Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10 Oligopoly Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10

Overview Oligopoly market characteristics Measure of market structure Barriers in oligopoly market Game theory approach to duopoly Cooperative collusion Cheating Future of oligopoly

Oligopoly When just a few large firms dominate a market So that actions of each one have an important impact on the others In such a market, each firm recognizes its strategic interdependence with others An oligopoly is a market dominated by a small number of strategically interdependent firms Would be foolish for any one firm to ignore its competitors’ reactions

Number of Firms Oligopoly requires that a few firms dominate the market How few? At some point, number of firms is large enough—and interdependence weak enough—that oligopoly becomes a poor description Monopolistic competition would fit better No absolute number at which oligopoly ends and monopolistic competition begins

Market Domination Strategic interdependence requires that a few firms dominate the market Their share of market is large As combined market share shrinks, strategic interdependence becomes weaker Oligopoly is a matter of degree Not an absolute classification

Economies of Scale: Natural Oligopolies When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market only a few large firms survive since small firms can’t compete Market becomes an (natural) oligopoly Remember, MES is defined as the lowest level of output at which it can achieve minimum cost per unit The output level at which the LRATC first hits bottom

Figure 1: Natural Oligopoly 25,000 Units per Month 100,000 80 $200 Dollars LRATCTypical Firm H F E DMarket

Reputation as a Barrier Established oligopolists are likely to have favorable reputations Investors decision: enter or not? Critical thing: is it worthy to take the risk of being a new firm in such market? If expected profit is greater than the initial loss, enter If initial loss is too big, stay out.

Strategic Barriers Strategies designed to keep out potential competitors, for example: Maintain excess production capacity as a signal Make special deals with distributors to receive best shelf space in retail stores Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product Maintain excess production capacity as a signal to a potential entrant that they could easily saturate market and leave new entrant with little or no revenue

Legal Barriers Patents and copyrights—which can be responsible for monopoly—can also create oligopolies Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination

Measures of Market Structure Concentration ratios: Aggregated market share of the largest N firms in the industry Range: 0-100% 4 Firm Concentration ratio: Market share controlled by the largest 4 firms

Measured Industry Concentration in Manufacturing D: Not disclosed Second and third columns: Percentage in value added in the industry Last column: Herfindahl index from the 50 largest firms Data based on the 2002 Economic Census. http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13

Measured Industry Concentration in Manufacturing D: Not disclosed Data based on the 2002 Economic Census. http://factfinder.census.gov/servlet/IBQTable?_bm=y&-geo_id=&-ds_name=EC0231SR13

Oligopoly vs. Other Market Structures Oligopoly presents the greatest challenge to economists essence of oligopoly is strategic interdependence economists have had to modify the tools used to analyze other market structures and to develop entirely new tools as well One approach—game theory—has yielded rich insights into oligopoly behavior

The Game Theory Approach An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves Elements Players Strategies Payoffs Pay off matrix Game tree

Game Theory Approach Some situations to which game theory can be applied: firms competing for business political candidates competing for votes animals fighting over prey bidders competing in an auction legislators' voting behavior under pressure from interest groups game theory can be used to illuminate economic, political, and biological phenomena.

Game Theory – Short History John Von Neumann (1903-1957) “Theory of Games and Economic Behavior” with Oskar Morgenstern This book established game theory as a field “An introduction to game theory” by Martin J. Osborne. Oxford University Press, 2002

Game Theory – Short History John F. Nash, Jr.(1928- ) One of the contributions is the introduction of the equilibrium notion now known as Nash equilibrium 1994 Nobel prize winner in economics with the game theorists John Harsanyi and Reinhard Selten “An introduction to game theory” by Martin J. Osborne. Oxford University Press, 2002

The Prisoner’s Dilemma Simple example to explain why a technique for obtaining confessions, commonly used by police, is so often successful Payoff matrix Players: Rose and Colin Payoffs: number in the matrix Strategies: Confess (C) / not confess (NC) for either of the players

Figure 2: The Prisoner’s Dilemma How to read the matrix? Players:{Rose, Colin} Strategies:{C, NC} Payoffs What will Rose do? What will Colin do? Rose Colin C NC -20, -20 -3, -30 -30, -3 -5, -5

The Prisoner’s Dilemma A dominant strategy: the player’s best strategy regardless of the other player’s strategy Rose’s dominant strategy is “confess” regardless of Colin’s choice So is Colin

Nash Equilibrium Outcome of this game is an example of a Nash equilibrium Exists when each player is taking the best action—given best actions taken by other players Under the Nash Equilibrium, no players want to deviate

Figure 3: Working on a joint project Elements Players:{you, your friend} Strategies:{work hard, Goof off} Payoffs What is the Nash Equilibrium? Friend You W G 2, 2 0, 3 3, 0 1, 1

Figure 4: Battle of Sex Elements What is the Nash Equilibrium? Mr. R Players:{Mr. R and Mrs. R} Strategies:{ go shopping, watch a baseball game} Payoffs What is the Nash Equilibrium? Mr. R Mrs. R S B 2, 1 0, 0 1, 2

Figure 5: Duopoly Elements What is the Nash Equilibrium? Firm A Firm B Players:{Firm A, Firm B} Strategies:{ Low price, High price} Payoffs What is the Nash Equilibrium? Firm A Firm B L H 10, 10 40, -5 -5, 40 20, 20

Simple Oligopoly Games - Duopoly Duopoly - oligopoly market with only two sellers Assume that Firm A and B must make their decisions independently Without knowing in advance what the other will do A’s dominant strategy is to charge a low price So is B’s dominant strategy Outcome is a Nash equilibrium (Low, Low)

Example: Price Competition for Duopoly Duopoly firms A & B have the same cost structure, produce the undifferentiated goods. Suppose the MC and ATC is constant, equal to c. If the two firms are going to set price to maximize their profit, what is the Nash equilibrium?

Oligopoly Games in the Real World Typically more than two strategies Usually more than two players In some games, one or more players may not have a dominant strategy A game with two players will have a Nash equilibrium as long as at least one player has a dominant strategy When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

Oligopoly Games in the Real World -- Static v.s. Dynamic We’ve limited the players to one play of the game In reality, for gas stations and almost all other oligopolies, there is repeated play Where both players select a strategy Observe the outcome of the trial Play the game again and again, as long as they remain rivals

Oligopoly Games in the Real World -- Cooperation in the long run One possible result of repeated trials is cooperative behavior Results may be very different from equilibrium in a game played only once Explicit collusion Simplest Managers meet face-to-face to decide how to set prices Tacit collusion No formal discussion

Explicit Collusion Most extreme form is creation of a cartel Group of firms that tries to maximize total profits of the group as a whole OPEC However, it is not commonly observed. Why? Usually illegal in U.S.A., EU & most of developed countries Penalties, if the oligopolists are caught, can be severe But oligopolists can collude in other, implicit ways

Tacit Collusion Two most common forms Tit for tat Price Leadership A game-theoretic strategy of doing to another player this period what he has done to you in previous period Price Leadership One firm—the price leader—sets its price and other sellers copy that price

Tacit Collusion - Tit For Tat Prominent in airline industry However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion Oligopolist will sometimes go further Attempting to punish a firm that threatens to destroy tacit cooperation Lead to price wars

Tacit Collusion – Price Leadership No formal agreement Rather the decisions come about because firms realize—without formal discussion—that system benefits all of them

The Limits to Collusion Oligopoly power—even with collusion—has its limits demand constraints collusion—even when it is tacit—may be illegal collusion is limited by powerful incentives to cheat on any agreement

The Incentive to Cheat Will firm stick to the collusion? Maybe, and maybe not Problem—each player may conclude that he can do even better by cheating, Figure 5 Two players would be back to non-cooperative outcome based on their dominant strategies May be in each player’s interest to cheat occasionally Analyzing this sort of behavior requires some rather sophisticated game theory models Economists are actively engaged in building them

When is Cheating Likely? While no firm wants to completely destroy a collusive agreement by cheating Since this would mean a return to the noncooperative equilibrium wherein each firm earns lower profit Some firms may be willing to risk destroying agreement if benefits are great enough Cheating is most likely to occur when there is Difficulty observing other firms’ prices Unstable market demand Large number of sellers

The Future of Oligopoly Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure Prediction has not come true Today, there are hundreds and thousands of ongoing businesses in United States Possible reasons Antitrust law Globalization of markets Technological change In 1932, two economists—Adolf Berle and Gardiner Means—noted trend toward big business Predicted the 200 largest U.S. firms would control nation’s entire economy by 1970 Unless something were done to stop it

Antitrust Legislation and Enforcement Three types of actions Preventing collusive agreements among firms Such as price-fixing agreements Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers Preventing mergers that would lead to harmful market domination While thrust of these policies is to preserve competition Type of competition preserved—and zeal with which policies are applied—can shift Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws

The Globalization of Markets Globalization introduces competition By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods While consumers in each nation may have access to more firms, these may be larger and more powerful firms Creating greater likelihood of strategic interaction and danger of collusion Although oligopolists often try to prevent it, they face increasingly stiff competition from foreign producers

Technological Change Technological change works To increase competition by creating new substitute goods To reduce barriers to entry To increase size of market However, technologies on the other hand encourage oligopoly by actually increasing MES of typical firm Result could be strategic interaction, or collusion, among large national players Thereby encouraging formation of oligopolies

The Four Market Structures: A Postscript Different market structures Perfect competition Monopoly Monopolistic competition Oligopoly Market structure models help us organize and understand apparent chaos of real-world markets

Summary on four types of market

Summary Oligopoly market characteristics Measure of market structure Small number of large strategically interdependent firms No free entry or exit Either differentiated or standardized products Measure of market structure Barriers to enter the oligopoly market Favorable reputation / legal / strategy / substantial economy of scale Game theory approach to duopoly Dominant strategy Nash equilibrium Prisoner’s dilemma Repeated game: cooperative collusion Explicit : Cartel Implicit : Tit – for – Tat ; Price leadership Cheating Future of oligopoly depends on Antitrust legislation / globalization of market / technological change