Presentation on theme: "Oligopoly and Strategic Behavior"— Presentation transcript:
1 Oligopoly and Strategic Behavior Chapter 27Oligopoly and Strategic Behavior
2 IntroductionOn a typical day, United Parcel Service will transport over 10 million packages. UPS and its main rival, FedEx Ground, earn more than three-fourths of total revenue earned in the ground delivery of packages.How can an economic model explain the dominance of only two firms in one industry?
3 Learning ObjectivesOutline the fundamental characteristics of oligopolyUnderstand how to apply game theory to evaluate the pricing strategies of oligopolistic firmsExplain the kinked demand theory of oligopolistic price rigidity
4 Learning ObjectivesDescribe theories of how firms may deter market entry by potential rivalsIllustrate why network effects and market feedback can explain why some industries are oligopolies
5 Chapter Outline Oligopoly Strategic Behavior and Game Theory Price Rigidity and the Kinked Demand Curve
6 Chapter OutlineStrategic Behavior with Implicit Collusion: A Model of Price LeadershipDeterring Entry into an IndustryNetwork EffectsComparing Market Structures
7 Did You Know That...Intel is the predominant seller of microprocessor chips, with a global market share of 80 percent?Industries such as this, with one predominant seller and several smaller competitors, are not monopolies.They are described by the term oligopoly.
8 OligopolyOligopolyA market situation in which there are very few sellersEach seller knows that the other sellers will react to its changes in prices and quantities
9 Oligopoly Characteristics of oligopoly Small number of firms InterdependenceStrategic dependence
10 Oligopoly Strategic Dependence A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry
11 Oligopoly Why oligopoly occurs Economies of scale Barriers to entry MergersVertical mergersHorizontal mergers
12 Oligopoly Vertical Merger Horizontal Merger The joining of a firm with another to which it sells an output or from which it buys an inputHorizontal MergerThe joining of firms that are producing or selling a similar product
13 Oligopoly Measuring industry concentration Concentration Ratio The percentage of all sales contributed by the leading four or leading eight firms in an industry
14 Computing the Four-Firm Concentration Ratio Annual SalesFirm ($ Millions)1 1502 1003 804 705 through 25 50Total numberof firms inIndustry = 25Total 450Four-firm concentration ratio =45040088.9%=Table 27-1
15 E-Commerce Example: Concentration in the Search-Engine Industry Internet search-engines collect revenue through advertisements posted on their websites.To measure the concentration ratio in this industry, economists count the number of searches conducted on each site.
16 E-Commerce Example: Concentration in the Search-Engine Industry The four most frequently used search- engines are Google, Yahoo, AOL Time Warner, and MSN.The four-firm concentration ratio in this industry is 91 percent, indicating that it qualifies as an oligopoly.
17 Oligopoly, Inefficiency, and Resource Allocation Oligopolistic firms have some degree of market power, which means each one can affect the market price.This creates some inefficiency in resource allocation.But to the extent that U.S. oligopolies must compete with firms from other countries, their market power is limited.
18 Strategic Behavior and Game Theory Explaining the pricing and output behavior of oligopoly marketsReaction FunctionThe manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry
19 Strategic Behavior and Game Theory A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly
20 Strategic Behavior and Game Theory Cooperative GameA game in which the players explicitly cooperate to make themselves better offNoncooperative GameA game in which the players neither negotiate nor cooperate in any way
21 Strategic Behavior and Game Theory Zero-Sum GameA game in which any gains within the group are exactly offset by equal losses by the end of the game
22 Strategic Behavior and Game Theory Negative-Sum GameA game in which players as a group lose at the end of the gamePositive-Sum GameA game in which players as a group are better off at the end of the game
23 Strategic Behavior and Game Theory Strategies in noncooperative gamesStrategyAny rule that is used to make a choiceAny potential choice that can be made by players in a gameDominant StrategiesStrategies that always yield the highest benefit
24 Example: The Prisoner’s Dilemma You and your partner rob a bank and get caught.
25 Prisoner’s Dilemma You are separated and given these options: Both confess and get five years in jailNeither confess and get two yearsOne confess and the other does notConfessor goes freeOne who does not confess gets ten years
26 Prisoner’s DilemmaWhat would you do?RememberNo cooperation
27 The Prisoners’ Dilemma Payoff Matrix Figure 27-1
28 Strategic Behavior and Game Theory Applying game theory to pricing strategiesWould you choose a high price or a low price?RememberNo collusion
30 Strategic Behavior and Game Theory Opportunistic BehaviorActions that ignore the possible long-run benefits of cooperation and focus solely on short-run gainsAn example might be writing a check that you know will bounce
31 Strategic Behavior and Game Theory Opportunistic behaviorImplies a noncooperative gameNot realisticWe make repeat transactions
32 Strategic Behavior and Game Theory Tit-for-Tat Strategic BehaviorIn game theory, cooperation that continues so long as the other players continue to cooperate
33 Price Rigidity and the Kinked Demand Curve Panel (a)d2MR2d1 is relatively elastic• if one firm raises itsprice the others will notand it will lose marketshared1MR1AqPPrice and Marginal Revenue per Unitd2 is relatively inelastic• if one firm lowers itsprice the others lowertheir price so gain in salesis smallQuantity per Time PeriodFigure 27-3, Panel (a)
34 Price Rigidity and the Kinked Demand Curve Panel (b)d21The kinked demand curve indicates the possibility of price rigidityMR21AqPPrice and Marginal Revenue per UnitQuantity per Time PeriodFigure 27-3, Panel (b)
35 Price Rigidity and the Kinked Demand Curve 21MR21qP'MCMCPrice, Marginal Revenue, andMarginal Cost per UnitMC"Changes in cost donot impact outputand prices as long asMC remains in thevertical portion of MRQuantity per Time PeriodFigure 27-4
36 Strategic Behavior with Implicit Collusion: A Model of Price Leadership A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced pricesPrice leadership behavior is apparent in the overnight package delivery industry
37 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Price WarA pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices
38 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Markets where price wars are commonCigarettesLong-distance telephone companiesAirlines
39 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Markets where price wars are commonDiapersFrozen foodsPC hardware and software
40 Example: A Price War in Diapers In 2001, the makers of Huggies disposable diapers reduced the size of its packages by one diaper, but left the package price unchanged.This increased the effective diaper price by 5 percent.
41 Example: A Price War in Diapers The response from Pampers, the main competitor, was to cut prices by 15 percent.Huggies soon followed with a price reduction, and a price war ensued.As would be expected, there was a benefit to consumers as package prices fell and coupons were made widely available.
42 Deterring Entry Into an Industry Entry Deterrence StrategyAny strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm
43 Deterring Entry Into an Industry Increasing entry costThreat of price warsGovernment regulationsEnvironmental regulationSafety standards
44 Deterring Entry Into an Industry Limit-Pricing StrategiesA model that hypothesizes that a group of colluding sellers will set the highest common price they believe they can charge, without new firms seeking to enter the industry
45 Deterring Entry Into an Industry Raising switching costs for customersExamplesNon-compatible softwareNon-transferability of college courses
46 Example: QWERTY and High Switching Costs The QWERTY keyboard was designed to solve a mechanical problem of the tendency for typewriter keys to jam.Now that the mechanical problem no longer exists, why does this keyboard layout persist?
47 Network EffectsA network effect is a situation in which a consumer’s inclination to use an item depends on how many others use it.For example, the value of a fax machine increases as there are more fax machines in use.
48 Network Effects Positive Market Feedback Negative Market Feedback Potential for a network effect to arise when an industry’s product catches onNegative Market FeedbackThe tendency for industry sales to spiral downward rapidly when the product falls out of favor
49 Network Effects and Industry Concentration In an industry selling products subject to network effects, a small number of firms may be able to secure the bulk of the payoffs resulting from positive market feedback.Oligopoly is likely to emerge as the prevailing market structure.
50 Comparing Market Structures Long-RunNumber Unrestricted Ability EconomicMarket of Entry and to Set Profits Product NonpriceStructure Sellers Exit Price Possible Differentiation Competition ExamplesPerfect Numerous Yes None No None None Agriculture, competition roofing nailsMonopolistic Many Yes Some No Considerable Yes Toothpaste competition toilet paper, soap, retail tradeOligopoly Few Partial Some Yes Frequent Yes Recorded music, college textbooksPure One Not Consider- Yes None Yes Some electric monopoly for entry able (product is companies, unique) some local telephone companiesTable 27-3
51 Issues and Applications: Oligopoly in the Ground-Shipping Business In the industry of shipping packages by ground, the four-firm concentration ratio in the U.S. is 100 percent.The four firms are UPS, FedEx Ground, the U.S. Postal Service, and DHL.Among these four firms, there is strategic dependence regarding both prices and delivery schedules.
52 Issues and Applications: Oligopoly in the Ground-Shipping Business FedEx Ground is willing to deliver on Saturdays.Each of the four delivery services employs computer technology to speed the pace of delivery and to allow customers to track packages in shipment.This industry fits the definition of oligopoly, with four firms competing interdependently.
53 Summary Discussion of Learning Objectives The fundamental characteristics of oligopolyEconomies of scaleBarriers to entryStrategic dependenceApplying game theory to evaluate the pricing strategies of oligopolistic firmsGame theory looks at competition for payoffsThat depends on the strategies that others employ
54 Summary Discussion of Learning Objectives The kinked demand theory of oligopolistic price rigidityIf a firm believes that rivals will follow price cuts but not price increases, it will be reluctant to change price.How firms may deter market entry by potential rivalsRaise entry costsLimit pricingSwitching policies
55 Summary Discussion of Learning Objectives Why network effects and market feedback encourage oligopoly:Network effects arise when a consumer’s demand for a good or service is affected by how many other consumers also use the itemOligopoly can arise because a handful of firms may be able to capture all of the positive market feedback
56 Oligopoly and Strategic Behavior End of Chapter 27Oligopoly and Strategic Behavior