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Chapter 27 Oligopoly and Strategic Behavior. Slide 27-2 Introduction On a typical day, United Parcel Service will transport over 10 million packages.

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Presentation on theme: "Chapter 27 Oligopoly and Strategic Behavior. Slide 27-2 Introduction On a typical day, United Parcel Service will transport over 10 million packages."— Presentation transcript:

1 Chapter 27 Oligopoly and Strategic Behavior

2 Slide 27-2 Introduction On 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 Slide 27-3 Learning Objectives Outline the fundamental characteristics of oligopoly Understand how to apply game theory to evaluate the pricing strategies of oligopolistic firms Explain the kinked demand theory of oligopolistic price rigidity

4 Slide 27-4 Learning Objectives Describe theories of how firms may deter market entry by potential rivals Illustrate why network effects and market feedback can explain why some industries are oligopolies

5 Slide 27-5 Chapter Outline Oligopoly Strategic Behavior and Game Theory Price Rigidity and the Kinked Demand Curve Price Rigidity and the Kinked Demand Curve

6 Slide 27-6 Chapter Outline Strategic Behavior with Implicit Collusion: A Model of Price Leadership Strategic Behavior with Implicit Collusion: A Model of Price Leadership Deterring Entry into an Industry Network Effects Comparing Market Structures

7 Slide 27-7 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 Slide 27-8 Oligopoly –A market situation in which there are very few sellers –Each seller knows that the other sellers will react to its changes in prices and quantities

9 Slide 27-9 Oligopoly Characteristics of oligopoly –Small number of firms –Interdependence Strategic dependence

10 Slide 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 Slide Oligopoly Why oligopoly occurs –Economies of scale –Barriers to entry –Mergers Vertical mergers Horizontal mergers

12 Slide Oligopoly Vertical Merger –The joining of a firm with another to which it sells an output or from which it buys an input Horizontal Merger –The joining of firms that are producing or selling a similar product

13 Slide Oligopoly Measuring industry concentration –Concentration Ratio The percentage of all sales contributed by the leading four or leading eight firms in an industry

14 Slide Computing the Four-Firm Concentration Ratio Annual Sales Firm($ Millions) through 2550 Total450 Total number of firms in Industry = 25 Four-firm concentration ratio = %  Table 27-1

15 Slide 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 Slide 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 Slide 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 Slide Strategic Behavior and Game Theory Explaining the pricing and output behavior of oligopoly markets –Reaction Function The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry

19 Slide Strategic Behavior and Game Theory 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 Slide Strategic Behavior and Game Theory Cooperative Game –A game in which the players explicitly cooperate to make themselves better off Noncooperative Game –A game in which the players neither negotiate nor cooperate in any way

21 Slide Strategic Behavior and Game Theory Zero-Sum Game –A game in which any gains within the group are exactly offset by equal losses by the end of the game

22 Slide Strategic Behavior and Game Theory Negative-Sum Game –A game in which players as a group lose at the end of the game Positive-Sum Game –A game in which players as a group are better off at the end of the game

23 Slide Strategic Behavior and Game Theory Strategies in noncooperative games –Strategy Any rule that is used to make a choice Any potential choice that can be made by players in a game –Dominant Strategies Strategies that always yield the highest benefit

24 Slide Example: The Prisoner’s Dilemma You and your partner rob a bank and get caught.

25 Slide Prisoner’s Dilemma You are separated and given these options: –Both confess and get five years in jail –Neither confess and get two years –One confess and the other does not Confessor goes free One who does not confess gets ten years

26 Slide Prisoner’s Dilemma What would you do? –Remember No cooperation

27 Slide The Prisoners’ Dilemma Payoff Matrix Figure 27-1

28 Slide Strategic Behavior and Game Theory Applying game theory to pricing strategies –Would you choose a high price or a low price? Remember –No collusion

29 Slide Strategic Behavior and Game Theory Figure 27-2

30 Slide Strategic Behavior and Game Theory Opportunistic Behavior –Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains –An example might be writing a check that you know will bounce

31 Slide Strategic Behavior and Game Theory Opportunistic behavior –Implies a noncooperative game –Not realistic We make repeat transactions

32 Slide Strategic Behavior and Game Theory Tit-for-Tat Strategic Behavior –In game theory, cooperation that continues so long as the other players continue to cooperate

33 Slide d 1 is relatively elastic if one firm raises its price the others will not and it will lose market share Price Rigidity and the Kinked Demand Curve Figure 27-3, Panel (a) MR 2 MR 1 d 2 d 2 d 1 d 1 A q 0 P 0 Panel (a) Quantity per Time Period d 2 is relatively inelastic if one firm lowers its price the others lower their price so gain in sales is small Price and Marginal Revenue per Unit

34 Slide The kinked demand curve indicates the possibility of price rigidity Price Rigidity and the Kinked Demand Curve Figure 27-3, Panel (b) MR 2 1 d 2 d 1 A q 0 P 0 Panel (b) Quantity per Time Period Price and Marginal Revenue per Unit

35 Slide Price Rigidity and the Kinked Demand Curve Figure 27-4 Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR Quantity per Time Period d 2 d 1 q 0 P 0 MR 2 1 'MC MC" Price, Marginal Revenue, and Marginal Cost per Unit

36 Slide 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 prices –Price leadership behavior is apparent in the overnight package delivery industry Strategic Behavior with Implicit Collusion: A Model of Price Leadership

37 Slide Price War –A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices Strategic Behavior with Implicit Collusion: A Model of Price Leadership

38 Slide Markets where price wars are common –Cigarettes –Long-distance telephone companies –Airlines Strategic Behavior with Implicit Collusion: A Model of Price Leadership

39 Slide Markets where price wars are common –Diapers –Frozen foods –PC hardware and software Strategic Behavior with Implicit Collusion: A Model of Price Leadership

40 Slide 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 Slide 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 Slide Entry Deterrence Strategy –Any 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 Deterring Entry Into an Industry

43 Slide Increasing entry cost –Threat of price wars –Government regulations Environmental regulation Safety standards Deterring Entry Into an Industry

44 Slide Limit-Pricing Strategies –A 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 Deterring Entry Into an Industry

45 Slide Raising switching costs for customers –Examples Non-compatible software Non-transferability of college courses Deterring Entry Into an Industry

46 Slide 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 Slide Network Effects A 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 Slide Network Effects Positive Market Feedback –Potential for a network effect to arise when an industry’s product catches on Negative Market Feedback –The tendency for industry sales to spiral downward rapidly when the product falls out of favor

49 Slide 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 Slide Comparing Market Structures Long-Run NumberUnrestrictedAbilityEconomic MarketofEntry andto SetProfitsProductNonprice StructureSellersExitPricePossibleDifferentiationCompetitionExamples PerfectNumerousYesNoneNoNoneNoneAgriculture, competitionroofing nails MonopolisticManyYesSome NoConsiderableYesToothpaste competitiontoilet paper, soap, retail trade OligopolyFewPartialSomeYesFrequentYesRecorded music, college textbooks Pure OneNot Consider-YesNoneYesSome electric monopoly for entry able (product is companies, unique) some local telephone companies Table 27-3

51 Slide 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 Slide 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 Slide Summary Discussion of Learning Objectives The fundamental characteristics of oligopoly –Economies of scale –Barriers to entry –Strategic dependence Applying game theory to evaluate the pricing strategies of oligopolistic firms –Game theory looks at competition for payoffs That depends on the strategies that others employ

54 Slide Summary Discussion of Learning Objectives The kinked demand theory of oligopolistic price rigidity –If 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 rivals –Raise entry costs –Limit pricing –Switching policies

55 Slide 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 item –Oligopoly can arise because a handful of firms may be able to capture all of the positive market feedback

56 End of Chapter 27 Oligopoly and Strategic Behavior


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