1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 12 Oligopoly and Strategic Behavior

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopoly An oligopoly is a market served by a few firms.An oligopoly is a market served by a few firms. The key feature of an oligopoly is that firms act strategically.The key feature of an oligopoly is that firms act strategically. Firms in an oligopoly are interdependent. The actions of one firm affect the profits of the other firms.Firms in an oligopoly are interdependent. The actions of one firm affect the profits of the other firms.

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopoly Economists use concentration ratios to measure the degree of concentration in a market.Economists use concentration ratios to measure the degree of concentration in a market. A four-firm concentration ratio is the percentage of the market output produced by the 4 largest firms.A four-firm concentration ratio is the percentage of the market output produced by the 4 largest firms.

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopolies in the United States BeveragesMusicTobacco Phone Service Cars Coca-Cola (45%) Universal/ Polygram (26%) Philip Morris (49%) AT&T/TCI (47%) General Motors (29%) Pepsi (31%) Warner Music (18%) RJR Nabisco (24%) Bell Atlantic/GTE (24%) Ford (25%) Cadbury Schweppes (14%) Sony Music (17%) Brown and Williamson (15%) SBC/Ameritech (18%) Daimler Chrysler (16%) EMI Group PLC (13%) MCI WorldCom (12%) BMG Entertainment (12%)

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Concentration Ratios in Selected Manufacturing Industries Industry Four-Firm Concentration Ratio (%) Eight-Firm Concentration Ratio (%) Cigarettes93 Not available Guided missiles and space vehicles 9399 Beer and malt beverages 9098 Batteries8795 Electric bulbs 8694 Breakfast cereals 8598 Motor vehicles and car bodies 8491 Greeting cards 8488 Engines and turbines 7992 Aircraft and parts 7993

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopoly and Barriers to Entry Economies of scale large enough to generate a natural oligopoly but not a natural monopolyEconomies of scale large enough to generate a natural oligopoly but not a natural monopoly Government barriers to entryGovernment barriers to entry Substantial investment in an advertising campaign necessary to enter the marketSubstantial investment in an advertising campaign necessary to enter the market Most firms in an oligopoly earn economic profit, yet additional firms do not enter the market, for three reasons:

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopolistic Firms A duopoly is a market with two firms.A duopoly is a market with two firms. A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service.A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service. Price fixing is an arrangement in which two firms coordinate their pricing decisions.Price fixing is an arrangement in which two firms coordinate their pricing decisions. The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly.The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly.

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin A Cartel Picks the Monopoly Price In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket.In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket. The firms also split the profit. Each firm earns $7,500 = [(400-300) x 150]/2.The firms also split the profit. Each firm earns $7,500 = [(400-300) x 150]/2.

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Competing Duopolists Pick a Lower Price When two firms compete against one another, they end up serving 100 passengers each, at a price of $350.When two firms compete against one another, they end up serving 100 passengers each, at a price of $350. Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm.Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm.

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Duopoly Versus Cartel Pricing The duopoly produces more output and charges a lower price than the cartel.The duopoly produces more output and charges a lower price than the cartel.

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Game Tree A game tree is a graphical representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies.A game tree is a graphical representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies.

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Cartel and Duopoly Outcomes in the Game Tree Two firms coordinating price decisions choose the high price. Two firms acting rationally and interdependently choose the low price.

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Outcome of the Price-Fixing Game Jill captures large share of market Jack captures large share of market Jill: Low Price Jack: High Price Price$350$400 Quantity17010 Average cost $300$300 Profit per passenger $50$100 Total profit $8,500$1,000

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Dominant Strategy Dominant strategy: An action that is the best choice under all circumstances.Dominant strategy: An action that is the best choice under all circumstances. Irrational for Jack to choose high price Jack chooses the low price when Jill chooses the high price.Jack chooses the low price when Jill chooses the high price.

15. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Dominant Strategy Jack chooses the low price when Jill chooses the low price.Jack chooses the low price when Jill chooses the low price. Irrational for Jack to choose high price Dominant Strategy: Jack chooses the low price regardless of Jill’s choice.Dominant Strategy: Jack chooses the low price regardless of Jill’s choice.

16. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Duopolists’ Dilemma Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price?Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price? Jill will choose the low price, and the trajectory of the game is X to Z to 4.Jill will choose the low price, and the trajectory of the game is X to Z to 4. Irrational for Jill to be under priced

17. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Duopolists’ Dilemma The duopolists’ dilemma is a situation in which both firms in a market would be better off if they chose the high price but each chooses the low price.The duopolists’ dilemma is a situation in which both firms in a market would be better off if they chose the high price but each chooses the low price.

18. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Prisoners’ Dilemma The prisoners’ dilemma is the duopolists’ dilemma. Although both criminals would be better off if they both kept quiet, they implicate each other because the police reward them for doing so.The prisoners’ dilemma is the duopolists’ dilemma. Although both criminals would be better off if they both kept quiet, they implicate each other because the police reward them for doing so.

19. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Guaranteed Price Matching Guaranteed price matching is a scheme under which a firm guarantees that it will match a lower price by a competitor; also known as meet-the-competition policy.Guaranteed price matching is a scheme under which a firm guarantees that it will match a lower price by a competitor; also known as meet-the-competition policy. How will Jack respond to Jill’s price-matching policy?How will Jack respond to Jill’s price-matching policy? Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits.Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits. Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price.Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price.

20. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Guaranteed Price Matching Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel.Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel. Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price!Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price!

21. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Repeated Pricing and Retaliation for Underpricing When firms play the price-fixing game repeatedly, price fixing is more likely because firms can punish a firm that cheats on a price-fixing agreement.When firms play the price-fixing game repeatedly, price fixing is more likely because firms can punish a firm that cheats on a price-fixing agreement.

22. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Retaliation Strategies Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack.Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack. Grim Trigger: Jill drops her price to the level that will result in zero economic profit.Grim Trigger: Jill drops her price to the level that will result in zero economic profit. Tit-for-tat: Jill chooses whatever price Jack chose the preceding month.Tit-for-tat: Jill chooses whatever price Jack chose the preceding month. Schemes to punish Jack if he underprices:

23. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Tit-for-Tat Response to Underpricing After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month.After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month. Jill chooses whatever price Jack chose the preceding month.Jill chooses whatever price Jack chose the preceding month.

24. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Leadership Price leadership is an implicit agreement under which firms in a market choose a price leader, observe that firm’s price, and match it.Price leadership is an implicit agreement under which firms in a market choose a price leader, observe that firm’s price, and match it.

25. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Leadership The problem with an implicit pricing agreement is that price signals sent by the leader may be misinterpreted.The problem with an implicit pricing agreement is that price signals sent by the leader may be misinterpreted. Firms could interpret a price cut in two ways:Firms could interpret a price cut in two ways: 1.A change in market conditions, in which case firms just match the lower price and price fixing continues 2.Underpricing, in which case a price war may be triggered, destroying the price- fixing agreement

26. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Kinked Demand Curve The kinked demand model is a model under which firms in an oligopoly match price reductions by other firms but do not match price increases by other firms.The kinked demand model is a model under which firms in an oligopoly match price reductions by other firms but do not match price increases by other firms.

27. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Kinked Demand Curve Increase price: the other firms will not change their prices and quantity will decrease by a large amount (elastic)Increase price: the other firms will not change their prices and quantity will decrease by a large amount (elastic) After the initial price of $6, the firm has two options: Decrease price: the other firms will decrease their prices, so quantity will increase only by a small amount (inelastic)Decrease price: the other firms will decrease their prices, so quantity will increase only by a small amount (inelastic)

28. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Kinked Demand Curve The demand curve of the typical firm has a kink at the prevailing price. It is relatively flat for higher prices, and relatively steep for lower prices.The demand curve of the typical firm has a kink at the prevailing price. It is relatively flat for higher prices, and relatively steep for lower prices. There is little evidence, however, that oligopolistic firms really act this way— that firms will not go along with a higher price but only match a lower price.There is little evidence, however, that oligopolistic firms really act this way— that firms will not go along with a higher price but only match a lower price.

29. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Entry Deterrence by an Insecure Monopolist An insecure monopoly is a monopoly that is faced with the possibility that a second firm will enter the market.An insecure monopoly is a monopoly that is faced with the possibility that a second firm will enter the market.

30. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Entry Deterrence by an Insecure Monopolist An insecure monopolist fears the entry of a second firm, and could react in one of two ways:An insecure monopolist fears the entry of a second firm, and could react in one of two ways: A passive strategy: allow the second firm to enter the marketA passive strategy: allow the second firm to enter the market An entry-deterrence strategy: try to prevent the firm from enteringAn entry-deterrence strategy: try to prevent the firm from entering The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit.The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit.

31. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Passive Strategy If Jane adopts a passive strategy, it will allow Dick to enter the market, and each will earn the duopoly profits of $5,000 each.If Jane adopts a passive strategy, it will allow Dick to enter the market, and each will earn the duopoly profits of $5,000 each.

32. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Entry-Deterrence Strategy Jane can prevent Dick from entering by incurring a large investment and committing herself to serving a large number of customers at a low price.Jane can prevent Dick from entering by incurring a large investment and committing herself to serving a large number of customers at a low price. If Dick enters anyway, market output will be very large and the firms will lose $1,300 each.If Dick enters anyway, market output will be very large and the firms will lose $1,300 each.

33. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Insecure Monopolist Strategy If Jane produces a large quantity and Dick stays out, Jane’s profits will be $12,600.If Jane produces a large quantity and Dick stays out, Jane’s profits will be $12,600.

34. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Game Tree for the Entry Game In order to keep Dick from entering, will Jane choose to serve a small or a large quantity of customers?In order to keep Dick from entering, will Jane choose to serve a small or a large quantity of customers?

35. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Outcome of the Entry Game If Jane is passive and chooses a small quantity, Dick will enter.If Jane is passive and chooses a small quantity, Dick will enter. If Jane chooses a large quantity, Dick would suffer losses, thus he would stay out.If Jane chooses a large quantity, Dick would suffer losses, thus he would stay out.

36. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Outcome of the Entry Game Jane’s profit is higher if she maintains the insecure monopoly position by choosing a large quantity.Jane’s profit is higher if she maintains the insecure monopoly position by choosing a large quantity. The strategy of picking a price lower than the normal monopoly price to deter entry is know as limit pricing.The strategy of picking a price lower than the normal monopoly price to deter entry is know as limit pricing.

37. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Entry Deterrence and Contestable Markets In the extreme case of perfect contestability, firms can enter and exit at zero cost, and the market price would be the same as the perfectly competitive price.In the extreme case of perfect contestability, firms can enter and exit at zero cost, and the market price would be the same as the perfectly competitive price. A contestable market is market in which the costs of entering and leaving are low, so the firms that are already in the market are constantly threatened by the entry of new firms.A contestable market is market in which the costs of entering and leaving are low, so the firms that are already in the market are constantly threatened by the entry of new firms.

38. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Characteristics of Different Types of Markets Perfect Competition Monopolistic Competition OligopolyMonopoly Number of firms Very large number ManyFewOne Type of product Standardized (homogeneous) Differentiated Standardized or differentiated Unique Demand faced by individual firm Price taker: demand is perfectly elastic Demand is price elastic but not perfectly elastic Demand is less elastic than demand facing monopolistically competitive firm Firm faces market demand curve Entry conditions No barriers Large barriers from government policies or economies of scale Large barriers from economies of scale or government policies Examples Wheat, soybeans Toothbrushes, clothing, music stores Air travel, beverages, automobiles, long- distance phone service, cigarettes Local phone service, patented drugs