3 Characteristics of Oligopolies: FOUR MARKET MODELSPerfectCompetitionMonopolisticCompetitionPureMonopolyOligopolyCharacteristics of Oligopolies:A Few Large Producers (Less than 10)Identical or Differentiated ProductsHigh Barriers to EntryControl Over Price (Price Maker)Mutual InterdependenceFirms use Strategic PricingExamples: OPEC, Cereal Companies, Car Producers
4 HOW DO OLIGOPOLIES OCCUR? Oligopolies occur when only a few large firms start to control an industry.High barriers to entry keep others from entering.Types of Barriers to Entry1. Economies of ScaleEx: The car industry is difficult to enter because only large firms can make cars at the lowest cost2. High Start-up Costs3. Ownership of Raw Materials
5 The study of how people behave in strategic situations Game TheoryThe study of how people behave in strategic situationsAn understanding of game theory helps firms in an oligopoly maximize profit.
6 Game theory helps predict human behavior Where is the best location? THE ICE CREAM MAN SIMULATION1. You are a ice cream salesmen at the beach2. You have identical prices as another salesmen.3. Beachgoers will purchase from the closest salesmen4. People are evenly distributed along the beach.5. Each morning the two firms pick locations on the beachWhere is the best location?
7 Where should you put your firm? Firm A decides where to goes first. BAFirm A decides where to goes first.What is the best strategy for choosing a location each day?Can you predict the end result each day?How is this observed in the “real-world”?
8 SIMULATION! Why learn about game theory? Oligopolies are interdependent since they compete with only a few other firms.Their pricing and output decisions must be strategic as to avoid economic losses.Game theory helps us analyze their strategies.SIMULATION!
9 Both Deny = 5 Years in jail each Both Confess= 10 Years in jail each The Prisoner’s DilemmaCharged with a crime, each prisoner has one of two choices: Deny or ConfessPrisoner 2DenyConfessBoth Deny = Years in jail eachConfess = FreeDeny =20 YearsDenyPrisoner 1Confess = FreeDeny = 20 YearsBoth Confess= 10 Years in jail eachConfess
10 Without talking, write down your choice Game Theory MatrixYou and your partner are competing firms. You have one of two choices: Price High or Price Low.Without talking, write down your choiceFirm 2HighLowBoth High =$20 EachLow = $30High = 0HighFirm 1High = 0Low = $30Both Low=$10 eachLow
11 Game Theory Matrix Firm 2 Firm 1 Notice that you have an incentive to collude but also an incentive to cheat on your agreementFirm 2HighLowBoth High =$20 EachLow = $30High = 0HighFirm 1High = 0Low = $30Both Low=$10 eachLow
12 Dominant Strategy Firm 2 $100, $50 $50, $90 Firm 1 $80, $40 $20, $10 The Dominant Strategy is the best move to make regardless of what your opponent doesWhat is each firm’s dominant strategy?Firm 2HighLowHigh$100, $50$50, $90Firm 1$80, $40$20, $10LowFirm 2 has no dominant strategyHow does each firm respond if they know each other’s info?
13 What is each player’s dominant strategy? Video: Split or StealWhat is each player’s dominant strategy?Firm 2SplitStealSplitHalf, HalfNone, AllFirm 1All, NoneNone, NoneSteal
14 What did we learn?Oligopolies must use strategic pricing (they have to worry about the other guy)Oligopolies have a tendency to collude to gain profit.(Collusion is the act of cooperating with rivals in order to “rig” a situation)Collusion results in the incentive to cheat.Firms make informed decisions based on their dominant strategies
15 Payoff matrix for two competing bus companies 2007 FRQ #3Payoff matrix for two competing bus companies
16 Payoff matrix for two competing bus companies 2009 FRQB #3Payoff matrix for two competing bus companies
20 Example: Small Town Gas Stations To maximize profit what will they do?OPEC does this with OIL
21 Price Leadership Collusion is ILLEGAL. Firms CANNOT set prices. Price leadership is a strategy used by firms to coordinate prices without outright collusionGeneral Process:“Dominant firm” initiates a price changeOther firms follow the leader
22 Price Leadership Breakdowns in Price Leadership Temporary Price Wars may occur if other firms don’t follow price increases of dominant firm.Each firm tries to undercut each other.
24 Cartel = Colluding Oligopoly A cartel is a group of producers that create an agreement to fix prices high.Cartels set price and output at an agreed upon levelFirms require identical or highly similar demand and costsCartel must have a way to punish cheatersTogether they act as a monopoly
25 Firms in a colluding oligopoly act as a monopoly and share the profit MCATCDMRQ
27 Kinked Demand Curve Model The kinked demand curve model shows how noncollusive firms are interdependentIf firms are NOT colluding they are likely to react to competitor’s pricing in two ways:Match price-If one firm cuts it’s prices, then the other firms follow suit causing inelastic demandIgnore change-If one firm raises prices, others maintain same price causing elastic demand
28 If this firm increases it’s price, other firms will ignore it and keep prices the same As the only firm with high prices, Qd for this firm will decrease a lotPElasticP1PeDQ1QeQ
29 If this firm decreases it’s price, other firms will match it and lower their prices Since all firms have lower prices, Qd for this firm will increase only a littlePElasticP1PeP2InelasticDQ1QeQ2Q
30 Where is Marginal Revenue? MR has a vertical gap at the kink. The result is that MC can move and Qe won’t change. Price is sticky.PMCPeMRDQQ
33 Name the market structure(s) that it is associated with each concept Price Maker (Demand > MR)Collusion/CartelsIdentical ProductsPrice Taker (Demand = MR)Excess CapacityLow Barriers to EntryGame TheoryDifferentiated ProductsLong-run ProfitsEfficiencyNormal ProfitDead Weight LossHigh Barriers to EntryFirm = IndustryMR=MC Rule