Market Failure: Oligopolies 2-11-09 Econ 100 Lecture 6-3 Market Failure: Oligopolies 2-11-09

What is an Oligopoly? market in which the industry is dominated by a small number of sellers Derived from the Greek for few sellers. Since there are few participants, each oligopolist (firm) is aware of the actions of the others decisions of one firm influence, and are influenced by the decisions of other firms i.e., firms’ behave strategically taking into account the likely responses of the other market participants (game theory)

Oligopoly Oligopoly markets are more concentrated than monopolistically competitive markets, but less concentrated than monopolies. Perfect Competition Monopoly Monopolistic Competition Oligopoly

Strategic Behavior Perfect Competition Only strategy is to reduce costs Price-taker => output decisions do not affect market price cross-price elasticity = -1 (perfect substitutes) Own-price = -∞ Monopoly Price-Searcher: output decision determines price Cross-price = 0 (no substitutes) Own-price: >= |1| Oligopoly Cross-price elasticity near -1 Own-price elasticity > |1| Will have to take into account actions of other similar firms when making output/pricing decisions Much more strategy

Oligopoly Behavior Cooperative Oligopoly Non-cooperative Oligopolies Cartels Agree to collude; act/price like a single firm monoploist Price leadership (Stackleberg leader) Dominant firm establishes the price; other firms react to “leader” Non-cooperative Oligopolies Sticky prices (kinked demand curve) Sticky upward Nash equilibrium Characterized by stable prices Perfect competition Completely rivalarous

How do we tell? Market concentration refers to the size and distribution of firm market shares and the number of firms in the market. Economists use two measures of industry concentration: Four-firm Concentration Ratio The Herfindahl-Hirschman Index

Attempts to Measure Market Concentration four-firm concentration ratio is often utilized to characterize/determine whether a market is an oligopoly. market share of the four largest firms in an industry Herfindahl index, also known as Herfindahl-Hirschman Index or HHI, widely applied in competition law and antitrust. sum of the squares of the market shares of each individual firm. Decreases in the Herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite.

Four-Firm Concentration Ratio The four-firm concentration ratio (CR4) measures market concentration by adding the market shares of the four largest firms in an industry. If CR4 > 60, then the market is likely to be oligopolistic.

Example Firm Market Share Nike 62% New Balance 15.5% Asics 10% Adidas 4.3%

Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in 1997

The Herfindahl-Hirschman Index The Herfindahl-Hirschman index (HHI) is found by summing the squares of the market shares of all firms in an industry. Advantages over the CR4 measure: Captures changes in market shares Uses data on all firms

Example Firm Market Share Nike 62% New Balance 15.5% Asics 10% Adidas 4.3%

Example (cont’d) What happens if market shares are evenly distributed? Firm Market Share Nike 22.95% New Balance Asics Adidas

Cartel Pricing Tactic Reduce Qs to monopoly levels in order to: a) obtain a higher price b) earn monopoly rents

Figure 12.4 Duopoly Equilibrium in a Centralized Cartel

How do Cartels Operate? Firms in the cartel need to agree on: 1) Market price 2) Quantity supplied by the Industry 3) Each firm’s “quota” 4) “Not to cheat” on either price or quantity supplied

Conditions for cartel success the cartel can significantly raise price cartel controls market low organizational costs few firms (or a few large ones) industry association many small buyers: no monopsony power cartel can be maintained cheating can be detected and prevented low expectation of severe government punishment

Cartels A cartel is a formal (explicit) agreement among firms. usually occur in an oligopolistic industry, where there are a small number of sellers usually involve homogeneous products. Cartel members may agree on such matters as price fixing, total industry output, market shares, allocation of customers, allocation of territories aim of such collusion is to increase individual member's profits by reducing competition. Competition laws forbid cartels. Several economic studies and legal decisions of antitrust authorities have found that the median price increase achieved by cartels in the last 200 years is around 25%. Private international cartels (those with participants from two or more nations) had an average price increase of 28%, whereas domestic cartels averaged 18%. Less than 10% of all cartels in the sample failed to raise market prices

How do Cartels Operate? Firms in the cartel need to agree on: 1) Market price 2) Quantity supplied by the Industry 3) Each firm’s “quota” 4) “Not to cheat” on either price or quantity supplied

Factors that work against a Cartel - in the long run Each firm has an incentive to cheat Price that firm receives is still above MC of production Could earn additional profits by slightly expanding output However, when all firms do this -> back at competitive market outcome Qs up to point where MV=MC See “prisoners dilemma”

What market conditions make Cartels more likely? Market demand is inelastic higher prices lead to increase revenues for the cartel Homogenous goods easier to initially set/enforce cartel price Small number of firms/high concentration of market share (easier to monitor, collude) Fringe players could defeat cartel More equal shares -> increase incentive to cheat

Non-Cooperative Cartels Some degree of price competition Firms engage in highly competitive pricing Similar outcome as perfect competition Firms have some market power Resembles monopolistic competition Stable prices prevail Non-collusive Firms choose not to compete because of kinked demand curve

Kinked-Demand Curve Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point

Nash Equilibrium If firm facing kinked demand curve tries to raise price: Other firms do not As demand is highly elastic and other firms are “close” substitutes Loses market share and revenues If firm lowers price Competitors match price decreases

Nash Equilibrium As a consequence Best strategy is to neither raise or lower prices; but to maintain “stable” prices Nash equilibrium in an oligopolistic market will be characterized by long-term stable prices or “sticky” prices Non-price competition Advertising to create brand name awareness/loyalty Product proliferation