Market Structures:Oligopoly

Imperfect Competition

• The spectrum of competition: Perfect Comp. ------------- Monopoly Monop. Comp.-- Oligopoly • Assumptions underlying oligopoly

– Few Sellers• Interdependence – each seller must be aware that their actions will

provoke actions by rival firms

– Differentiated versus non-differentiated products (cars or oil• Differentiated products leads to non-price competition through

activities such as advertising, style changes, quality

Oligopoly• Price competition vs. non-price competition

– Interdependence in pricing means that price wars may develop and reduce profits

– Product differentiation avoids price competition– Advertising is used to increase market share

• Informative • Persuasive (self-cancelling)

• Modeling oligopoly is difficult because interdependence can lead to different behaviors

Duopoly Example

• Assumptions – Two producers: Jack and Jill

– Zero marginal costs – (for simplicity revenue=profits

• Outcomes– Competition: Maximum production, zero

price(remember there are no costs) , and no profits

– Monopoly: Reduced Output, highest price, positive profits

– Oligopoly: Let the games begin!

Table 1 The Demand Schedule for Water

Copyright © 2004 South-Western

-Jack and Jill collude with 30 gals each Profit max = $3,600 split two ways $1,800-Jack assumes Jill will stay at 30 gals, increases production to 40 gals. price falls to $50, Jack’s profit rises to $2,000, but Jill may do the same and price falls to $40, both make $1,600-If Jack tries to increase to 50 gals, price falls to $30 and his profits go to $1,500

Table 1 The Demand Schedule for Water

Copyright © 2004 South-Western

-At 40 gals. Neither Jacknor Jill have an incentiveto change production.-Nash Equilibrium :choose the best strategy given the strategies that theother economic agents have chosen.-Note: when firms in aduopoly act to max. profitthey chose a level of outputless than a competitive firmbut more than a monopolistwould produce.

• Duopoly (cont.)– Collusion – form a cartel and act like a monopolist –

highest economic profit, in most cases in the US, this is illegal.

– Pursuing own self-interest – actions depend on what you think the other will do: not react or react

• The incentive to “cheat”:– If you produce more (or charge a lower price and sell more),

assuming MR>MC, your profits will rise, that is, if the other firm does not do the same thing.

• The incentive to “cooperate”– If you produce more (or charge a lower price and sell more), the

other firm will do the same, and your profits will fall

Oligopolist’s Supply Decision

• Raising (or lowering) output produces two effects:– Output effect: because P>MC, the additional output will raise profits– Price effect: additional output will lower the price and reduce profits

on all those units that would have been sold at the old price

• Rules for action:– Raise output if OE>PE– Don’t raise output if OE<PE

• As the number of firms increases, the PE falls, so output is increased, many firms produce the competitive or efficient solution.– Freer trade has resulted in increasing number of firms in the

automobile market, the camera market, and the electronics markets.

Cartels

• Explicit agreements among firms to fix output and prices• Examples are OPEC, Electrical Conspiracy (Econ USA),

Shipping Cartel• Incentive to cooperate – earn monopoly profits• Incentive to cheat – increase individual profits if cheating is

not detected or punished.• Sources of instability in cartels:

– Number of Sellers– Cost differences– Potential competition– Recessions– Cheating

Links

• http://www.sunship.com/mideast/oil.html

• http://www.eia.doe.gov/emeu/cabs/chron.html

• http://www.naseo.org/energy_sectors/fossil/oil/Supply_Graphs.htm#Prices,%201973-97

Game Theory

• Game theory is an attempt to model and understand behavior given the presence of interdependence

• Games have the following characteristics:– Rules– Strategies– Payoffs– Outcome

The Prisoner’s Dilemma

• Two criminals, Bill and Paul, are caught red-handed stealing a car, and will receive 2 year sentences; however, they become suspects in a previous bank robbery. The DA’s job is to see if he can solve the bank robbery.– Rules:

• Each player is held in separate rooms and cannot communicate.

• Each is told that he is suspected of the larger crime and– if both confess to the bank robbery, they get 5 year sentences– if one rats on the other and the other does not confess to the bank

robbery, he gets off, and the other gets a 10 year sentence

– Strategies: Each player has two possible actions• Confess to the bank robbery

• Do not confess to the bank robbery

– Payoffs: Two players with two outcomes four possible outcomes with the following payoffs

• Both confess – each get 5 year sentences

• Both deny – each get 2 year sentence

• Bill confesses and Paul denies – Bill gets off and Paul gets 10 years

• Paul confesses and Bill denies – Paul gets off and Bill gets 10 years.

BILL

PAUL

ConfessDeny

Confess

Deny

5 years 10 years

5 years Off

Off 2 years

10 years 2 years

Bill

Paul

Paul – if Bill confesses I should too (5 vs 10), if Bill denies, I shouldstill confess (off vs 2)Bill – if Paul confesses I should too (5 vs 10); if Paul doesn’t. I should still confess (off vs 2)

• Nash Equilibrium – the player does what is best for himself after he takes into account the other players’ actions.

• Dominant solution – the outcome that is better than all the rest.

• Dominant solution for Paul is to confess and the same is true for Bill.

• The ‘best’ solution for both is to cooperate, but the dilemma is that they can’t so they end up with a second best solution.

Kinked Demand Curve Model

• Show a situation where the best situation for players is to maintain current prices and that prices remain stable in spite of firms with different cost structures.

• Asymmetry in price movements:– If firm raises price, no one follows, therefore quantity demanded is

elastic

– If firm lowers price, all follow suit so the quantity demanded is quite inelastic

• Marginal revenue curve is discontinuous and allows for various marginal cost curves.

Kinked Demand Curve

– If the firm raises its price above P, it faces an elastic demand curve, payoff low

– If the firm lowers its price below P, it faces an inelastic demand curve, payoff low

Kinked Demand Curve– Different firms can have

different MCs. As long as they fall with in the discontinuous MR, P will remain stable.

– Output Effect < Price Effect for price movements with the discontinuous MR curve.

– If MC increases enough, all firms raise their prices and the kink vanishes.

Dominant Firm Price Leadership

• A large dominant firm with lower costs that it competitors becomes the price maker.

• A competitive fringe with many firms that are price takers or followers.

• The dominant firm’s demand curve is the total market demand minus the supply of the competitive fringe.

• The dominant firm sets price and its quantity based upon residual demand and this determines the price for competitive firms and their supply. (Examples OPEC).

Dominant Firm– The large firm can set the price and receives a marginal

revenue that is less than price along the curve MR.

ResidualDemand

Dominant Firm’sDemand Curve

Dominant Firm– As long as the dominant firm has lower costs, it can act like

a monopolist over the residual demand.

Other Price Leadership Models

• Barometric price leadership - firms come to tacit agreement to allow one firm to set the price according to cost considerations. If cost move is justified, others will follow and validate the price . If not, or if some firm decides to defect, the price change will not be validated.

• Rotating price leadership – firms come to tacit agreement to allow the price leading firm to rotate among key players in the industry.

Cartels and Government

• Monopoly power is often granted by government via regulation. Example Ma Bell (Econ USA).

• Other examples are shipping and the airline industry (pre-deregulation).

• Justifications for government regulation include infant industry and natural monopoly.

• Criticisms include decreased competition, increased costs due to x-inefficiency and lobbying, and regulation outlives its usefulness.

Measuring Market Power : Market Concentration

• One presumption is that as the number of sellers decreases, market power increases.

• Concentration Ratios – percentage of market share controlled by x number of firms, most commonly a four-firm concentration ratio

• Four-firm concentration ratio = (Sales by four largest firms in an industry/Sales by all firms in the industry) x 100

Concentration RatiosPrimary Copper 98,95

Cigarettes 93,99

Beer 90,90

Breakfast Cereals 85,83

Motor Vehicles 84,83

Greeting Cards 84

Small-arms munitions 84,89

Household Refrigerators and Freezers

82,82

Problems with Concentration Ratios

• Do not take into account foreign competition

• Fail to account for potential competition. – Contestable markets – firms are able to enter

and exit at low cost. Potential entry acts as a limit to market power.

US Auto Industry 2001GM 27

Ford 24

Daimler-Chrysler 16

Toyota 10

Honda 7

Nissan 4

Mitsubishi 2

Mazda 2

Subaru 1

Suzuki .3

4 US firms Control 67%

Japanese FirmsControl26%

WSJ 4/4/2001 and Carbaugh page 201

Mergers – Increasing Concentration

• Vertical Merger – merging with a firm that supplies inputs

• Horizontal Merger – merging with a competitor • Conglomerate Merger –merging with firms that

are not related• Successful mergers – Boeing and McDonnell-

Douglas• Unsuccessful Mergers – AOL Time Warner