Economics for Managersby Paul Farnhamy

Chapter 9Market Structure: Oligopoly

9.1© 2005 Prentice Hall, Inc.

OligopolyOligopoly

A market structure characterized byA market structure characterized by competition among a small

number of large firms that have gmarket power, but that must take

their rivals’ actions into id ti h d l iconsideration when developing

their competitive strategies

9.2© 2005 Prentice Hall, Inc.

Characteristicsf Oli lof an Oligopoly

Firms have market power derived from barriers to entryyHowever, a small number of firms compete with each othercompete with each otherEach firm doesn’t have to consider the actions of otherconsider the actions of other firms, thus, behavior is interdependent

9.3© 2005 Prentice Hall, Inc.

interdependent

Noncooperative Oli l M d lOligopoly Models

Assumes that firms pursue profit-maximizing strategies based on g gassumptions about rivals’ behavior and the impact of this behavior on th i fi ’ t t ithe given firm’s strategies 1. Kinked demand curve model2. Game theory models3 Strategic entr deterrence

9.4© 2005 Prentice Hall, Inc.

3. Strategic entry deterrence

Kinked Demand C M d lCurve Model

Assumes that a firm is faced with two demand curves, assuming

fthat other firms will not match price increases but will match price decreasesprice decreasesIf the firm considers raising the price above P1, its quantity demanded will depend upon the beha ior of ri al firms

9.5© 2005 Prentice Hall, Inc.

behavior of rival firms

Kinked Demand C M d lCurve Model

Assumes that managers will inflict maximum damage on other firmsgImplies oligopoly prices tend to be “sticky” and not change asbe sticky and not change as they would in other market structuresDoes not explain why price P1exists initially

9.6© 2005 Prentice Hall, Inc.

exists initially

Kinked Demand CurveKinked Demand Curve

Figure 9.1g

MC

P1 MR2MR2D2 = Rivals don’t follow

Q0 Q

D1 = rivals followMR1

9.7© 2005 Prentice Hall, Inc.

Q0 Q1

Game Theory ModelsGame Theory Models

Mathematically analyzes situations in which players make various strategic moves and have different outcomes ormoves and have different outcomes or payoffs associated with those movesDominant strategy: results in best o a t st ategy esu ts bestoutcome to a given player

9.8© 2005 Prentice Hall, Inc.

Nash EquilibriumNash Equilibrium

Strategies for which all players are choosing their best strategy, g gy,given actions of other playersProves useful when there is onlyProves useful when there is only one unique equilibrium in the gamegThere may be multiple Nash equilibrium

9.9© 2005 Prentice Hall, Inc.

equilibrium

Strategic Entry D tDeterrence

Policies that prevent rivals from entering the marketg

• Limit pricing: charging a price lower than the profit-maximizinglower than the profit maximizing price

• Predatory pricing: lowering pricesPredatory pricing: lowering prices below cost to drive out existing competitors and scare off

9.10© 2005 Prentice Hall, Inc.

potential entrants

Limit Pricing ModelLimit Pricing ModelFigure 9.2

Potential Entrant

ATC

Established FirmMCATCEN

PM A CPL

ATCMATCL

ATCBPL

0

ATCL

0 Q Q

F

9.11© 2005 Prentice Hall, Inc.

0Q

0 Q1 Q2

Limit Pricing ModelLimit Pricing Model

Assumes existing firms have lower costsAttracts other firms into the industryindustry Established firms can thwart entry by charging the limit price (or aby charging the limit price (or a lower price) rather than profit-maximization price

9.12© 2005 Prentice Hall, Inc.

maximization price

Predatory PricingPredatory PricingFigure 9.3

KT L

PUS

LRAC = LRMCT

JL

GR SPC

PJ

MN

DemandPP

MR

Demand

09.13© 2005 Prentice Hall, Inc.

Q0 QUS QPQPP QC E

Determinates of Successful P d t P i iPredatory Pricing

How far the predatory price is below costPeriod of time in which the predatory price is in effectRate of return used for judging theRate of return used for judging the investment in predatory pricingHow many rivals enter the industryHow many rivals enter the industry after predation endsTime over which recouping of profits

9.14© 2005 Prentice Hall, Inc.

p g poccurs

Cooperative Oligopoly M d lModels

Focus on cooperative behavior among rivalsgTwo types

C t l• Cartels• Tacit collusion

9.15© 2005 Prentice Hall, Inc.

CartelsCartels

Firms that get together and agree to coordinate behavior regarding pricing and output decisionsand output decisionsJoint profit maximization: strategy that maximizes profits for a cartel but may a es p o ts o a ca te but aycreate incentives for individual members to cheatH i t l ti f i l tHorizontal summation of marginal cost curve: calculated from marginal cost curve for the cartel

9.16© 2005 Prentice Hall, Inc.

Allocation Rule for Joint P fit M i i tiProfit Maximization

MC1 = MC2 = MC3

whereMC Fi #1’ i l t

MC2 = Firm #2’s marginal cost

MC1 = Firm #1’s marginal cost

MC2 Firm #2 s marginal cost

MCC = Cartel’s marginal cost

9.17© 2005 Prentice Hall, Inc.

When a Carteli S f lis Successful

It can raise market price without inducing significant competition f t l bfrom non-cartel membersThe expected punishment from f i th t l i l l tiforming the cartel is low relative to the expected gainsTh t f t bli hi dThe costs of establishing and enforcing agreement are low relative to the gains

9.18© 2005 Prentice Hall, Inc.

relative to the gains

Tacit CollusionTacit Collusion

Tacit collusion: coordinated behavior that is an achieved without a formal agreementagreementTacit collusion practices:

Uniform prices• Uniform prices• Penalty for price discounts

Advantage notice of price changes• Advantage notice of price changes• Information exchanges

Swaps and exchanges

9.19© 2005 Prentice Hall, Inc.

• Swaps and exchanges

Managerial Rule of Thumb: di d iCoordinated Actions

Managers must• Coordinate efforts, but withinCoordinate efforts, but within

constraints of antitrust legislation• Recognize incentives for cheating g g

in coordinated behavior• Remember that even coordinated

ff fl i i hefforts are fleeting, given the dynamic and competitive nature of a market environment

9.20© 2005 Prentice Hall, Inc.

a market environment

Summary of Key TermsSummary of Key Terms

C t lCartelCooperative oligopoly modelsDominant strategyGame theoryGame theoryHorizontal summation of marginal cost curvescost curvesJoint profit maximization

9.21© 2005 Prentice Hall, Inc.

Kinked demand curve model

Summary of Key TermsSummary of Key Terms

Limit pricingLimit pricingNash equilibriumNoncooperative oligopoly modelsOligopolyg yPredatory pricingStrategic entry deterrenceStrategic entry deterrenceTacit collusion

9.22© 2005 Prentice Hall, Inc.

Do you haveany questions?

9.23© 2005 Prentice Hall, Inc.