Let’s say… You were one of hundreds of producers of the same type of product. How would you determine your price? 2. You were the ONLY producer of that type of product. How would you determine your price? 3. You are one of TWO producers of that type of product. Now how do you determine your price?

Monopolistic competition Types of Market Structure This system of market structures is based on two dimensions: The number of producers in the market (one, few, or many) Whether the goods offered are identical or differentiated Differentiated goods are goods that are different but considered somewhat substitutable by consumers (think Coke versus Pepsi). Are Products Differentiated? No Yes One Monopoly Not applicable How Many Producers Are There? Oligopoly Few Figure Caption: Figure 14-1: Types of Market Structure The behavior of any given firm and the market it occupies are analyzed using one of four models of market structure—monopoly, oligopoly, perfect competition, or monopolistic competition. This system for categorizing market structure is based on two dimensions: (1) whether products are differentiated or identical and (2) the number of producers in the industry—one, a few, or many. Perfect competition Monopolistic competition Many

Oligopoly (10/31) Basics: 1. Few sellers in the industry 2. Each firm in competition w/each other, but interdependent 3. Each firm has some market power “Imperfect competition” Examples of oligopolies: Airlines (specific routes only offered by a few carriers) Soda companies Grocery stores (2 or 3 in a town = oligopoly)

Partner practice: Explain why each of the following industries is an oligopoly, and will not turn perfectly competitive. The world’s oil industry The microprocessor industry, where 2 firms, Intel and its bitter rival AMD, dominate the market The wide-bodied passenger jet industry, composed of the American firm Boeing and the European firm Airbus

Is it oligopoly or not? The Herfindahl-Hirschman Index (HHI): the square of each firm’s share of the market sales summed over the firms in the industry Ex: Industry has 3 firms, and their market shares are 60%, 25% and 15% -- HHI = 602 + 252 + 152 = 4,450

HHI used by US Justice Dept and FTC to ensure adequate competition – prosecutes price-fixing, breaks up inefficient monopolies, disallowing mergers that will reduce competition HHI below 1000: strongly competitive market HHI between 1000-1800: somewhat competitive HHI over 1800: oligopoly

Practice example: Retail grocers Store Market Share Safeway 29% Lucky’s 20% Albertson’s 18% Raley’s 10% Target 9% Nob Hill 8% Walmart 6% Calculate the HHI of the retail grocer market. If Raley’s and Nob Hill wanted to merge, calculate the new HHI. Go back to the initial situation. If Lucky’s and Albertson’s wanted to merge, calculate the new HHI. Which merger would the government most likely approve?

Understanding Oligopoly The easiest example – the duopoly With only 2 firms in the industry, they know that overproduction will drive down market price. Like a monopolist, each firm realizes that if they limit production, they can charge a higher price and earn higher profits. So… How much will each firm produce?

Option #1: Collusion (cooperation to raise each other’s profits) and actually STICK with the deal 1. The cartel: agreement between producers to limit output in order to increase joint profits – they act as a single monopolist Real-life example: OPEC (Org. of Petroleum Exporting Countries)

Option #2: Non-cooperative behavior Each firm has an incentive to “cheat” and produce a little more than the agreed-upon quantity

Collusion to revenue-maximize (ignoring costs for this one) Price of lysine (per pound) Quantity Demanded (millions of pounds) Total revenue (millions) $12 $0 11 10 110 20 200 9 30 270 8 40 320 7 50 350 6 60 360 5 70 4 80 3 90 2 100 1 120 Collusion to revenue-maximize (ignoring costs for this one) The duopoly would produce 60 million pounds and make $360 million in revenue (assumption: firms only have fixed cost, so no marginal cost) Each firm would produce 30 million pounds and each would make $180m in revenue But what if one firm cheats?

Let’s say one firm cheats and produces 40 million pounds instead. This increases output to 70 million pounds, price falls from $6 per pound to $5 per pound. The cheater firm’s revenue rises from $180m to $200m, and the revenue for the other company falls from $180m to $150m. BUT…who’s to say that the other firm didn’t do the same thing? In that case, each firm’s profits would fall from $180m to $160m (the result of producing 80 million pounds at $4 per) Price of lysine (per pound) Quantity Demanded (millions of pounds) Total revenue (millions) $12 $0 11 10 110 20 200 9 30 270 8 40 320 7 50 350 6 60 360 5 70 4 80 3 90 2 100 1 120

The bottom line – oligopolists are only concerned with the price effect on its own units of output, not those of the industry as a whole. The puzzle with oligopoly: will they practice collusion, or will they engage in noncooperative behavior? Collusion is ultimately more profitable, but formal agreements to do so are illegal in the US and many other countries.

Quantity demanded (gallons) The market for olive oil in NYC is controlled by two families: the Sopranos and the Contraltos. The marginal cost is a constant $40 per gallon. There is no fixed cost. Price (per gallon) Quantity demanded (gallons) $100 1,000 90 1,500 80 2,000 70 2,500 60 3,000 50 3,500 40 4,000 30 4,500 20 5,000 10 5,500

The Sopranos and Contraltos form a cartel The Sopranos and Contraltos form a cartel. For each quantity, calculate TR and MR (add columns). How many gallons of olive oil will the cartel sell in total and at what price? How many gallons will each family sell? How much profit does each family make? Uncle Junior, the head of the Soprano family, breaks the agreement and sells 500 more gallons. The Contraltos maintain the current agreement. How much profit will the Sopranos make now? What about the Contraltos? Anthony Contralto decides to punish Uncle Junior by also increasing his sales by 500 gallons as well. How much profit does each family earn now?

Competing in Prices vs. Competing in Quantities (12/2/2014) Quantity competition (the Cournot model) Example: Boeing and Airbus The decision of how many planes to produce is important – they really can only produce what their capabilities allow Boeing decides to build 50 planes in 1 year. Airbus can be fairly confident that Boeing will stick to this amount (since increasing this amount will be very difficult). Airbus will then decide to produce 50 planes, thus splitting the market 50-50. End result: output is less than under perfect competition , and each firm earns a profit. This LOOKS like collusion, but without the formal agreement

Price competition – “price wars” – undercutting the competition (the Bertrand behavior) Example: flights from Chicago to London, and the economy sucks (empty seats) As long as each firm finds that cutting prices leads to additional sales, they will do this until price equals marginal cost (any price lower will lead to loss) – perfect substitutes and P = MC: becomes like perfect competition Ideally, oligopolists would like to avoid this, since it leads to zero profits

Game Theory When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. The reward received by a player in a game—such as the profit earned by an oligopolist—is that player’s payoff. A payoff matrix shows how the payoff to each of the participants in a two player game depends on the actions of both. Such a matrix helps us analyze interdependence. 18

A Payoff Matrix Ajinomoto Produce 30 million pounds Ajinomoto makes $180 million profit. Ajinomoto makes $200 million profit. Produce 30 million pounds ADM makes $180 million profit ADM makes $150 million profit ADM Figure Caption: Figure 15-1: A Payoff Matrix Two firms, ADM and Ajinomoto, must decide how much lysine to produce. The profits of the two firms are interdependent: each firm’s profit depends not only on its own decision but also on the other’s decision. Each row represents an action by ADM, each column one by Ajinomoto. Both firms will be better off if they both choose the lower output; but it is in each firm’s individual interest to choose the higher output. Ajinomoto makes $150 million profit. Ajinomoto makes $160 million profit. Produce 40 million pounds ADM makes $200 million profit ADM makes $160million profit

The Prisoners’ Dilemma Economists use game theory to study firms’ behavior when there is interdependence between their payoffs. The game can be represented with a payoff matrix. Depending on the payoffs, a player may or may not have a dominant strategy. When each firm has an incentive to cheat, but both are worse off if both cheat, the situation is known as a prisoners’ dilemma. The game based on two premises: (1) Each player has an incentive to choose an action that benefits itself at the other player’s expense. (2) When both players act in this way, both are worse off than if they had acted cooperatively. 20

The Prisoners’ Dilemma Louise Don’t confess Confess Louise gets 5-year sentence. Louise gets 2-year sentence. Don’t confess Thelma gets 5-year sentence. Thelma gets 20-year sentence. Thelma Figure Caption: Figure 15-2: The Prisoners’ Dilemma Each of two prisoners, held in separate cells, is offered a deal by the police—a light sentence if she confesses and implicates her accomplice but her accomplice does not do the same, a heavy sentence if she does not confess but her accomplice does, and so on. It is in the joint interest of both prisoners not to confess; it is in each one’s individual interest to confess. Louise gets 20-year sentence. Louise gets 15-year sentence. Confess Thelma gets 2-year sentence. Thelma gets 15-year sentence.

A Nash equilibrium, also known as a non-cooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players.

Determine the dominant strategies for both players Determine the dominant strategies for both players. What is Nash Equilibrium? Is this situation a prisoner’s dilemma? Nikita Build missile Don’t build missile -10 -20 Build missile -10 8 Jack Figure Caption: Figure 15-1: A Payoff Matrix Two firms, ADM and Ajinomoto, must decide how much lysine to produce. The profits of the two firms are interdependent: each firm’s profit depends not only on its own decision but also on the other’s decision. Each row represents an action by ADM, each column one by Ajinomoto. Both firms will be better off if they both choose the lower output; but it is in each firm’s individual interest to choose the higher output. 8 Don’t build missile -20

For each problem: Create a payoff matrix Identify each player’s dominant and dominated strategies. Find the Nash Equilibrium. Is it a prisoner’s dilemma? Coke and Pepsi can choose to advertise or not. If both firms advertise, they both will earn 100. If no one advertises, both will earn 80. If one advertises while the other does not, the one that advertises will earn 120, and the one that doesn’t will earn 45. You are in a class with one other student. Your teacher has said that the final exam will be graded so that anyone who scores the class average will receive an “B” in the class. Anyone who scores above the average will receive an “A” in the class, and anyone who falls below average will get an “F”. You are smarter than the other guy. You and the other guy agree to not take the exam so the class average is zero and you both receive a “B”. a. Also answer this: Using a 4-pt scale, which choice results in the highest class GPA?

There are two coffee shops that compete against each other in a small town. Buckstar and Teep’s realize that each must consider the method of attracting customers that the other is using. The payoff matrix below illustrates the possible strategies and relative profits. Teep’s Concentrate on coffee Concentrate on tea 150, 100 200, 150 80, 125 70, 95 Buckstar

Based on the payoffs, which of the following statements is true? a. Buckstar has a dominant strategy to concentrate on coffee. b. Buckstar has a dominant strategy to concentrate on tea. c. Teep’s has a dominant strategy to concentrate on coffee. d. Teep’s has a dominant strategy to concentrate on tea. e. Neither shop has a dominant strategy. 2. What is the Nash equilibrium in this game? a. Both shops should choose to concentrate on coffee. b. Both shops should choose to concentrate on tea. c. Buckstar should choose to concentrate on coffee, and Teep’s should choose to concentrate on tea. d. Buckstar should choose to concentrate on tea, and Teep’s should choose to concentrate on coffee. e. There is no Nash equilibrium in this game.

Interpret “standing at a concert” in terms of the prisoner’s dilemma game. Explain at least one way the optimal outcome for players, which would be for all players to play the dominated strategy, can be reached in Question 1. What are the possible commitment problems? A rivalry exists between the US jet producer Boeing and the European jet producer Airbus. Each government has an opportunity to subsidize its jet producer to give it a competitive edge in the global market. Using game theory, explain what you would expect to observe in practice.

Overcoming the Prisoners’ Dilemma Repeated Interaction and Tacit Collusion Players who don’t take their interdependence into account arrive at a Nash, or non-cooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners’ dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion. Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusion. 29

How Repeated Interaction Can Support Collusion Ajinomoto Tit for tat Always cheat Ajinomoto makes $180 million profit each year. Ajinomoto makes $200 million profit 1st year, $160 profit each later year. Tit for tat ADM makes $150 million profit 1st year, $160 million profit each later year. ADM makes $180 million profit each year. ADM Ajinomoto makes $150 million profit 1st year, $160 million profit each later year. Ajinomoto makes $160 million profit each year. Figure Caption: Figure 15-3: How Repeated Interaction Can Support Collusion A strategy of “tit for tat” involves playing cooperatively at first, then following the other player’s move. This rewards good behavior and punishes bad behavior. If the other player cheats, playing “tit for tat” will lead to only a short-term loss in comparison to playing “always cheat.” But if the other player plays “tit for tat,” also playing “tit for tat” leads to a long-term gain. So a firm that expects other firms to play “tit for tat” may well choose to do the same, leading to successful tacit collusion. Always cheat ADM makes $200 million profit 1st year, $160 million profit each later year. ADM makes $160 million profit each year.

Oligopoly in Practice Antitrust policies are efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors, including: large numbers of firms firms produce many different products bargaining power of buyers (large buyers can negotiate better prices) conflicts of interest among firms (difference in MC, length of time in market, etc) 31

The Kinked Demand Curve If production increases beyond Q*, other firms will retaliate and produce more too  firm will gain very few sales. If production decreases , firm does not expect rivals to do the same  firm will lose relatively large # of sales. Price, cost marginal revenue W Tacit collusion outcome MC 1 P * MC 2 X 1. Any marginal cost in this region Figure Caption: Figure 15-4: The Kinked Demand Curve This oligopolist believes that her demand curve is kinked at the tacit collusion price and quantity levels, P* and Q*. That is, she believes that if she increases her output and lowers her price, her rivals will retaliate, increasing their output and lowering their prices as well, leading to only a small gain in sales. So her demand curve is very steep to the right of Q*. But the oligopolist believes that if she lowers her output and raises her price, her rivals will refuse to reciprocate and will steal a substantial number of her customers, leading to a large fall in sales. So her demand curve is very flat to the left of Q*. The kink in the demand curve leads to the break XY in the marginal revenue curve. As shown by the marginal cost curves, MC1and MC2, any marginal cost curve that lies within the break leads the oligopolist to produce the same output level, Q*. So starting at the tacit collusion outcome, changes in marginal cost within a certain range will leave the firm’s output unchanged. But large changes in marginal cost—changes that cause the marginal cost curve to cut the marginal revenue curve in the segment WX or the segment YZ—will lead to changes in output. Y MR D Q * Z Quantity 2. … corresponds to this level of output

Which of the following factors make it more likely that oligopolists will play non-cooperatively? Which make it more likely that they will engage in tacit collusion (if they had a formal agreement)? a. Each oligopolist expects several new firms to enter the market in the future. b. It is very difficult for a firm to detect whether or not another firm has raised output. c. The firms have co-existed while maintaining high prices for a long time.

Product Differentiation and Price Leadership To limit competition, oligopolists often engage in product differentiation (ex: Southwest Airlines) When products are differentiated, it is sometimes possible for an industry to achieve tacit collusion through price leadership (ex: General Motors) Oligopolists often avoid competing directly on price, engaging in non-price competition through advertising and adding extras, etc. 34