted for by the top eight firms in the market.

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Concentration Ratios: Very Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers

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Concentration Ratios: Less Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers

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Seller interdependence If Kroger offers deep discounts on soft drinks, will Wal-Mart follow suit? Northwest Airlines “perks” miles do not expire—how did United, Delta, et al react? AT&T’s “where’s the savings?” ad campaign prompted an effective retaliatory ad strategy by MCI. Some ISP’s now pledge not to sell information to database companies—will this affect AOL? Alcoa’s decision to add production capacity is conditioned upon the investment plans of rival aluminum producers.

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Game Theory and Seller Interdependence 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.

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A situation of competitive rivalry must involve two or more players whose choice of actions affect each other. 1. Players and their actions 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, choice of hubs, ordering planes, expanding terminals, use of computerized reservations systems, mergers and acquisitions, and human resource decisions.

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2. Outcomes and Payoffs The firm’s action, together with the actions of its rivals, determine its payoff In 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.

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3. Underlying “rules” The rules of the game define the range of possible outcomes and payoffs For 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?

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Prisoner’s dilemma Ralph and Gertie 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.

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OK, Ralph. Confess, rat on Gertie, and you get a reduced sentence of one year in prison. Let’s make a deal

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What will Gertie do?

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The payoff matrix Stay Mum Confess Stay Mum 2 years, 2 years 8 years, 1 year Confess1 year, 8 years 5 years, 5 years Ralph Gertie

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Confess is the dominant strategy in this case, since it gives the shortest sentence irrespective of whether the other prisoner selects the “confess” or “stay mum” strategy Dominant strategy A dominant strategy yields the best possible payoff for any strategy selected by the other player(s).

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Price wars in a duopoly The preceding is what we call a “non-cooperative” game. Cooperation among duopolists is a strategy that maximizes joint profits. So why do price wars break out?

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The payoff matrix for a running shoe duopoly High Price Low Price High Price $10 million, $10 million $5 million, $12 million Low Price $12 million, $5 million $7 million, $7 million REEBOK NIKE Notice that “low price” is the dominant strategy

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Pizza Planet and Luigi’s are rivals in the market for home-delivered pizza. Each rival seeks to gain an advantage through advertising (product differentiation). Advertising is presumed NOT to affect market demand--only market share. Market share depends on the intensity of advertising relative to one’s rival. Advertising rivalry

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Let P = $15 Q = 100 pizzas (market quantity-demanded) AC (w/o advertising expense) = $5. Hence: /Pizza = (TR - TC)/Q = ($1500 - $500)/100 = $10

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If neither seller advertises, each will sell 50 pizzas and earn a profit of $500. However, advertising could potentially increase sales to 75 pizzas.

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The payoff matrix for a pizza duopoly Low Advertising High Advertising Low Advertising $400, $400 $150, $550 High Advertising $550, $150 $300, $300 LUIGI’S PIZZA PLANET Notice that “high advertising” is the dominant strategy

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Nash Equilibrium A list of strategies, one for each player, is a Nash equilibrium if each player’s strategy maximizes his (or her) payoff given the strategies selected by the other players and if this condition holds for all players simultaneously. You have Russell Crowe—er, I mean John Nash, to thank for this concept

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Nash Equilibrium and the Shoe, Pizza Duopoly Games A Nash equilibrium is given by the “low- low” strategy in the running shoe duopoly gamerunning shoe duopoly game A Nash equilibrium is given by the “high- high strategy” in the pizza duopoly game.pizza duopoly game

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