Oligopoly Look for: 1.Determination of the profit maximizing price and quantity. 2.Implications for efficiency Issues of Oligopoly Game theory and collusion 3 oligopoly models Profit maximization Efficiency Please listen to the audio as you work through the slides.

Learning objectives Students should be able to thoroughly and completely explain: 1.The characteristics of oligopoly 2.The conditions under which the Oligopolist firm achieves profit maximization and loss minimization. 3.Oligopoly Behavior, including collusion and game theory.

Some Oligopoly examples In the US, 90% of the music produced and sold comes from one of 4 studios: Universal, Sony, Warner, or EMI. Limited price competition. Talent search and marketing are critical to gain advantage. The $1 billion stent market is dominated by 3 firms: Boston Scientific, Johnson & Johnson, and Medtronic. Limited price competition. R&D is the competitive advantage tool. Two companies control US grain trading: Cargil – Continental, and Archer, Daniels, Midland (ADM). 3 Companies control 44% of the global proprietary seed market: Monsanto, DuPont, and Syngenta.

Some Oligopoly examples 4 Companies control over 80% of the US beef market: Tyson, Cargil, Swift, and National Beef Packing Company Airlines – fierce price competition among a small number of firms. Industry consolidation. 4 firms dominate the market for tennis balls – Wilson, Penn, Dunlop, Spalding Oligopolies compete on: – price, new product development, marketing, advertising, and development of complements.

The market structures – compare the characteristics Type of products Control over price Exit and entry Non price competition Price output determination Efficiency

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Oligopoly: characteristics A Few Large Producers with large market share: – “big 3”, “big 6” Homogeneous (standardized) or Differentiated Products Steel, lead, aluminum, cement – industrial products Automobiles, tires, electronic equipment, breakfast cereals, cigarettes (non-price competition / advertising) – consumer products

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Oligopoly: characteristics Control Over Price – price makers, Mutual Interdependence – profits depend on strategies of others Strategic Behavior – self interested behavior that takes into account the reactions of others. Entry Barriers – Economies of scale – they have it and exploit it Large capital expenditures – refineries, auto assemblers, commercial aircraft, large scale mfg. facilities. Ownership of raw materials – mining, food production Patents – big pharma, electronics, seeds Preemptive and retaliatory pricing and ad strategies

Evolution of Oligopolies Growth of dominant firms – they just get big Mergers – auto industry, banking, food manufacturers, airlines, They attempt to achieve monopoly power – without attracting the attention of the anti-trust division of the Justice Dept. Where do Oligopolies come from?

Oligopoly Behavior Game theory – a subfield of economics that analyzes the choices made by rival firms, people, and even governments as they try to maximize their own well-being while anticipating and reacting to the actions of others in their environment. A key tool during the Cold War period.

Oligopoly Behavior Game Theory Mutual Interdependence Collusive Tendencies Collusion – cooperation with rivals 1.Independent behavior of firms leads to lower prices – a benefit to consumers 2.Collusive behavior of firms leads to higher prices - a benefit to business Incentive to Cheat Introduction to Game Theory…

Oligopoly Behavior – 2 firms, 2 strategies A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15

Oligopoly Behavior A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Greatest Combined Profit

Oligopoly Behavior A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Independent Actions Stimulate Response

Oligopoly Behavior A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Independent Actions Stimulate Response Gravitating to the Worst Case

Oligopoly Behavior A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Collusion Invites a Different Solution.

Oligopoly Behavior A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Collusion Invites a Different Solution.

Oligopoly Behavior A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 But, the incentive to cheat is very real. Collusion Invites a Different Solution.

Diversity of Oligopolies 1.Tight oligopolies – 2 to 3 firms dominate industry 2.Loose oligopolies – 6 to 7 firms share 70% or more of the market (the smaller firms share the rest) 3.Both sell differentiated or standard products Complications of Interdependence 1.Firms cannot (or have great difficulty) estimate their demand or MR data, and are challenged to determine their profit maximizing price and output 2.Can’t predict the reaction of rivals with certainty. Three Oligopoly Models No Standard Model due to the diversity of oligopoly

Three Oligopoly Models Alternative models - Two interrelated characteristics: 1. If the macro economy is stable then prices are typically inflexible 2. When prices do change, firms are likely to change their prices together The 3 Models 1 – Kinked Demand Curve model* 2 – Cartels and Collusion model 3 – Price Leadership model

Kinked Demand Curve Theory Assumptions: 3 firms Independent pricing, no collusive behavior Differentiated products What does a firms’ demand curve look like? Location and shape depends on how rivals react to a price change Two plausible assumptions about behavior of rivals. 1.The 2 rivals match price changes of firm #1 1.Firm 1 cuts price - firm #1 would achieve small sales increase because rivals also cut price to match. 2.Firm 1 raises price – firm #1 has small sales loss because rivals also raise prices to match. 2.The 2 rivals ignore price changes of firm #1 1.Firm 1 lowers price and rivals don’t. Firm 1 gains sales. 2.Firm 1 raises price and rivals don’t. Firm 1 looses sales.

Conclusion about strategy Rival behavior will depend on the direction of firm 1’s price change!! Key point! There exists a price: – below which they will match price decreases and – above which they will ignore price increases. Given a price change by firm 1, – Case 1: Rivals will ignore price increases above that price and gain customers. – Case 2: Rivals will match price decreases below that price to avoid losing customers

D1D1 MR 1 Quantity Case 1. Firm 1’s demand and marginal revenue curves assuming a price decrease by firm 1 and the 2 rivals match the change. Firm 1 receives only a small increase in sales. Kinked Demand Theory: Noncollusive Oligopoly Price

MR 2 D1D1 D2D2 MR 1 Quantity Case 2. Firm 1’s Demand and marginal revenue curves assuming a price increase by firm 1 and the 2 rivals ignore the price increase. Firm 1 has only a small sales loss. Kinked Demand Theory: Noncollusive Oligopoly Price

MR 2 D1D1 D2D2 MR 1 Quantity Kinked Demand Theory: Noncollusive Oligopoly Price Rivals tend to follow a price cut

MR 2 D1D1 D2D2 MR 1 Quantity Kinked Demand Theory: Noncollusive Oligopoly Price Rivals tend to follow a price cut or ignore a price increase

MR 2 D1D1 D2D2 MR 1 Quantity Effectively creating a kinked demand curve For firm #1 Kinked Demand Theory: Noncollusive Oligopoly Price

D Quantity Effectively creating a kinked demand curve For firm #1 Kinked Demand Theory: Noncollusive Oligopoly Price

D MR 1 Quantity Effectively creating a kinked demand curve For firm #1 Note: the MR curves Kinked Demand Theory: Noncollusive Oligopoly Price MR 2

D Quantity Profit maximization or loss minimization for firm #1 occurs at the kink where MR = MC Kinked Demand Theory: Noncollusive Oligopoly Price MC 2 MC 1 MR 2 MR 1

If a few firms face identical or highly similar demand and costs... Oligopoly is conducive to collusion. they will tend to seek joint profit maximization. Cartels and Other Collusion Graphically…

3 similar Colluding Oligopolists Will Split the Monopoly Profits by limiting output and setting a single common price. D MC ATC MR Economic Profit MR = MC Price and costs Q0Q0 P0P0 A0A0 Cartels and Other Collusion

Overt Collusion Cartels with defined – written agreements The OPEC Cartel Covert Collusion U.S. – It is Illegal Tacit Understandings – gentlemen's agreements 1993 Borden, Pet, Dean Foods bid rigging on milk products 1996 ADM and 3 Japanese and South Korean firms price fixing on livestock feed additives. 1960’s - manufacturers of heavy electrical equipment including General ElectricelectricalGeneral Electric Cartels and Other Collusion

Obstacles to Collusion Demand and Cost Differences Number of Firms: more firms = less collusion Cheating Recession – pressure to lower prices. Potential Entry – successful collusion requires blocking entry in some way. Antitrust Law Cartels and Other Collusion

Price Leadership Model Leadership Tactics - Requires implicit understanding among the players such that they can coordinate prices without engaging in outright collusion based on formal agreements and secret meetings. (General Mill, Post Foods, Kellogs) Infrequent Price Changes Communications – press conferences Limit Pricing They want to keep price below the short run profit maximizing level to discourage new competitors from entering. Breakdowns in Price Leadership - Price Wars

Oligopoly and Advertising Product development and advertising are less easily duplicated by rivals Oligopolists typically financially strong – Cash flow, economic profit Positive Effects of AdvertisingPositive Effects of Advertising Providing information to consumers Diminishes monopoly power – Toyota and Honda vs the Big 3 of the USA (check out the 1989 pre-launch commercial) Enhance efficiency Greater competition, more technological progress, higher output, lower LR ATC, better able to achieve economies of scale. Potential Negative Effects of AdvertisingPotential Negative Effects of Advertising Disinformation to consumers Barrier to entry Brand Development

Oligopoly and efficiency 1.Many oligopolists sustain economic profit 2.Production often occurs where price > MC and price > minimum ATC. 3.Production is below the output at which ATC is minimized 4.Neither productive efficiency nor allocative efficiency is achieved.

Pure Competition conditions: Productive Efficiency: P = Minimum ATC and Allocative Efficiency: P = MC Oligopoly Situation relative to efficiency: P > Minimum ATC P > MC Output is below the output at which ATC is minimized Oligopoly and efficiency

monopolistic competition product differentiation nonprice competition excess capacity oligopoly homogeneous oligopoly differentiated oligopoly strategic behavior mutual interdependence concentration ratio interindustry competition import competition Herfindahl index game-theory model collusion kinked-demand curve price war cartel tacit understandings price leadership