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Presentation on theme: "© 2010 Pearson Addison-Wesley CHAPTER 1. © 2010 Pearson Addison-Wesley."— Presentation transcript:

1 © 2010 Pearson Addison-Wesley CHAPTER 1

2 © 2010 Pearson Addison-Wesley

3 What Is Oligopoly? Oligopoly is a market structure in which Natural or legal barriers prevent the entry of new firms. A small number of firms compete.

4 © 2010 Pearson Addison-Wesley Barriers to Entry Either natural or legal barriers to entry can create oligopoly. Figure 15.1 shows two oligopoly situations. In part (a), there is a natural duopolya market with two firms. What Is Oligopoly?

5 © 2010 Pearson Addison-Wesley In part (b), there is a natural oligopoly market with three firms. A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms. What Is Oligopoly?

6 © 2010 Pearson Addison-Wesley Small Number of Firms Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. Interdependence: With a small number of firms, each firms profit depends on every firms actions. Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit. Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down. What Is Oligopoly?

7 © 2010 Pearson Addison-Wesley Two Traditional Oligopoly Models The Kinked Demand Curve Model In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.

8 © 2010 Pearson Addison-Wesley Figure 15.2 shows the kinked demand curve model. The firm believes that the demand for its product has a kink at the current price and quantity. Two Traditional Oligopoly Models

9 © 2010 Pearson Addison-Wesley Above the kink, demand is relatively elastic because all other firms prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms prices change in line with the price of the firm shown in the figure. Two Traditional Oligopoly Models

10 © 2010 Pearson Addison-Wesley The kink in the demand curve means that the MR curve is discontinuous at the current quantityshown by that gap AB in the figure. Two Traditional Oligopoly Models

11 © 2010 Pearson Addison-Wesley Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit- maximizing quantity and price unchanged. For example, if costs increased so that the MC curve shifted upward from MC 0 to MC 1, the profit- maximizing price and quantity would not change. Two Traditional Oligopoly Models

12 © 2010 Pearson Addison-Wesley The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact. If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesnt maximize profit. Two Traditional Oligopoly Models

13 © 2010 Pearson Addison-Wesley Dominant Firm Oligopoly In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. The large firm operates as a monopoly, setting its price and output to maximize its profit. The small firms act as perfect competitors, taking as given the market price set by the dominant firm. Two Traditional Oligopoly Models

14 © 2010 Pearson Addison-Wesley Figure 15.3 shows10 small firms in part (a). The demand curve, D, is the market demand and the supply curve S 10 is the supply of the 10 small firms. Two Traditional Oligopoly Models

15 © 2010 Pearson Addison-Wesley At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing. Two Traditional Oligopoly Models

16 © 2010 Pearson Addison-Wesley But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm. Two Traditional Oligopoly Models

17 © 2010 Pearson Addison-Wesley The demand curve for the large firms output is the curve XD on the right. Two Traditional Oligopoly Models

18 © 2010 Pearson Addison-Wesley The large firm can set the price and receives a marginal revenue that is less than price along the curve MR. Two Traditional Oligopoly Models

19 © 2010 Pearson Addison-Wesley The large firm maximizes profit by setting MR = MC. Lets suppose that the marginal cost curve is MC in the figure. Two Traditional Oligopoly Models

20 © 2010 Pearson Addison-Wesley The profit-maximizing quantity for the large firm is 10 units. The price charged is $1.00. Two Traditional Oligopoly Models

21 © 2010 Pearson Addison-Wesley The small firms take this price and supply the rest of the quantity demanded. Two Traditional Oligopoly Models

22 © 2010 Pearson Addison-Wesley In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs. Two Traditional Oligopoly Models

23 © 2010 Pearson Addison-Wesley Oligopoly Games Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. The Prisoners Dilemma The prisoners dilemma game illustrates the four features of a game. Rules Strategies Payoffs Outcome

24 © 2010 Pearson Addison-Wesley Rules The rules describe the setting of the game, the actions the players may take, and the consequences of those actions. In the prisoners dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. Each is held in a separate cell and cannot communicate with each other. Oligopoly Games

25 © 2010 Pearson Addison-Wesley Each is told that both are suspected of committing a more serious crime. If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes. If both confess to the more serious crime, each receives 3 years in jail for both crimes. If neither confesses, each receives a 2-year sentence for the minor crime only. Oligopoly Games

26 © 2010 Pearson Addison-Wesley Strategies Strategies are all the possible actions of each player. Art and Bob each have two possible actions: 1. Confess to the larger crime. 2. Deny having committed the larger crime. With two players and two actions for each player, there are four possible outcomes: 1. Both confess. 2. Both deny. 3. Art confesses and Bob denies. 4. Bob confesses and Art denies. Oligopoly Games

27 © 2010 Pearson Addison-Wesley Payoffs Each prisoner can work out what happens to himcan work out his payoffin each of the four possible outcomes. We can tabulate these outcomes in a payoff matrix. A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player. The next slide shows the payoff matrix for this prisoners dilemma game. Oligopoly Games

28 © 2010 Pearson Addison-Wesley Oligopoly Games

29 © 2010 Pearson Addison-Wesley Outcome If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player. If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibriumfirst proposed by John Nash. Finding the Nash Equilibrium The following slides show how to find the Nash equilibrium. Oligopoly Games

30 © 2010 Pearson Addison-Wesley Bobs view of the world

31 © 2010 Pearson Addison-Wesley Bobs view of the world

32 © 2010 Pearson Addison-Wesley Arts view of the world

33 © 2010 Pearson Addison-Wesley Arts view of the world

34 © 2010 Pearson Addison-Wesley Equilibrium

35 © 2010 Pearson Addison-Wesley An Oligopoly Price-Fixing Game A game like the prisoners dilemma is played in duopoly. A duopoly is a market in which there are only two producers that compete. Duopoly captures the essence of oligopoly. Cost and Demand Conditions Figure 15.4 on the next slide describes the cost and demand situation in a natural duopoly. Oligopoly Games

36 © 2010 Pearson Addison-Wesley Part (a) shows each firms cost curves. Part (b) shows the market demand curve. Oligopoly Games

37 © 2010 Pearson Addison-Wesley This industry is a natural duopoly. Two firms can meet the market demand at the least cost. Oligopoly Games

38 © 2010 Pearson Addison-Wesley How does this market work? What is the price and quantity produced in equilibrium? Oligopoly Games

39 © 2010 Pearson Addison-Wesley Collusion Suppose that the two firms enter into a collusive agreement. A collusive agreement is an agreement between two (or more) firms to restrict output, raise the price, and increase profits. Such agreements are illegal in the United States and are undertaken in secret. Firms in a collusive agreement operate a cartel. Oligopoly Games

40 © 2010 Pearson Addison-Wesley The strategies that firms in a cartel can pursue are to Comply Cheat Because each firm has two strategies, there are four possible combinations of actions for the firms: 1. Both comply. 2. Both cheat. 3. Trick complies and Gear cheats. 4. Gear complies and Trick cheats. Oligopoly Games

41 © 2010 Pearson Addison-Wesley Colluding to Maximize Profits Firms in a cartel act like a monopoly and maximum economic profit. Oligopoly Games

42 © 2010 Pearson Addison-Wesley To find that profit, we set marginal cost for the cartel equal to marginal revenue for the cartel. Oligopoly Games

43 © 2010 Pearson Addison-Wesley The cartels marginal cost curve is the horizontal sum of the MC curves of the two firms and the marginal revenue curve is like that of a monopoly. Oligopoly Games

44 © 2010 Pearson Addison-Wesley The firms maximize economic profit by producing the quantity at which MC I = MR. Oligopoly Games

45 © 2010 Pearson Addison-Wesley Each firm agrees to produce 2,000 units and each firm shares the maximum economic profit. The blue rectangle shows each firms economic profit. Oligopoly Games

46 © 2010 Pearson Addison-Wesley When each firm produces 2,000 units, the price is greater than the firms marginal cost, so if one firm increased output, its profit would increase. Oligopoly Games

47 © 2010 Pearson Addison-Wesley One Firm Cheats on a Collusive Agreement Suppose the cheat increases its output to 3,000 units. Industry output increases to 5,000 and the price falls. Oligopoly Games

48 © 2010 Pearson Addison-Wesley For the complier, ATC now exceeds price. For the cheat, price exceeds ATC. Oligopoly Games

49 © 2010 Pearson Addison-Wesley The complier incurs an economic loss. The cheat makes an increased economic profit. Oligopoly Games

50 © 2010 Pearson Addison-Wesley Both Firms Cheat Suppose that both increase their output to 3,000 units. Oligopoly Games

51 © 2010 Pearson Addison-Wesley Industry output is 6,000 units, the price falls, and both firms make zero economic profitthe same as in perfect competition. Oligopoly Games

52 © 2010 Pearson Addison-Wesley Possible Outcomes If both comply, each firm makes $2 million a week. If both cheat, each firm makes zero economic profit. If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million. If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million. The next slide shows the payoff matrix for the duopoly game. Oligopoly Games

53 © 2010 Pearson Addison-Wesley Payoff Matrix

54 © 2010 Pearson Addison-Wesley Tricks view of the world

55 © 2010 Pearson Addison-Wesley Tricks view of the world

56 © 2010 Pearson Addison-Wesley Gears view of the world

57 © 2010 Pearson Addison-Wesley Gears view of the world

58 © 2010 Pearson Addison-Wesley Equilibrium

59 © 2010 Pearson Addison-Wesley Nash Equilibrium in Duopolists Dilemma The Nash equilibrium is that both firms cheat. The quantity and price are those of a competitive market, and the firms make zero economic profit. Other Oligopoly Games Advertising and R&D games are also prisoners dilemmas. An R&D Game Procter & Gamble and Kimberley Clark play an R&D game in the market for disposable diapers. Oligopoly Games

60 © 2010 Pearson Addison-Wesley The payoff matrix for the Pampers Versus Huggies game. Oligopoly Games

61 © 2010 Pearson Addison-Wesley The Disappearing Invisible Hand In all the versions of the prisoners dilemma that weve examined, the players end up worse off than they would if they were able to cooperate. The pursuit of self-interest does not promote the social interest in these games. Oligopoly Games

62 © 2010 Pearson Addison-Wesley A Game of Chicken In the prisoners dilemma game, the Nash equilibrium is a dominant strategy equilibrium, by which we mean the best strategy for each player is independent of what the other player does. Not all games have such an equilibrium. One that doesnt is the game of chicken. Oligopoly Games

63 © 2010 Pearson Addison-Wesley Payoff Matrix

64 © 2010 Pearson Addison-Wesley KCs view of the world

65 © 2010 Pearson Addison-Wesley KCs view of the world

66 © 2010 Pearson Addison-Wesley P&Gs view of the world

67 © 2010 Pearson Addison-Wesley P&Gs view of the world

68 © 2010 Pearson Addison-Wesley Equilibrium

69 © 2010 Pearson Addison-Wesley Repeated Games and Sequential Games A Repeated Duopoly Game If a game is played repeatedly, it is possible for duopolists to successfully collude and make a monopoly profit. If the players take turns and move sequentially (rather than simultaneously as in the prisoners dilemma), many outcomes are possible. In a repeated prisoners dilemma duopoly game, additional punishment strategies enable the firms to comply and achieve a cooperative equilibrium, in which the firms make and share the monopoly profit.

70 © 2010 Pearson Addison-Wesley One possible punishment strategy is a tit-for-tat strategy. A tit-for-tat strategy is one in which one player cooperates this period if the other player cooperated in the previous period but cheats in the current period if the other player cheated in the previous period. A more severe punishment strategy is a trigger strategy. A trigger strategy is one in which a player cooperates if the other player cooperates but plays the Nash equilibrium strategy forever thereafter if the other player cheats. Repeated Games and Sequential Games

71 © 2010 Pearson Addison-Wesley Table 15.5 shows that a tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game. Repeated Games and Sequential Games

72 © 2010 Pearson Addison-Wesley Price wars might result from a tit-for-tat strategy where there is an additional complicationuncertainty about changes in demand. A fall in demand might lower the price and bring forth a round of tit-for-tat punishment. Repeated Games and Sequential Games

73 © 2010 Pearson Addison-Wesley A Sequential Entry Game in a Contestable Market In a contestable marketa market in which firms can enter and leave so easily that firms in the market face competition from potential entrantsfirms play a sequential entry game. Repeated Games and Sequential Games

74 © 2010 Pearson Addison-Wesley Figure 15.8 shows the game tree for a sequential entry game in a contestable market. Repeated Games and Sequential Games

75 © 2010 Pearson Addison-Wesley In the first stage, Agile decides whether to set the monopoly price or the competitive price. Repeated Games and Sequential Games

76 © 2010 Pearson Addison-Wesley In the second stage, Wanabe decides whether to enter or stay out. Repeated Games and Sequential Games

77 © 2010 Pearson Addison-Wesley In the equilibrium of this entry game, Agile sets a competitive price and makes zero economic profit to keep Wanabe out. A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out. Repeated Games and Sequential Games

78 © 2010 Pearson Addison-Wesley Antitrust Law Antitrust law provides an alternative way in which the government may influence the marketplace. The Antitrust Laws The first antitrust law, the Sherman Act, was passed in 1890. It outlawed any combination, trust, or conspiracy that restricts interstate trade, and prohibited the attempt to monopolize.

79 © 2010 Pearson Addison-Wesley Antitrust Law

80 © 2010 Pearson Addison-Wesley A wave of merger activities at the beginning of the twentieth century produced a stronger antitrust law, the Clayton Act, and created the Federal Trade Commission. The Clayton Act was passed in 1914. The Clayton Act made illegal specific business practices such as price discrimination, interlocking directorships, and acquisition of a competitors shares if the practices substantially lessen competition or create monopoly. Antitrust Law

81 © 2010 Pearson Addison-Wesley Table 15.7 (next slide) summarizes the Clayton Act and its amendments, the Robinson-Patman Act passed in 1936 and the Cellar-Kefauver Act passed in 1950. The Federal Trade Commission, formed in 1914, looks for cases of unfair methods of competition and unfair or deceptive business practices. Antitrust Law

82 © 2010 Pearson Addison-Wesley Antitrust Law

83 © 2010 Pearson Addison-Wesley Price Fixing Always Illegal Price fixing is always a violation of the antitrust law. If the Justice Department can prove the existence of price fixing, there is no defense. Antitrust Law

84 © 2010 Pearson Addison-Wesley Three Antitrust Policy Debates But some practices are more controversial and generate debate. Three of them are Resale price maintenance Tying arrangements Predatory pricing Antitrust Law

85 © 2010 Pearson Addison-Wesley Resale Price Maintenance Most manufacturers sell their product to the final consumer through a wholesale and retail distribution chain. Resale price maintenance occurs when a manufacturer agrees with a distributor on the price at which the product will be resold. Resale price maintenance is inefficient if it promotes monopoly pricing. But resale price maintenance can be efficient if it provides retailers with an incentive to provide an efficient level of retail service in selling a product. Antitrust Law

86 © 2010 Pearson Addison-Wesley Tying Arrangements A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another different product as well. Some people argue that by tying, a firm can make a larger profit. Where buyers have a differing willingness to pay for the separate items, a firm can price discriminate and take a larger amount of the consumer surplus by tying. Antitrust Law

87 © 2010 Pearson Addison-Wesley Predatory Pricing Predatory pricing is setting a low price to drive competitors out of business with the intention of then setting the monopoly price. Economists are skeptical that predatory pricing actually occurs. A high, certain, and immediate loss is a poor exchange for a temporary, uncertain, and future gain. No case of predatory pricing has been definitively found. Antitrust Law

88 © 2010 Pearson Addison-Wesley Merger Rules The Federal Trade Commission (FTC) uses guidelines to determine which mergers to examine and possibly block. The Herfindahl-Hirschman index (HHI) is one of those guidelines (explained in Chapter 9). If the original HHI is between 1,000 and 1,800, any merger that raises the HHI by 100 or more is challenged. If the original HHI is greater than 1,800, any merger that raises the HHI by more than 50 is challenged. Antitrust Law

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