Presentation on theme: "Oligopoly and Strategic Behavior"— Presentation transcript:
1 Oligopoly and Strategic Behavior 13Oligopoly and Strategic Behavior
2 Oligopoly Policy: Antitrust Antitrust policyGovernment efforts that attempt to prevent oligopolies from behaving like monopoliesSherman 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 detrimentalPrice discrimination that lessens competitionExclusive dealings that restrict the ability of a buyer to deal with competitorsTying arrangements (similar to bundling)Mergers that lessen competitionPrevents a person from serving as a director on more than one board in the same industryFrom 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 costsPrice-taker => output decisions do not affect market pricecross-price elasticity = -1 (perfect substitutes)Own-price = -∞MonopolyPrice-Searcher: output decision determines priceCross-price = 0 (no substitutes)Own-price: <= |1|OligopolyCross-price elasticity < |1|Own-price elasticity ~ |1|Will have to take into account actions of other similar firms when making output/pricing decisionsMuch more strategy
5 Oligopoly Behavior Cooperative Oligopoly Non-cooperative Oligopolies CartelsAgree to collude; act/price like a single firm monoploistPrice leadership (Stackleberg leader)Dominant firm establishes the price; other firms react to “leader”Non-cooperative OligopoliesSticky prices (kinked demand curve)Sticky upwardNash equilibriumCharacterized by stable pricesPerfect competitionCompletely rivalarous
6 Cooperative Oligopolies Cartels (highly cooperative)Firms act as single-firm monopolistStackelberg Price Leader (passive cooperation)- leader firm moves first and then the follower firms move sequentiallyStackelberg 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 ConcentrationCR4: market share for the 4 largest firmsHerfindahl Index (HHI): computed from the squares of the market sharesStrategic behavior (how do they behave in the market place)Collusive: act togetherNon-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 ratiomarket share of the four largest firms in an industryHerfindahl 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 4.3%
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 isLarge 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 4.3%
15 Example (cont’d) What happens if market shares are evenly distributed? FirmMarket ShareNike22.95%New BalanceAsicsAdidas
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 agreementalthough for the act to be illegal there must be a real communication between companiesfor 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 CartelOrganization 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 fluctuationsOPEC 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 marketIllegal, but difficult to prosecuteOften difficult to distinguish between predatory pricing and intense market competitionExamples:Wal-Mart is often assumed to be a predator but is never prosecutedMicrosoft was prosecuted eventually for tying, but not for predatory pricingLecture 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 PriceCompetitor EntersCompetitor LeavesAVC,MC“Beyond the Book” SlideSpirit 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 externalityOccurs when the number of customers who purchase a good influences the quantity demandedOften is a factor in whether the resulting market structure is oligopolyClassic examples include technologies such as cell phones and fax machinesA new technology has to reach “critical mass” before it is effective for consumersHow 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 externalitiesBandwagon effectIndividual preferences for a good increase as the number of people buying the good increasesInternet, social networks, cell phones, fax machines, MMORPGs, video game consoles, fads, night clubsLecture notes:Positive network externalitiesThe 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 externalitiesSnob effectIndividual preferences for a good decrease as the number of people buying the good increasesExotic pets and sports carsHipstersServices 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 costsCosts that are incurred by a consumer when he switches suppliersAnother advantage to a firm having a large networkDemand for existing product becomes more inelastic if costs of switching to a new product are higherExample: cellphone providersEarly termination feesFree in-network callsFTC reduced switching costs in 2003 by requiring phone companies to allow a consumer to take their old phone number to a new providerFrom 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 TakingPrice MakingPerfect CompetitionMonopolistic CompetitionOligopolyMonopoly1. Many firms1. Few firms1. One firm2. Atomistic assumption—firms are so small that no single buyer or seller has ANY control over price2. Each firm has some control over price2. 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 price3. Product differentiation3. Mutual interdependence3. The firm IS the industry4 Homogeneous output4. Easy entry/exit4. Long run economic profit possible4. Long run economic profit probable5. There is perfect information about product price and quantity5. Output can be homogenous or differentiated6. Easy entry/exitLecture 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 firmsFirms interact strategicallyCan be competitive (results closer to monopolistic competition)Can be collusive (results closer to monopoly)Antitrust policiesRestrain excessive market powerGive incentives to compete instead of colludeEach industry examined on a case-by-case basis
27 SummaryOligopoly: 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 SummaryOligopolistic 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 SummaryA dominant strategy ignores the long run benefits of cooperation and focuses solely on the short run gainsWhenever repeated interaction exists, decision-makers fare better under tit for tat, an approach that maximizes the long run profitAntitrust laws are complex and cases are hard to prosecute, but they provide firms an incentive to compete rather than colludeThe 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 KnowWhich of the following is most likely to become an oligopoly industry?An industry without entry barriersAn industry where economies of scale are very smallAn industry with sizeable network effectsAn industry with hundreds of competitorsClicker QuestionCorrect answer: CNoticeable 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 StatesAll oligopoly industries will try to colludeOligopoly industries generally have a high concentration ratioFirms in an oligopoly act independently from other firms in the oligopolyClicker QuestionCorrect answer: CWhen 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 agreementCartel profits are lower than competitive profitsCartels create more competitionFirms know that cartels are often illegal so they break the deal to escapeClicker QuestionCorrect answer: ALooking at a payoff matrix, each firm has a dominant strategy to either overproduce quantity or undercut the price of competitors.
33 Practice What You KnowWhat is an example of a good with a positive network effect?An online multiplayer gameA fast-food burgerA dry-cleaning serviceA cable TV subscriptionClicker QuestionCorrect answer: AOnline gaming may have a higher demand if you can play with more people (a larger network).
34 Practice What You KnowHow can a pure strategy Nash equilibrium be accurately described?It is always the overall best outcomeIt’s an outcome in which neither player wants to change strategiesIt can only be reached by collusionOne exists in all gamesClicker QuestionCorrect answer: BJust 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.