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Several topics in oligopoly. 2 More on asymmetric information: trust and reputation  Trust: an agent is expected to do something (actions). Applies to.

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Presentation on theme: "Several topics in oligopoly. 2 More on asymmetric information: trust and reputation  Trust: an agent is expected to do something (actions). Applies to."— Presentation transcript:

1 Several topics in oligopoly

2 2 More on asymmetric information: trust and reputation  Trust: an agent is expected to do something (actions). Applies to moral hazard problems. Involves repetition (if players interact frequently enough) and punishments. There is a trade-off between short-term gains and long- term losses. Example: oligopoly agreements to fix price.  Folk theorem: If players are patient enough (i.e., if the future matters sufficiently), then there exist equilibria of mutual trust.  There must be no possibility of changing identity (name) without being noticed (but e-markets facilitate this…), otherwise the punishments are ineffective.

3 3  Reputation: an agent is believed to be of a certain type. Applies to adverse selection problems. Reputation eases these problems and is dynamically built through Bayesian updating (by the uninformed party) and/or through signalling (by the informed party). Examples: having the reputation of being a good payer, of selling a high-quality product, of fighting entry by rivals. More on asymmetric information: trust and reputation

4 4  It may be worth investing in reputation: through the actions, influencing the perception of the type. Two possibilities: improve reputation by pooling with good types; improve reputation by separating from bad types through costly actions.  Reputation may be attached to names. In this case brands have a value (called brand equity) and there may exist a market for names.

5 5 Market power  As the number of firms in the industry increases, oligopoly solutions approach perfect competition (try with Cournot: the more firms there are, the higher the incentive of each one to increase production, because the negative effects on profits resulting from the price fall will be shared by a larger number of firms).  Market power: the capacity to set price above marginal cost. It is null in perfectly competitive environments and maximum in monopoly (or collusion).

6 6 Market power  Concentration measures C k and H (Herfindahl-Hirschman index). s i = market share of firm i, with firms ranked in descending order for C k.

7 7 Market power  The Lerner index of market power: L=H(1+  )/   The conjectural variation  expectation of the rivals’ response to a change in the firm’s strategic variable.  The value of  under several models:  Bertrand:  = -1, L=0  Cournot:  = 0, L=H/   Collusion:  = n-1, L=nH/   Monopoly: H=1,  = 0, L=1/   Other values for  : as  decreases (increases), competition is intensified (softened).

8 8 Strategic substitutes and strategic complements  The slope of reaction curves:  If the decision variables of firms are strategic complements, reaction curves are positively sloped. Response reinforces the action of rival. Example: price.  If the decision variables of firms are strategic substitutes, reaction curves are negatively sloped. Response goes in the opposite direction. Example: quantity.  Other strategic variables: advertising, investments in R&D, number of varieties, …

9 9 Product differentiation  Vertical differentiation: through quality. It’s an objective criterion.  Horizontal differentiation: through preferences and through consumer perception (the role of advertising). It’s a subjective criterion.  Through differentiation firms choose their location in the product space: recall the linear and the circular city models.

10 10 Product differentiation  Differentiation helps solving the Bertrand paradox. Other solutions: search costs and uninformed consumers (advertising prices increases price competition); switching costs; capacity restrictions.

11 11 Advertising  Informative versus persuasive advertising.  Search goods, experience goods, credence goods.  Advertising as a signal of product quality.  Advertising as an investment in brand equity.

12 12 Advertising  The Dorfman-Steiner condition: a/R , where  =demand elasticity to advertising and a/R=ratio of advertising (a) to total sales (revenue R). The lower , the larger the gain per additional unit sold (because the larger the price-cost margin).  Higher concentration implies that the firm is able to benefit more from each additional unit sold (higher price-cost margin) and from the demand expansion effect of advertising.

13 13 Advertising  Advertising has a prisoners’ dilemma nature: it would be better to cooperate in a no-advertising solution, but then each one has an incentive to break the agreement and all end up advertising.

14 14 Entry barriers  Legal. Examples: large supermarkets; licenses in the mobile phones market or in the pharmaceutical market; the gasoline retail market.  Natural: learning; scale economies (blockaded entry).

15 15 Entry barriers  Strategic entry barriers (preemption; only credible and effective if irreversible) (deterred entry):  Excess capacity (capacity costs must be sunk for it to be credible)  Product proliferation  Brand proliferation  Exclusive dealing upstream or downstream (Coca-Cola example: impose on its clients clauses that do not allow them to sell other brands)  Artificial switching costs. If fighting entry is more costly than the profit difference for the incumbent between no-entry and entry, then accommodate entry ( accommodated entry ).

16 16 Entry barriers The long-term contract case The long-term contract case The pharmaceutical industry case The pharmaceutical industry case

17 17 Inducing exit  Inducing exit: predation. Example: predatory pricing (P

18 18 Market definition - the relevant market  The product market:  Cross price elasticities (high between products in the same market, and low between these and the others)  Price correlations  The SSNIP (Small, Significant, Non-transitory Increase in Price) test: simulate a, say 5 or 10%, price increase in a restricted market; if profits rise, the market is defined; if they fall, identify main substitute, enlarge the market definition and proceed from the beginning.  The geographic market

19 19 Mergers  Merger motives:  Suppress rival  Generate synergies by combining assets or complementary capabilities – cost efficiencies: eliminate fixed costs and/or reduce marginal costs.  Increase buyer or seller power  Enter into a new market

20 20 Mergers  Profitability effects of the merger (upon participants) versus welfare effects (upon participants, nonparticipants, and consumers):  participants tend to benefit from the merger (except under quantity competition when the market power gain is not sufficiently high and without any of the above mentioned effects - recall strategic substitutes and strategic complements);  the Williamsom trade-off in horizontal mergers: higher market power, but also higher efficiency. The lower , the larger must be the cost efficiencies for social welfare to increase.

21 21 Mergers  Sometimes mergers occur in waves: this happens because as concentration increases, further mergers become more profitable.

22 22 Mergers  The antitrust authority’s objective: consumer surplus (look at price variation) or external welfare (consumers plus nonparticipants).  The concentration index H as a measure of the social desirability of the merger (US and EU merger guidelines:  in the absence of cost efficiencies, the larger the change in H, the worse the social welfare effects of the merger;  in the presence of cost efficiencies, the change in H looses significance.  Authorities tend to look at the estimated price increase caused by the merger when deciding whether or not to approve it (merger simulation).

23 23 Mergers  The informativeness of the insiders’ market share: lower combined market share implies lower price increase and thus may be an indicator of important efficiency gains.  The antitrust authority’s decision horizon: take into account the possibility of sequential mergers – the proposed merger may be welfare-detrimental, but lead to others which finally increase social welfare.

24 24 Mergers  Merger defenses:  Efficiency  Bargaining power  Contestable markets  Failing firm  Merger remedies:  divestitures

25 25 Mergers Show Simulator Link para Lei da Concorrência Link para Lei da Concorrência DaimlerChrysler merger case DaimlerChrysler merger case Staples merger case and market definition Staples merger case and market definition

26 26 Network externalities  Utility derived from consumption increases with number of users.  Examples: phone, , fax, modem, a given software, a given technology.  Network externalities are typical in information technology.  (In fashion there is usually an upper bound to network externalities).

27 27 Network externalities  Easier communication and more assistance.  Critical mass of buyers to build up the network (snowball effect). Importance of early adopters: they are decisive to determine the standard that prevails (which, due to historical circumstances, may not be the best).  Introductory low price/free samples/allow copies as strategies to quickly capture the critical mass.

28 28 Network externalities  Excess inertia: change technology only if others do. There are two equilibria in a simultaneous game: either all change, or nomeone changes.  Switching technology may become very costly (high switching costs): lock-in. Ex: Microsoft Windows.  Excess momentum: change occurs too fast.

29 29 Network externalities  Network compatibility and standardization (the videos case):  Enlarge the size of the network  Benefits consumers, but less variety  Decreases product differentiation (less variety), so increases firm competition  Critical mass becomes less important  Throws rivals out of the market  The net effect on profits from compatibility is unclear.  Compatibility may be achieved  cooperatively, through agreements with rivals, or  unilaterally, through “adaptors”

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