1. OLIGOPOLY 1 Copyright ACDC Leadership 2015

2. FOUR MARKET MODELS Characteristics of Oligopolies: A Few Large Producers (Less than 10) Homogeneous or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms use Strategic Pricing Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly Copyright ACDC Leadership 2015 2

5. EXAMPLES Tennis Balls: Wilson, Penn, Dunlop and Spalding. Cars: GM, Ford, DaimlerChrysler Cereal: Quaker, Ralston Food, Kellogg, Post and General Mills. Aircraft: Boeing (McDonnell Douglas) and Lockheed Martin Grocery stores: (Giant Eagle, Shopn’Save, Wal-Mart)

6. Oligopolies occur when only a few large firms start to control an industry. High barriers to entry keep others from entering. What are some Barriers to Entry? 1. Economies of Scale 2. High Start-up Costs 3. Ownership of Raw Materials 4. Patents Mergers… HOW DO OLIGOPOLIES OCCUR? Copyright ACDC Leadership 2015 6 ???

7. HORIZONTAL MERGER How does the government decide if it will allow a merger? Does it reduce competition in a way that will hurt consumers? Announced, March 2011 Abandoned, Dec. 2011

8. HORIZONTAL MERGER

10. GAME THEORY How do firms in Oligopoly behave strategically to choose price/output? Mutual interdependence Pricing policy Collusion Enhances profit Incentive to cheat Prisoner’s dilemma 11-10

11. Game Theory An understanding of game theory helps firms in an oligopoly maximize profit. The study of how people behave in strategic situations Copyright ACDC Leadership 2015 11

12. JOHN NASH AND GAME THEORY Copyright ACDC Leadership 2015

13. VIDEO: SPLIT OR STEAL Copyright ACDC Leadership 2015

14. The Prisoner’s Dilemma Charged with a crime, each prisoner has one of two choices: Deny or Rat Prisoner 2 Prisoner 1 Both Deny = 5 Years in jail each Both Rat = 10 Years in jail each DenyConfess Deny Confess Rat = Free Deny = 20 Years Rat = Free Deny =20 Years Copyright ACDC Leadership 2015 14

16. What did we learn? 1.Oligopolies must use strategic pricing (they have to worry about the other guy) 2.Oligopolies have a tendency to collude to gain profit. (Collusion is the act of cooperating with rivals in order to “rig” a situation) 3.Collusion results in the incentive to cheat. 4.Firms make informed decisions based on their dominant strategies Copyright ACDC Leadership 2015 16

17. 2008 Audit Exam

18. 2007 FRQ #3 Payoff matrix for two competing bus companies Copyright ACDC Leadership 2015 18

19. 2007 FRQ #3 Copyright ACDC Leadership 2015

20. OLIGOPOLY GRAPHS Copyright ACDC Leadership 2015 20

21. Because firms are interdependent There are 3 types of Oligopolies 1. Price Leadership (no graph) 2. Colluding Oligopoly 3. Non Colluding Oligopoly Copyright ACDC Leadership 2015 21

22. #1. PRICE LEADERSHIP Copyright ACDC Leadership 2015 22

23. Example: Small Town Gas Stations To maximize profit what will they do? OPEC does this with OIL Who is the “leader” with OPEC? Copyright ACDC Leadership 2015 23

24. Price Leadership Collusion is ILLEGAL. Firms CANNOT set prices. Price leadership is a strategy used by firms to coordinate prices without outright collusion General Process: 1.“Dominant firm” initiates a price change 2.Other firms follow the leader Copyright ACDC Leadership 2015 24

25. PRICE LEADERSHIP MODEL Leadership tactics o Usually largest/most efficient firm o Infrequent price changes o Communications o Limit pricing to keep barriers to entry o How might Price Leadership break down?: 11-25

26. 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. Examples… Copyright ACDC Leadership 2015 26 Price Leadership

27. #2. COLLUDING OLIGOPOLIES Copyright ACDC Leadership 2015 27

28. A cartel is a group of producers that create an agreement to fix prices high. Why didn’t your cartel work? 1.Cartels set price and output at an agreed upon level 2.Firms require identical or highly similar demand and costs 3.Cartel must have a way to punish cheaters 4.Together they act as a monopoly Cartel = Colluding Oligopoly Copyright ACDC Leadership 2015 28

29. Firms in a colluding oligopoly act as a monopoly and share the profit **easier with homogenous product D MC ATC Q P MR 29

30. CARTELS AND OTHER COLLUSION Covert collusion Tacit understandings Obstacles to collusion Demand and cost differences Number of firms Cheating Recession (increases in ATC) Potential entry of new firms Legal obstacles: antitrust law 11-30

31. #3. NON- COLLUDING OLIGOPOLIES Copyright ACDC Leadership 2015 31

32. 1.Match price-If one firm cuts it’s prices, then the other firms follow suit causing inelastic demand 2.Ignore change-If one firm raises prices, others maintain same price causing elastic demand Kinked Demand Curve Model If firms are NOT colluding they are likely to react to competitor’s pricing in two ways: The kinked demand curve model shows how noncollusive firms are interdependent Copyright ACDC Leadership 2015

33. D Q If this firm increases it’s price, other firms will ignore it and keep prices the same P PePe QeQe As the only firm with high prices, Qd for this firm will decrease a lot ( Q e to Q 1 ) P1P1 Q1Q1 Elastic Copyright ACDC Leadership 2015 33

34. D Q If this firm decreases it’s price, other firms will match it and lower their prices P PePe QeQe Since all firms have lower prices, Qd for this firm will increase only a little ( Q e to Q 2 ) P2P2 Q2Q2 Inelastic P1P1 Q1Q1 Elastic Copyright ACDC Leadership 2015 34

35. D Q Where is Marginal Revenue? P PePe Q MR has a vertical gap at the kink. The result is that MC can move and Q e won’t change. Price is sticky. MC MR Copyright ACDC Leadership 2015 35

36. Criticisms of the model How does price get to P 0 Explains inflexibility, not price Price/Quantity remains the profit maximizing level for a wide range of cost structures Prices are not that rigid (unstable economy) Price wars (often due to recession) Kinked-Demand Curve 11-36