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Oligopoly and Strategic Behavior

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1 Oligopoly and Strategic Behavior
13 Oligopoly and Strategic Behavior

2 Oligopoly Policy: Antitrust
Antitrust policy Government efforts that attempt to prevent oligopolies from behaving like monopolies Sherman Act of 1890 “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.” From the Text: Efforts to curtail the adverse consequences of oligopolistic cooperation began with the Sherman Antitrust Act of This was the first federal law to place limits on cartels and monopolies. The Sherman Act was created in response to the increase in the concentration ratios in many leading U.S. industries, including steel, railroads, mining, textiles, and oil. Prior to the passage of the Sherman Act, firms were free to pursue contracts that created mutually beneficial outcomes. Once the act took effect, certain cooperative actions became criminal.

3 Oligopoly Policy: Antitrust
Clayton Act of 1914 added a few more items that were considered detrimental Price discrimination that lessens competition Exclusive dealings that restrict the ability of a buyer to deal with competitors Tying arrangements (similar to bundling) Mergers that lessen competition Prevents a person from serving as a director on more than one board in the same industry From the Text: Additional legislation, and court interpretations of existing antitrust law, have made it difficult to determine whether or not a company has violated the law. The U.S. Justice Department is charged with oversight but it often lacks the resources to be able to fully investigate every case. Antitrust law is complex and cases are hard to prosecute, but these laws are essential to maintain a competitive business environment. Without effective restraints on excessive market power, firms would organize into cartels more often or find ways to restrict competition.

4 Strategic Behavior Perfect Competition
Only strategy is to reduce costs Price-taker => output decisions do not affect market price cross-price elasticity = -1 (perfect substitutes) Own-price = -∞ Monopoly Price-Searcher: output decision determines price Cross-price = 0 (no substitutes) Own-price: <= |1| Oligopoly Cross-price elasticity < |1| Own-price elasticity ~ |1| Will have to take into account actions of other similar firms when making output/pricing decisions Much more strategy

5 Oligopoly Behavior Cooperative Oligopoly Non-cooperative Oligopolies
Cartels Agree to collude; act/price like a single firm monoploist Price leadership (Stackleberg leader) Dominant firm establishes the price; other firms react to “leader” Non-cooperative Oligopolies Sticky prices (kinked demand curve) Sticky upward Nash equilibrium Characterized by stable prices Perfect competition Completely rivalarous

6 Cooperative Oligopolies
Cartels (highly cooperative) Firms act as single-firm monopolist Stackelberg Price Leader (passive cooperation) - leader firm moves first and then the follower firms move sequentially Stackelberg leader is sometimes referred to as the Market Leader.

7 Where We’re Going How do we tell if a market is an oligopoly?
Market Concentration CR4: market share for the 4 largest firms Herfindahl Index (HHI): computed from the squares of the market shares Strategic behavior (how do they behave in the market place) Collusive: act together Non-collusive: act separately and/or strategically

8 How do we tell? Market concentration
size and distribution of firm market shares and the number of firms in the market. Economists use two measures of industry concentration: Four-firm Concentration Ratio (CR4) The Herfindahl-Hirschman Index (HHI)

9 Attempts to Measure Market Concentration
four-firm concentration ratio market share of the four largest firms in an industry Herfindahl index, also known as Herfindahl-Hirschman Index or HHI, widely applied in competition law and antitrust. sum of the squares of the market shares of each individual firm. Decreases in the Herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite.

10 Four-Firm Concentration Ratio
The four-firm concentration ratio (CR4) measures market concentration by adding the market shares of the four largest firms in an industry. If CR4 > 60, then the market is likely to be oligopolistic.

11 Example Firm Market Share Nike 62% New Balance 15.5% Asics 10% Adidas

12 Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in 1997

13 The Herfindahl-Hirschman Index
The Herfindahl-Hirschman index (HHI) is found by summing the squares of the market shares of all firms in an industry. Advantages over the CR4 measure: Measures how “concentrated” the market is Large market shares -> squared -> HHI increases exponentially (rather than linearly) Uses data on all firms

14 Example Firm Market Share Nike 62% New Balance 15.5% Asics 10% Adidas

15 Example (cont’d) What happens if market shares are evenly distributed?
Firm Market Share Nike 22.95% New Balance Asics Adidas

16 Non-competitive Oligopolies
Non-competitive/collusive behavior (cooperative oligopolies) Cartels: firms may collude to raise prices and restrict production in the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. Dominant Firm/Price Leader: collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development. does not require formal agreement although for the act to be illegal there must be a real communication between companies for example, in some industries, there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership. Stackleberg price-leader model

17 An Example of a Cartel Organization of the Petroleum Exporting Countries (OPEC) is an international cartel made up of Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Principal aim of the organization, according to its Statute, is the determination of the best means for safeguarding their interests, individually and collectively; devising ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations OPEC triggered high inflation across both the developing and developed world using oil embargoes in the 1973 oil crisis. OPEC's ability to control the price of oil has diminished due to the subsequent discovery/development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization. OPEC nations still account for two-thirds of the world's oil reserves, and, in 2005, 41.7% of the world's oil production,

18 Game Theory Models of Oligoploy
Stackelberg's duopoly. In this model the firms move sequentially (see Stackelberg competition). Cournot's duopoly. In this model the firms simultaneously choose quantities (see Cournot competition). Bertrand's oligopoly. In this model the firms simultaneously choose prices (see Bertrand competition). Monopolistic competition. A market structure in which several or many sellers each produce similar, but slightly differentiated products. Each producer can set its price and quantity without affecting the marketplace as a whole.

19 Anti-Competitive Pricing Tactics Predatory Pricing
Firms set prices below AVC with the intent of driving rivals from the market Illegal, but difficult to prosecute Often difficult to distinguish between predatory pricing and intense market competition Examples: Wal-Mart is often assumed to be a predator but is never prosecuted Microsoft was prosecuted eventually for tying, but not for predatory pricing Lecture tip: Questions to ask students: Can an incumbent firm survive a temporary loss? Probably. Can a new firm survive losses? Not as likely. What does the incumbent firm do to prices after the newcomer leaves? Raises prices again. The person in the photo is Bill Gates, CEO of Microsoft.

20 Predatory Pricing Scheme
$ Incumbent Firm’s Price Competitor Enters Competitor Leaves AVC,MC “Beyond the Book” Slide Spirit Airlines accused Northwest Airlines of doing this sort of pricing scheme in the NWA hubs of Minneapolis and Detroit. Story: An incumbent firm is operating its business profitably. A rival enters, hoping to make profits. The incumbent lowers prices so low that they are below AVC. The incumbent firm is even experiencing losses. Eventually, the new competitor leaves. He can’t compete with the super-low price. (Remember that prices send a signal about the profitability of a market.) The incumbent firm raises its prices after the potential competitor exits. Time

21 Network Externalities
Network externality Occurs when the number of customers who purchase a good influences the quantity demanded Often is a factor in whether the resulting market structure is oligopoly Classic examples include technologies such as cell phones and fax machines A new technology has to reach “critical mass” before it is effective for consumers How useful would a fax machine be if only 10 people had the machine? Lecture notes: Picture: an old-school cell phone. Network externalities allow cell phones to be useful for many people. For example, the sheer size of Facebook makes it a better place to do social networking than MySpace. As a result, Facebook will be able to grow its business even if MySpace, Google, or another rival builds a social networking site with better features. Without enough users the best social networking site is simply an empty shell with no value to the consumer. As a result, the first firm to enter the market is often the one that ends up dominating the industry.

22 Network Externalities
Positive network externalities Bandwagon effect Individual preferences for a good increase as the number of people buying the good increases Internet, social networks, cell phones, fax machines, MMORPGs, video game consoles, fads, night clubs Lecture notes: Positive network externalities The bandwagon effect is a positive feedback loop—popularity makes the good more popular, and it seems like demand can grow rapidly once a tipping point is reached. MMORPRG = Massively multiplayer online role playing game. Think World of Warcraft. The game is popular partly because there are so many people playing it online. It’s even become an advertising point for the game. Facebook is a great example as well. The value of it increases when there are more people you can connect with. These types of externalities can help a product “dominate” the industry when it becomes so large that all other competitors seem small and undesirable by comparison. This domination may lead to the elimination of a competitor with incompatible products. Think about HD-DVD being eliminated by Blu-ray, and Betamax being eliminated by the VCR.

23 Network Externalities
Negative network externalities Snob effect Individual preferences for a good decrease as the number of people buying the good increases Exotic pets and sports cars Hipsters Services that are prone to “congestion.” Pool, beach, student union gets “too crowded,” and you don’t want to go. Lecture notes: Negative network externalities. Beyond high-end pricey stuff like luxury cars, sometimes goods, services, or activities just don’t seem as appealing if there are already a bunch of people consuming the good. Many people don’t like going to clubs, bars, restaurants, or beaches if it will be very loud or crowded. Thus, you could often see that certain goods (perhaps a night club) may have both positive AND negative network externalities at some point as a function of the number of people in the club. Increasing the number of people in the club may make it more desirable (positive), but if it gets TOO crowded, you may not want to go (negative).

24 Network Externalities
Switching costs Costs that are incurred by a consumer when he switches suppliers Another advantage to a firm having a large network Demand for existing product becomes more inelastic if costs of switching to a new product are higher Example: cellphone providers Early termination fees Free in-network calls FTC reduced switching costs in 2003 by requiring phone companies to allow a consumer to take their old phone number to a new provider From the Text: For instance, the transition from listening to music on CDs to using digital music files involved a substantial switching cost for many users. Today, among the many digital music options there are switching costs as well. Once a consumer has established a library of MP3s or uses iTunes, the switching costs of transferring the music from one format to another creates a significant barrier to change. Oligopolists leverage not only the number of customers they maintain in their network, but they also try to make switching to another network more difficult.

25 Monopolistic Competition
Price Taking Price Making Perfect Competition Monopolistic Competition Oligopoly Monopoly 1. Many firms 1. Few firms 1. One firm 2. Atomistic assumption—firms are so small that no single buyer or seller has ANY control over price 2. Each firm has some control over price 2. Medium to high entry barriers to entry. The firm has more control over price. 2. Extremely high barriers to entry. The firm has significant control over price. 3. Firms are so small that no single buyer or seller has ANY control over price 3. Product differentiation 3. Mutual interdependence 3. The firm IS the industry 4 Homogeneous output 4. Easy entry/exit 4. Long run economic profit possible 4. Long run economic profit probable 5. There is perfect information about product price and quantity 5. Output can be homogenous or differentiated 6. Easy entry/exit Lecture notes: This slide is a concise but informative review of the characteristics of all four market structures.

26 Conclusion Oligopoly Antitrust policies
A market structure in which there are a small number of firms Firms interact strategically Can be competitive (results closer to monopolistic competition) Can be collusive (results closer to monopoly) Antitrust policies Restrain excessive market power Give incentives to compete instead of collude Each industry examined on a case-by-case basis

27 Summary Oligopoly: a small number of firms sell a differentiated product in a market with significant barriers to entry. The small number of sellers in oligopoly leads to mutual interdependence. An oligopolist is like a monopolistic competitor in that it sells differentiated products. It is also like a monopolist in that it enjoys significant barriers to entry. Oligopolists have a tendency to collude and to form cartels in hope of achieving monopolylike profits.

28 Summary Oligopolistic markets are socially inefficient since P > MC. The result under oligopoly will fall somewhere between the competitive and monopoly outcomes. Game theory helps determine when cooperation among oligopolists is most likely. In many cases, cooperation fails to materialize because decision-makers have dominant strategies that lead them to be uncooperative. This causes firms to compete with price, advertising, or R & D when they could potentially earn more profit by curtailing these activities.

29 Summary A dominant strategy ignores the long run benefits of cooperation and focuses solely on the short run gains Whenever repeated interaction exists, decision-makers fare better under tit for tat, an approach that maximizes the long run profit Antitrust laws are complex and cases are hard to prosecute, but they provide firms an incentive to compete rather than collude The presence of significant positive network externalities causes small firms to be driven out of business or to merge with larger competitors

30 Practice What You Know Which of the following is most likely to become an oligopoly industry? An industry without entry barriers An industry where economies of scale are very small An industry with sizeable network effects An industry with hundreds of competitors Clicker Question Correct answer: C Noticeable network effects mean that there is only room for a small number of large networks. Oligopoly will develop after networks that are “too small” either go out of business or merge with other networks.

31 Practice What You Know Which of the following is true about oligopoly?
Oligopolies are illegal in the United States All oligopoly industries will try to collude Oligopoly industries generally have a high concentration ratio Firms in an oligopoly act independently from other firms in the oligopoly Clicker Question Correct answer: C When the industry is very concentrated with the size and power of the market owned by a few firms, we have an oligopoly.

32 Practice What You Know Why do cartel deals tend not to last?
Each firm in the cartel has a dominant strategy to be uncooperative and defect from the cartel agreement Cartel profits are lower than competitive profits Cartels create more competition Firms know that cartels are often illegal so they break the deal to escape Clicker Question Correct answer: A Looking at a payoff matrix, each firm has a dominant strategy to either overproduce quantity or undercut the price of competitors.

33 Practice What You Know What is an example of a good with a positive network effect? An online multiplayer game A fast-food burger A dry-cleaning service A cable TV subscription Clicker Question Correct answer: A Online gaming may have a higher demand if you can play with more people (a larger network).

34 Practice What You Know How can a pure strategy Nash equilibrium be accurately described? It is always the overall best outcome It’s an outcome in which neither player wants to change strategies It can only be reached by collusion One exists in all games Clicker Question Correct answer: B Just by definition, the Nash equilibrium is where no player wants to change strategies, given that the other player isn’t changing his strategy. In other words, nobody wants to unilaterally deviate. Not all games have a pure strategy Nash equilibrium. Paper, Rock, Scissors is an example of a game without an equilibrium.

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