1. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Chapter 10

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure Most firms possess some market power.

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Degrees of Power We classify firms into specific market structures based on the number and relative size of firms in an industry. –Market structure – The number and relative size of firms in an industry.

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Degrees of Power In imperfect competition, individual firms have some power in a particular product market. Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service.

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Market Structures

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Market Structures

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of Market Power The determinants of market power include: –Number of producers. –Size of each firm. –Barriers to entry. –Availability of substitute goods.

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of Market Power Market power increases: –The fewer the number of firms in the market. –The larger the relative size of the firms in the market. –The higher the entry barriers. –The fewer the substitutes.

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of Market Power Barriers to entry determine to what extent the market is a contestable market. –Contestable market – An imperfectly competitive industry subject to potential entry if prices or profits increase.

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Measuring Market Power The standard measure of market power is the concentration ratio. The concentration ratio is a measure of market power that relates the size of firms to the size of the market.

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Concentration Ratio The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Firm Size Market power isn’t necessarily associated with firm size. A small firm could possess a lot of power in a relatively small market.

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Measurement Problems Many smaller firms acting in unison can achieve market power. Concentration ratios do not convey the extent to which market power may be concentrated in a local market.

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Behavior Market structure affects market behavior and outcomes. Assume that the computer market has three oligopolists.

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial Equilibrium Initial conditions and market shares of each firms are described in the following slides. –Market share - The percentage of total market output produced by a single firm.

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial Conditions in Computer Market 20,0000 $1000 Market demand Quantity Demanded (computers per month) Price (per computer) Industry output

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial Market Shares of Microcomputer Producers

18. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Battle for Market Shares In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms.

19. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Increased Sales at the Prevailing Market Price Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists.

20. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Increased Sales at Reduced Prices Lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. There simply isn’t any way that a firm can do so without causing alarms to go off in the industry.

21. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Retaliation Oligopolists respond to aggressive marketing by competitors. –Step up marketing efforts. –Cut prices on their product(s).

22. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Retaliation One way oligopolists market their products is through product differentiation. –Product differentiation – Features that make one product appear different from competing products in the same market.

23. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Retaliation An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price. This is why oligopolists avoid price competition and instead pursue nonprice competition.

24. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Rivalry for Market Shares F G Market demand $1000 900 020,00025,000 Quantity Demanded (computers per month) Price (per computer)

25. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Kinked Demand Curve Close interdependence – and the limitations it imposes on price and output decisions – is a characteristic of oligopoly.

26. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Rivals’ Response to Price Reductions The degree to which sales increase when the price is reduced depends on the response of rival oligopolists. We expect oligopolists to match any price reductions by rival oligopolists.

27. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Rivals’ Response to Price Increases Rival oligopolists may not match price increases in order to gain market share.

28. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Kinked Demand Curve Confronting an Oligopolist The shape of the demand curve facing an oligopolist depends on how its rivals responded to a change in the price of its own output. The demand curve will be kinked if rival oligopolists match price reductions but not price increases.

29. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 1000 PRICE (per computer) QUANTITY DEMANDED (computers per month) 0 The Kinked Demand Curve Confronting an Oligopolist Demand curve facing oligopolist if rivals match price changes Demand curve facing oligopolist if rivals don't match price changes Demand curve facing oligopolist if rivals match price cuts but not price hikes M A C D B $1100 900 8000

30. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Game Theory Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies. The payoff to an oligopolist’s price cut depends on how its rivals respond.

31. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Game Theory Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.

32. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Game Theory Each oligopolist is uncertain about its rival’s behavior. –The collective interests of the oligopoly are protected if no one cuts the market price. –But an individual oligopolist could lose if it holds the line on price when rivals reduce price.

33. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Payoff Matrix The payoff to an oligopolist’s price cut depends on how its rivals respond.

34. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Payoff Matrix The decision to initiate a price cut requires a risk assessment.        cutspricefrom loss ofSize matchingrivals of Probability value Expected        cutprice lonefromGain matching notrivals of Probability

35. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Payoff Matrix

36. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly vs. Competition Oligopolists may try to coordinate their behavior in a way that maximizes industry profits.

37. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Output An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit.

38. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Output To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.

39. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price or Cost (dollars per unit) Quantity (units per period) 0 Maximizing Oligopoly Profits Industry marginal cost Industry average cost Market demand Industry marginal revenue Profits J Profit- maximizing price Average cost at profit- maximizing output Profit-maximizing output

40. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Sticky Prices Prices in oligopoly industries tend to be stable. Like all producers, oligopolists want to maximize profits by producing where MR = MC.

41. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Sticky Prices The kinked demand curve is really a composite of two separate demand curves. There is a gap in an oligopolist’s marginal revenue (MR) curve. –Marginal revenue – The change in total revenue that results from a one-unit increase in the quantity sold.

42. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Sticky Prices As a result, modest shifts of the cost curve will have no impact on the production decision of an oligopolists.

43. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. An Oligopolist’s Marginal Revenue Curve A G H d2d2 S 0 8000 Price (dollars per computer) Quantity Demanded (computers per month) mr 2 mr 1 d1d1 F The kink in the demand curve The MR gap

44. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cost Cushion Price or Cost (dollars per unit) MC 2 MC 1 MC 3 Marginal revenue 0 Quantity (units per period)

45. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Coordination Problems There is an inherent conflict in the joint and individual interests of oligopolists. –Each oligopolist wants industry profits to be maximized. –Each oligopolist wants to maximize it’s own market share.

46. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Coordination Problems To avoid self-destructive behavior, each oligopolist must coordinate production decisions so that: –Industry output and price are maintained at profit-maximizing levels. –Each oligopolistic firm is content with its market share.

47. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Fixing The most explicit form of coordination among oligopolists is called price fixing. Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold.

48. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators. They were charged again in 1972 for continued price fixing.

49. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states.

50. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Vitamins – Seven firms from four nations were accused of fixing global prices on bulk vitamins from 1990 - 1998.

51. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Baby Formula – Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula.

52. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Cola – The Coca-Cola Bottling Co. of North Carolina agreed to pay a fine and give consumers discount coupons to settle charges of conspiring to fix soft-drink prices from 1982 to 1985.

53. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD.

54. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Laser Eye Surgery – The FTC charged VISX and Summit Technology with price- fixing that raised the price of surgery by $500 per eye.

55. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Price Fixing Memory chips – In 2004, prosecutors claimed the world’s largest memory-chip (DRAM) makers (Samsung, Micron, and Infineon) fixed prices in the $16 billion-a- year market.

56. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Leadership Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry.

57. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocation of Market Shares One way to allocate market share is a cartel agreement. A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market.

58. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocation of Market Shares An oligopolist may resort to predatory pricing when market shares are not being divided in a satisfactory manner. –Predatory pricing - temporary price reductions designed to alter market shares or drive out competition.

59. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Barriers to Entry Above-normal profits cannot be maintained over the long-run unless barriers to entry exist. Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market.

60. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Patents Patents prevent potential competitors from setting up shop. They either have to develop an alternative method for producing a product or receive permission from the patent holder to use the patented process.

61. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Distribution Control The control of distribution outlets can be accomplished through selective discounts, long-term supply contracts, or expensive gifts at Christmas.

62. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mergers and Acquisition A firm can limit competition by acquiring competitors through mergers and acquisition.

63. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Regulation Patents are issued by the federal government. Licensing requirements imposed by government limit competition.

64. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Nonprice Competition Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market.

65. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Training Early market entry can create an important barrier to later competition. Customers of training-intensive products (such as computer hardware and software) become familiar with a particular system.

66. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Network Economies The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.

67. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Antitrust Enforcement Market power contributes to market failure when it leads to resource misallocations or greater inequity. Market failure is an imperfection in the market mechanism that prevents optimal outcomes.

68. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Behavior Antitrust law is government intervention designed to alter market structure or prevent abuse of market power.

69. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Behavior There are several problems with the behavioral approach to antitrust law: –Limited government resources. –Public apathy. –Difficulty of proving collusion.

70. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Structure Public efforts to alter market structure have been less frequent than efforts to alter market behavior.

71. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Objections to Antitrust Some argue that we shouldn’t punish those who achieved monopolies through hard work and innovation. Noncompetitive behavior, not industry structure, should be the only concern of antitrust.

72. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Herfindahl-Hirshman Index The Herfindahl-Hirshman index (HHI) is a measure of industry concentration that accounts for number of firms and size of each.

73. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Herfindahl-Hirshman Index The Herfindahl-Hirshman Index of market equals the sum of the squares of the market shares of each firm in an industry.

74. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Herfindahl-Hirshman Index For policy purposes, the Justice Department decided it would draw the line at a value of 1,800.

75. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Contestability If entry barriers were low enough, even a highly concentrated industry might be compelled to behave more competitively.

76. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavioral Guidelines: Cost Savings The FTC now also looks to see if a proposed merger will allow for greater efficiencies and lower costs.

77. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly End of Chapter 10