t h i r t e e n c h a p t e r © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn Quijano Oligopoly: Firms in Less Competitive Markets

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 2 of 21 After studying this chapter, you should be able to: Show how barriers to entry explain the existence of oligopolies. Use game theory to analyze the actions of oligopolistic firms. Use a sequential games to analyze business strategies. Use the five competitive forces model to analyze competition in an industry. Competing with Wal-Mart LEARNING OBJECTIVES … In an oligopoly, a firm’s profitability depends crucially on its interactions with other firms.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 3 of 21 Oligopoly Oligopoly A market structure in which a small number of interdependent firms compete. The approach we use to analyze competition among oligopolists is called game theory.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 4 of 21 Oligopoly and Barriers to Entry Barriers to Entry LEARNING OBJECTIVE 1 Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits. Examples of Oligopolies in Retail Trade and Manufacturing RETAIL TRADEMANUFACTURING INDUSTRY FOUR-FIRM CONCENTRATION RATIO INDUSTRY FOUR-FIRM CONCENTRATION RATIO Warehouse Clubs and Superstores 90%Cigarettes99% Discount Department Stores88%Beer90% Hobby, Toy, and Game Stores 70%Aircraft85% Radio, Television, and Other Electronic Stores 62%Breakfast Cereal83% Athletic Footwear Stores62%Automobiles80% College Bookstores58%Dog and Cat Food58% Pharmacies and Drugstores47%Computers45%

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 5 of 21 Oligopoly and Barriers to Entry Barriers to Entry Economies of scale Economies of scale exist when a firm’s long-run average costs fall as it increases output Economies of Scale Help Determine the Extent of Competition in an Industry

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 6 of 21 Oligopoly and Barriers to Entry Barriers to Entry In addition to economies of scale, other barriers to entry include: Ownership of a key input Government–Imposed Barriers Patent The exclusive right to a product for a period of 20 years from the date the product was invented.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 7 of 21 Using Game Theory to Analyze Oligopoly LEARNING OBJECTIVE 2 Game theory The study of how people make decisions in situations where attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms. Key characteristics of all games: 1.Rules that determine what actions are allowable. 2.Strategies that players employ to attain their objectives in the game. 3.Payoffs that are the results of the interaction among the players’ strategies. Business strategy Actions taken by a business firm to achieve a goal, such as maximizing profits.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 8 of 21 Using Game Theory to Analyze Oligopoly A Duopoly Game: Price Competition between Two Firms Payoff matrix A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Collusion An agreement among firms to charge the same price, or to otherwise not compete A Duopoly Game

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 9 of 21 Using Game Theory to Analyze Oligopoly A Duopoly Game: Price Competition between Two Firms Dominant Strategy A strategy that is the best for a firm, no matter what strategies other firms use. Nash equilibrium A situation where each firm chooses the best strategy, given the strategies chosen by other firms. In the film, A Beautiful Mind, Russell Crowe played John Nash, winner of the Nobel Prize in Economics. A Beautiful Mind: Game Theory Goes to the Movies

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 10 of 21 Using Game Theory to Analyze Oligopoly Firm Behavior and the Prisoners’ Dilemma Cooperative equilibrium An equilibrium in a game in which players cooperate to increase their mutual payoff. Noncooperative equilibrium An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoners’ dilemma A game where pursuing dominant strategies results in noncooperation that leaves everyone worse off.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 11 of 21 Is Advertising a Prisoners’ Dilemma for Coca-Cola and Pepsi? LEARNING OBJECTIVE 2 On eBay, bidding the maximum value you place on an item is a dominant strategy. Is There a Dominant Strategy for Bidding on eBay? Advertising is the optimal decision for both firms, given the decision by the other firm.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 12 of 21 Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoners’ Dilemma? Changing the Payoff Matrix in a Repeated Game The airlines have trouble raising the price this business traveler pays for a ticket. American Airlines and Northwest Airlines Fail to Cooperate on a Price Increase

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 13 of 21 Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC Cartel A group of firms that colludes by agreeing to restrict output to increase prices and profits World Oil Prices Sustaining high prices has been difficult because members often exceed their output quotas.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 14 of 21 Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC The equilibrium of this game will occur with Saudi Arabia producing a low output and Nigeria producing a high output. The OPEC Cartel with Unequal Members

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 15 of 21 Sequential Games LEARNING OBJECTIVE The Decision Tree for an Entry Game The best decision for Wal-Mart is to build a large store to deter Target’s entry. Deterring Entry

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 16 of 21 Is Deterring Entry Always a Good Idea? LEARNING OBJECTIVE 4 In this case, Wal-Mart will build a small store and Target will enter. Deterrence is only worth pursuing if its costs are not too high.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 17 of 21 Sequential Games The Decision Tree for a Bargaining Game Bargaining

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 18 of 21 The Five Competitive Forces Model LEARNING OBJECTIVE The Five Competitive Forces Model

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 19 of 21 Is Business Strategy More Important Than the Structure of the Airline Industry? Southwest’s business strategy allowed it to remain profitable when many other airlines faced heavy losses.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 20 of 21

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 13: Oligopoly: Firms in Less Competitive Markets 21 of 21 Barrier to entry Business strategy Cartel Collusion Cooperative equilibrium Dominant strategy Economies of scale Game theory Nash equilibrium Noncooperative equilibrium Oligopoly Patent Payoff matrix Prisoners’ dilemma