1. OLIGOPOLY Managerial Economics Lecturer: Jack Wu

2. S AMSUNG E LECTRONICS Oligopoly: Market with a small number of sellers who behave strategically Samsung How to adjust pricing and capacity as Korean Won appreciates against U.S. dollar? 2 (c) 1999-2012, I.P.L. Png

3. O UTLINE Price competition Limit pricing Capacity competition Capacity leadership 3

4. STRATEGIC VARIABLE FOR OLIGOPOLISTIC SELLERS In the short run, the strategic variable for oligopolistic sellers is price. In the long run, the strategic variable for oligopolistic sellers is production capacity.

5. PRICE COMPETITION The outcome of oligopolistic competition on price depends on whether the product is homogeneous or differentiated.

6. BENCHMARK: MONOPOLY

7. PRICE COMPETITION: HOMOGENEOUS PRODUCT Simple Case: Duopoly in Wireless Telecommunication Luna Cellular and Mercury Wireless – Produce at constant marginal cost with unlimited capacity – Compete on price to sell a homogeneous product. 7

8. BERTRAND MODEL Under these conditions, the market equilibrium is perfectly competitive. Even though the industry is duopoly, the outcome is the same as with perfect competition. Demand curve is infinitely elastic with respect to a price cut. Extreme competition – selling undifferentiated commodities Game in strategic form – competing sellers set prices simultaneously.

9. PRICE COMPETITION: HOMOGENEOUS PRODUCT Marginal cost = $30 per subscriber per month Suppose that Luna charges $32. Mercury has three choices: Price > $32: no customers Price = $32: split the market demand in half Price < $32: gain the whole market – the best strategy. Nash equilibrium: Both sellers charge price = $30 (marginal cost). 9

10. PRICE COMPETITION: DIFFERENTIATED PRODUCTS Case: Luna Cellular and Mercury Wireless – Produce at constant marginal cost with unlimited capacity – Compete on price to sell a product differentiated by distance from consumer. – The price cutter’s demand is not infinitely elastic. 10

11. HOTELLING MODEL Suppose that consumers are located uniformly along a street one mile long, with the Luna and Mercury dealers at each end of the street. Assumption: Differentiation is due to the difference in the consumer’s distances from the two dealers. The competing products are differentiated by location. Game in strategic form – competing sellers set prices simultaneously

12. PRICE COMPETITION: DIFFERENTIATED PRODUCTS Residual demand: Demand given the actions of competing sellers. Given Mercury's price and any price that Luna could set Consumers relatively closer to Luna would buy from Luna Consumers relatively closer to Mercury would buy from Mercury Residual demand curve slopes downward If Luna raises price, some consumers (located relatively far from Luna) would switch to Mercury 12

13. P RICE COMPETITION : D IFFERENTIATED PRODUCTS

14. Luna’s profit maximum Produce at scale where residual marginal revenue = marginal cost Set price accordingly – as function of Mercury’s price Best response function: Seller’s best action as a function of the actions of competing sellers. 14

15. P RICE COMPETITION : D IFFERENTIATED PRODUCTS 15

16. PRICE COMPETITION: DIFFERENTIATED PRODUCTS In fact, Hotelling model applies to differentiation in terms of any attribute on which consumers have differing preferences. “Transport cost” = consumer’s disutility from consuming any attribute that differs from the ideal or most preferred= strength of consumer preference Extreme case: : zero transport cost => consumers consider that products are homogeneous => Hotelling model collapses to Bertrand model Higher transport cost (stronger consumer preference) Residual demand more inelastic => higher price Best-response function shifts toward higher prices Nash Equilibrium: Higher prices 16

17. PRICE COMPETITION: DIFFERENTIATED PRODUCTS Higher demand Higher residual demand Best-response function shifts toward higher prices Nash Equilibrium: Higher prices Higher marginal cost Best-response function shifts toward higher prices Nash Equilibrium: Higher prices 17

18. STRATEGIC COMPLEMENTS Strategic complements: Adjustment by one party leads other parties to adjust in the same direction Hotelling model : Prices are strategic complements Best-response functions slope upward 18

19. LIMIT PRICING What if one seller can act before others? Game in extensive form – competing sellers set prices in sequence 19

20. LIMIT PRICING Limit pricing Entrant must incur fixed cost of production Set such price so low that potential competitor’s residual demand is so low that potential competitor cannot break even. 20

21. LIMIT PRICING

22. Luna’s average cost curve is “U” shaped because of fixed cost Mercury (incumbent, first-mover) sets its price so that: Luna’s (entrant) residual demand curve is below its average cost curve

23. LIMIT PRICING Limit pricing – Necessary conditions Production requires substantial fixed cost Leader’s price must be credible Potential competitors must believe that leader will not change price if potential competitor enters For leader, must be more profitable to produce at entry-deterring price than to accommodate entry and produce an equal share with competitors. 23

24. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT Luna Cellular and Mercury Wireless Produce at constant marginal cost Compete on capacity to sell a homogeneous product Game in strategic form – competing sellers set capacities simultaneously Cournot Model : The market price equates the demand with the total capacity offered by the two providers. 24

25. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT Residual demand: Demand given the actions of competing sellers. Given Mercury’s capacity, Luna’s residual demand curve slopes downward Luna’s profit maximum Produce at scale where residual marginal revenue = marginal cost Set capacity accordingly – as function of Mercury’s capacity 25

26. C APACITY COMPETITION : H OMOGENEOUS PRODUCT

27. Best response function: Seller’s best action as a function of the actions of competing sellers.

28. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT Higher demand Higher residual demand Best-response function shifts toward higher capacity Nash Equilibrium: Higher capacities Higher marginal cost Best-response function shifts toward lower capacity Nash Equilibrium: Lower capacities Seller with lower cost gains Directly, from lower cost (Strategic response) Forces competitor to reduce capacity 28

29. STRATEGIC SUBSTITUTES Strategic substitutes: Adjustment by one party leads other parties to adjust in opposite direction Cournot model : Capacities are strategic substitutes Best-response functions slope downward 29

30. STRATEGIC COMPLEMENTS OR SUBSTITUTES? Generally, there may be either strategic complements or strategic substitutes depending on the relevant demand and cost conditions. Examples: Advertising & R&D Increased R&D spending can have a similar effect to increasing capacity. On the other hand, an increase in one seller’s R&D spending may drive competitors to increase R&D as well, particularly when they compete for patents. So, R&D spending might be strategic complements or strategic substitutes depending on circumstances.

31. CAPACITY LEADERSHIP What if one seller can act before others? Game in extensive form – competing sellers set capacities in sequence Stackelberg model : Leader commits to capacity to grab larger share. Trade-off Larger market share => higher profit Larger total capacity (all producers) => Lower profit Leader does not drive out competitor, simply reduces the follower’s share 31

32. CAPACITY LEADERSHIP

33. First mover advantage Necessary conditions -- Leader’s capacity must be credible Potential competitors must believe that leader will not change capacity if potential competitor enters For leader, must be more profitable to produce at Stackelberg capacity than to accommodate entry and produce an equal share with competitors. 33