Microeconomics ECON 2302 May 2009 Marilyn Spencer, Ph.D. Professor of Economics Chapter 13

Chapter 13. Oligopoly: Firms in Less Competitive Markets

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. LEARNING OBJECTIVES In an oligopoly, a firm’s profitability depends crucially on its interactions with other firms.

Oligopoly 4 Oligopoly A market structure in which a small number of interdependent firms compete. 4 The approach we use to analyze competition among oligopolists is called game theory.

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 CONCENTRATIO N RATIO Warehouse Clubs and Superstores 90%Cigarettes99% Discount Department Stores 88%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 Drugstores 47%Computers45%

Oligopoly and Barriers to Entry Barriers to Entry: 1.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

Oligopoly and Barriers to Entry Barriers to Entry: In addition to economies of scale, other barriers to entry include: 2.Ownership of a key input 3.Government–Imposed Barriers  Patent The exclusive right to a product for a period of 20 years from the date the product was invented.  Other government barriers?

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.

Game Theory 4 Key characteristics of all games: ÜRules that determine what actions are allowable. ÜStrategies that players employ to attain their objectives in the game. ÜPayoffs that are the results of the interaction among the players’ strategies. 4 Business strategy Actions taken by a business firm to achieve a goal, such as maximizing profits.

Game Theory A Duopoly Game: Price Competition between Two Firms 4 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

Game Theory A Duopoly Game: Price Competition between Two Firms 4 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.

A Beautiful Mind: Game Theory Goes to the Movies In the film, “A Beautiful Mind,” Russell Crowe played John Nash, winner of the Nobel Prize in Economics.

Game Theory Firm Behavior and the Prisoners’ Dilemma 4 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.

Is Advertising a Prisoners’ Dilemma for Coca-Cola and Pepsi? LEARNING OBJECTIVE 2 Advertising is the optimal decision for both firms, given the decision by the other firm.

Is There a Dominant Strategy for Bidding on eBay? On eBay, bidding the maximum value you place on an item is a dominant strategy.

Game Theory Can Firms Escape the Prisoners’ Dilemma? Changing the Payoff Matrix in a Repeated Game

American Airlines and Northwest Airlines Fail to Cooperate on a Price Increase The airlines have trouble raising the price this business traveler pays for a ticket.

Game Theory 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.

Game Theory 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

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

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.

Sequential Games: The Decision Tree for a Bargaining Game Bargaining

The Five Competitive Forces Model LEARNING OBJECTIVE The Five Competitive Forces Model

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.

4 Barrier to entry 4 Business strategy 4 Cartel 4 Collusion 4 Cooperative equilibrium 4 Dominant strategy 4 Economies of scale 4 Game theory 4 Nash equilibrium 4 Noncooperative equilibrium 4 Oligopoly 4 Patent 4 Payoff matrix 4 Prisoners’ dilemma

Assignments for May 28: 4 Study Ch. 14 and be able to answer: ÜReview Questions: p. 498, 1.1; p. 499, 2.1, 2.2 & 2.4; p. 500, 3.1 & 3.2; p. 501,4.1, 4.2, 5.1, 5.2 & 5.3 (1 st edition: 1-4, & 6-12 on pp ); and ÜProblems and Applications: p. 498: 1.4; p. 499: 2.6 & 2.8; p. 500, 3.6; p. 501, 4.6; p. 502, 5.4, 5.5 & 5.6 (1 st edition: 3, 4, 8, 9, 10, 11, 20 & 28 on pp ); and ÜUse game theory to explain why:  (a) sometimes an innocent person will confess to a crime;  (b) OPEC members don’t always cooperate; and  (c) countries build stockpiles of nuclear weapons to avoid nuclear war.