1 Chapter 11 Oligopoly. 2 Define market structures Number of sellers Product differentiation Barrier...

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Chapter 11

Oligopoly

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Define market structures

Number of sellers Product differentiation Barrier to entry

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Types of Market Structure

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Oligopoly:

A small number of firms mutually dependent on one another, and each has a substantial market share

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Characteristics of Oligopoly

mutual dependence

(or interdependence) each firm has a substantial market

share, thus is big enough to affect market price

barriers to entry

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Barriers to entry:

Entry limiting pricing Capacity barrier Economies of scope New product development

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Barriers to entry: strategic deterrence

Entry limiting pricing Capacity barrier Economies of scope New product development

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Entry limiting pricing

if cost situation allows,

set P< min LAC

of the potential entrant

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Capacity barrier

Keep excess capacity as a threat for larger Q and lower P.

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Other barriers:

Economies of scope (multi-product cost barrier) new product development

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Economic Theories

General Equilibrium theory Mechanism Design theory Decision theory

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General Equilibrium theory

a relatively large number of individual consumers and producers, how the combined individual efforts help define the environment

trade and production (markets) macroeconomic analysis

– monetary or tax policy– stock markets– interest and exchange rates– trade policy and the role of

international trade agreements

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Mechanism Design theory

the consequences of different types of rules

the design of compensation and wage agreements that effectively spread risk while maintaining incentives, and the design of actions to maximize revenue, or achieve other goals.

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Decision theory

theory of one person behavior, or a single player against a big environment.

preferences among alternatives, maximization of benefits and minimization of costs

**how best to acquire information before making a decision.

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Game Theory

Psychologists:

the theory of social situations

focus on how groups of people interact

study of behavior in situations of interdependence

Key characteristic:

Interdependence

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Interdependencies

In making choices, people must consider the effect of their behavior on others.

In making decisions, firms may consider how rivals will respond to their price changes or new advertising.

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Basic Elements of a Game

The playersTheir strategiesThe payoffs

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The Prisoners’ Dilemma

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Nash Equilibrium

Dominant vs. Dominated Strategy:dominant: a strategy that yields a higher payoff no matter what the other players in a game choosedominated: Any other strategy available

Nash equilibrium occurs when each player has a dominant strategy and follows that strategy

There can be an equilibrium when players do not have a dominant strategy

Prisoner’s dilemma: A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

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Raise ad spending Keep same ad spending

Raise adspending

Same spending

$5,500 $5,500 for for American

$5,500 $5,500 for United United

American’s Choices

$2,000 $2,000 for Americanfor American

$8,000 $8,000 for Unitedfor United

$6,$6,000 for Americanfor American

$6,$6,000 for Unitedfor United



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The Payoff Matrix for an Advertising Game

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Dominant Strategies

United: increase ad spending American: increase ad spending

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Equilibrium When One Player Lacks a Dominant Strategy

Raise ad spending Leave ad spending same

Raise adspending

Leave adspendingthe same










United’s Choices

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Strategies:

American: dominant – increase ad spending

United: no dominant strategy:– If American increases ad spending, United

should not increase ad spending– If American does not increase ad spending,

United should increase ad spending Nash Equilibrium: American increases ad

spending (dominant strategy), and United does not increase ad spending

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Exercise 11.1, P. 287

Does each company have a dominant strategy?

What each company should do?

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Two main branches of game theory

cooperative: all parties involved cooperate (collude) to achieve best result for all

non-cooperative: how intelligent individuals interact with one another in an effort to achieve their own goals.

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With Mutual Dependence

uncertainty in D and MR– decisions have to take into account of

reactions from others. Cooperative: follow changes initiated by

rivals Non-cooperative: do not accommodate

price changes of other firms

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Recall: The Prisoners’ Dilemma

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Non-Cooperative Oligopoly

Each acts for its own benefit, not for the benefits of all players

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The desire for non-cooperation:

The Prisoners’ Dilemma

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Raise ad spending Keep same ad spending

Raise adspending

Leave adspendingthe same


$5,500 $5,500 for United United




$6,$6,000 for Americanfor American

$6,$6,000 for Unitedfor United



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ho

ices

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ho

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The desire for non-cooperation: The Prisoners’ Dilemma

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The desire for non-cooperation: Advertiser’s Dilemma

Gp = 600

Gc = 600

Gp = 900

Gc = -400

Gp = -400

Gc = 900

Gp = 200

Gc = 200

Low Budget

High Budget

Low

B

ud

get

Hig

h

Bu

dg

et

Pepsi

Cok

e

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Cooperation

The best result for all players

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Cooperative:

Openly or secretly enter into contract to act for the best result for all members

Partners of a game Tendency to cheat

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Cooperative Oligopoly: in general

With homogenous products:

behave as monopoly With differentiated products:

– harder to cooperate; – specific agreement in difference in price or

quality;

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Cooperative Methods

Price Leadership:

one firm sets a price that the other firms follow

Tacit Collusion:

agreement without explicit communication

cooperation without explicit agreement Cartel: an extreme case

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Cooperative Oligopoly: Cartel

A group of firms with the objective of limiting competitive forces within a market

A coalition of firms that agrees to restrict output for the purpose of earning an economic profit

A collusive agreement by several producers that increases their combined profits by deciding how much each firm should produce

example: OPEC

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Cartel: Output Allocation among Members – market sharing

Pre-cartel sales Production capacity Bargaining power Importance Marginal cost

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Market Sharing based on MC

In order to produce the profit maximizing output, a cartel should allocate production among its members so that MC for all member producers are equal, which is also equal to the common MR. That is, MR=MC1=MC2=MC3...

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Figure 11.1

Assume• 2 firms (Aquapure &

Mountain Spring)• MC = 0• Cartel is formed & agree

to split output and profits

Impact of Cartel

•Q = 1,000 bottles/day

•P = $1/bottle

•Each firm makes $500/day

The Market Demand for Mineral Water

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Figure 11.2

Aquapure lowers P

•P = $.90/bottle

•Q = 1,100 bottles/day

Mountains Spring retaliates

•P = $.90/bottle

•Both firms split 1,100 bottles/day @ $.90

•Profit for each firm = $495/day

The Temptation to Violate a Cartel Agreement

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Charge $1/bottle Charge $0.90/bottle

Charge$1/bottle

Charge$0.90/bottle

Mountain Spring

Aquapure

$990/$990/day for day for Mt. SpringMt. Spring

$0 $0 forforAquapureAquapure$500/$500/day day

for eachfor each

$0 $0 for for Mt. SpringMt. Spring

$990 $990 forforAquapureAquapure $495/$495/day day

for eachfor each

The Payoff Matrix for a Cartel Agreement

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Cartel:

There is intention to cheat Cooperation between players will

increase the payoff in a prisoner’s dilemma

With time there is a motive to enforce cooperation

Explicit agreement is illegal (antitrust; anti price-fixing)

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Policy Implication: Cigarette Advertising

Advertise on TV Don’t advertise on TV

Advertise on TV

Don’tAdvertiseon TV

$5 $5 million/yrmillion/yrfor Philip Morrisfor Philip Morris

$10 $10 million/yrmillion/yr for for each

$35 $35 million/yrmillion/yr for RJRfor RJR

Philip Morris

RJR

$$20 million/yrmillion/yr for eachfor each$35 $35 million/yrmillion/yr

for for Philip Morris Morris

$5 $5 million/yr/yr for RJRfor RJR

1 Chapter 11 Oligopoly. 2 Define market structures Number of sellers Product differentiation Barrier...

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