1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 12 Oligopoly and Strategic Behavior

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market Structures Market Structures we have investigated so far:Market Structures we have investigated so far: 1. Perfectly Competitive 2. Monopoly 3. Monopolistic Competition Now we look at the 4th:Now we look at the 4th: 4.Oligopoly

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopoly An oligopoly is a market served by a few firms.An oligopoly is a market served by a few firms. BeveragesMusicTobacco Phone Service Cars Coca-Cola (45%) Universal/ Polygram (26%) Philip Morris (49%) AT&T/TCI (47%) General Motors (29%) Pepsi (31%) Warner Music (18%) RJR Nabisco (24%) Bell Atlantic/GTE (24%) Ford (25%) Cadbury Schweppes (14%) Sony Music (17%) Brown and Williamson (15%) SBC/Ameritech (18%) Daimler Chrysler (16%) EMI Group PLC (13%) MCI WorldCom (12%) BMG Entertainment (12%)

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopoly In order to determine if a market is considered an oligopoly, we use a concentration ratioIn order to determine if a market is considered an oligopoly, we use a concentration ratio Four-firm concentration ratio = percentage of total output a market produces by the four largest firmsFour-firm concentration ratio = percentage of total output a market produces by the four largest firms if over 40%, we consider it an oligopoly if over 40%, we consider it an oligopoly We could also look at the eight-firm concentration ratioWe could also look at the eight-firm concentration ratio how would you define this term? how would you define this term?

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Concentration Ratios in Selected Manufacturing Industries Industry Four-Firm Concentration Ratio (%) Eight-Firm Concentration Ratio (%) Cigarettes93 Not available Guided missiles and space vehicles 9399 Beer and malt beverages 9098 Batteries8795 Electric bulbs 8694 Breakfast cereals 8598 Motor vehicles and car bodies 8491 Greeting cards 8488 Engines and turbines 7992 Aircraft and parts 7993

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopoly An oligopoly arises when:An oligopoly arises when: 1.If there are large indivisible inputs, it is too costly for small firms to operate, only large outputs are profitable. (remember monopoly) 2.The government may limit the number of firms in a market. 3.Sometimes a firm can not enter a market without significant amount of advertising.

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Oligopolistic Strategies In an oligopoly, firms tend to act strategicallyIn an oligopoly, firms tend to act strategically Since they produce similar products and consumers can easily switch between firms if one firm lowers a price, consumers will switchSince they produce similar products and consumers can easily switch between firms if one firm lowers a price, consumers will switch Therefore, other firms must lower prices to remain competitive Therefore, other firms must lower prices to remain competitive 2 common strategies:2 common strategies: 1. Price Fixing 2. Entry Deference

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Fixing Normally, competition between firms drives prices downNormally, competition between firms drives prices down In some markets, firms will cooperate with each other when setting pricesIn some markets, firms will cooperate with each other when setting prices cartel = a group of firms that coordinate pricing decisionscartel = a group of firms that coordinate pricing decisions These firms also need to consider ways of punishing firms who do not complyThese firms also need to consider ways of punishing firms who do not comply

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Fixing price fixing = an arrangement under which multiple firms act as one, coordinating their pricing decisionsprice fixing = an arrangement under which multiple firms act as one, coordinating their pricing decisions Price fixing is usually illegalPrice fixing is usually illegal If they didn't conspire, each firms individual demand would decrease since consumers are divided (monopoly)If they didn't conspire, each firms individual demand would decrease since consumers are divided (monopoly) as a result price must decrease to match demand as a result price must decrease to match demand

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Game Tree Two firms coordinating price decisions choose the high price. Two firms acting rationally and interdependently choose the low price. A graphical way to represent the impact of different strategies in an oligopolyA graphical way to represent the impact of different strategies in an oligopoly

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Game Tree Refer to page 256 in your text. Jack will choose the low price regardless of Jill's decisionJack will choose the low price regardless of Jill's decision Jill will choose the low price, because she knows Jack will choose the low priceJill will choose the low price, because she knows Jack will choose the low price But if they both choose the low price, they don't earn as much as they could otherwiseBut if they both choose the low price, they don't earn as much as they could otherwise Therefore, these firms will maximize profit if they both agree on the high price.Therefore, these firms will maximize profit if they both agree on the high price.

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Prisoners’ Dilemma The prisoners’ dilemma = although both criminals would be better off if they both kept quiet, they implicate each other because the police reward them for doing so.The prisoners’ dilemma = although both criminals would be better off if they both kept quiet, they implicate each other because the police reward them for doing so.

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Fixing Price fixing is difficult because participating firms need to ensure other firms in the oligopoly do not undercut, and choose the lower pricesPrice fixing is difficult because participating firms need to ensure other firms in the oligopoly do not undercut, and choose the lower prices One way to avoid under-cutting is price matchingOne way to avoid under-cutting is price matching = one firm guarantee's it will match the price of any competitor

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Guaranteed Price Matching Consider Jack and Jill again: Jill chooses the high price, but sets a price matching guaranteeJill chooses the high price, but sets a price matching guarantee Jack must decide what to do:Jack must decide what to do: Choose high price, each firm earns 7,500 Choose high price, each firm earns 7,500 Choose low price and Jill switches to the low price (price match guarantee), Jack earns only 5,000 Choose low price and Jill switches to the low price (price match guarantee), Jack earns only 5,000 Therefore it makes the most sense for Jack to choose the high priceTherefore it makes the most sense for Jack to choose the high price = Prime Fixing