Principles of Economics by Fred M Gottheil Chapter 12 Price and Output Determination Under Oligopoly PowerPoint Slides prepared by Ken Long ©1999 South-Western College Publishing

What is Oligopoly? A market structure consisting of only a few firms producing goods that are close substitutes ©1999 South-Western College Publishing

What are some examples of Oligopoly? Automobiles Steel Soup Cereals ©1999 South-Western College Publishing

What determines if a market is an Oligopoly? The concentration ratio can be used as a guide ©1999 South-Western College Publishing

What concentration ratio constitutes an Oligopoly? There is no magic number, but if a large percentage of the sales are from the 4 largest firms, it’s an Oligopoly ©1999 South-Western College Publishing

What is an example of a high concentration ratio? Out of 151 firms in the aircraft industry the leading 4 constitutes 79% of total sales ©1999 South-Western College Publishing

For more information on industry concentration check out these web pages - http://www.census.gov http://www.census.gov/econ/www/manumenu.html ©1999 South-Western College Publishing

What is the Herfindahl-Hirschman Index (HHI)? A measure of industry concentration, calculated as the sum of the squares of the market shares held by each firm in the industry ©1999 South-Western College Publishing

where Si = the ith firms market share, n= number of firms in industry Calculation of the HHI HHI = s12 + s22 + …..sn2 where Si = the ith firms market share, n= number of firms in industry

Problems: For an industry with only 1 firm, (monopoly), what would be the HHI?

Suppose the industry has 10 equal size firms, what is the HHI? What if the industry has 100 equal size firms?

Answers: Monopoly, HHI = 10,000 10 equal size firms, HHI = 1,000

How Oligopolistic is the U.S. Economy? Oligopoly is very much of a fact of life in the U.S. ©1999 South-Western College Publishing

Is the U.S. becoming more Oligopolistic? Answer appears to be NO to this question. While there have been some periods of time when industries appeared to be getting more concentrated into fewer firms, there are other periods of history where just the opposite happened.

What is Market Power? A firm’s ability to select and control market price and output ©1999 South-Western College Publishing

What is an Unbalanced Oligopoly? An oligopoly in which the sales of the leading firms are distributed unevenly among them ©1999 South-Western College Publishing

What is a Balanced Oligopoly? An oligopoly in which the sales of the leading firms are distributed fairly evenly among them ©1999 South-Western College Publishing

In which type is market power most concentrated? Unbalanced Oligopoly ©1999 South-Western College Publishing

Why do Oligopolies exist? Mergers Economies of scale Reputation Strategic barriers Government barriers ©1999 South-Western College Publishing

What is a Horizontal Merger? A merger between firms producing the same good in the same industry ©1999 South-Western College Publishing

What is a Vertical Merger? A merger between firms that have a supplier - purchaser relationship ©1999 South-Western College Publishing

What is a Conglomerate Merger? A merger between firms in unrelated industries ©1999 South-Western College Publishing

For more information on mergers check out these sites: http://www.stocksmart.com/ newsipos.html http://www.antitrust.org http://www.usdoj.gov/atr/index.html http://www.usdoj.gov/atr/guidelin.htm http://www.ftc.gov ©1999 South-Western College Publishing

Firms in Oligopoly are said to be Mutually Interdependent Firms realize the large impact that other firms behavior has on their profits Leads to many models of oligopoly, depending on how the firms deal with the mutual interdependence issue

One way to deal with the Mutual Interdependence problem is….. LET’S CHEAT!!!! THE COLLUSION SOLUTION!!!

What is Collusion? The practice of firms to negotiate price and market decisions that limit competition ©1999 South-Western College Publishing

What is a Cartel? A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares ©1999 South-Western College Publishing

One model of collusion that can be used is the cartel model Internationally, some cartels like OPEC exist Domestically, these would be illegal If the cartel can collude perfectly, would tend to charge the monopoly price

Ingredients for a successful cartel Control a large share of the market Inelastic and stable demand for the product Similar costs among cartel members Fairly homogenous product Few number of firms Ways of preventing cheating on the agreement

Check out the Opec Cartel http://www.opec.org

What is the relationship between market concentration and price? A high concentration ratio in an industry may translate into noncompetitive prices and behavior ©1999 South-Western College Publishing

Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts but not price increases. Under this assumption, its as if each firm faces a “kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals quickly match price cuts.

Kinked Demand Curve Price Starting price P1 MR Gap D MR Q1 Quantity 33

Graph explanation: Let P1 and Q1 be the existing price and quantity for this oligopoly firm: due to the assumptions of this model, the demand curve has a kink in it at this price and output. Because of the strange shape of the demand curve, the MR curve is discontinuous, or has a gap in it.

Kinked demand curve model is an attempt to explain rigid prices in oligopoly: That is, firms might not change price very often. Why? Firm is reluctant to raise price if its competitors do not, since it could lose sales to them, and little reason is seen to lower price if competitors quickly match the price cut, since little will be gained.

What does the kinked demand curve illustrate? There is a great deal of price stability and nonprice competition is important ©1999 South-Western College Publishing

How do firms in an Oligopoly set price? Most often they practice price leadership ©1999 South-Western College Publishing

Price leadership in Oligopoly One firm, the dominant firm, sets the price, others follow the leader Often the dominant firm is the low cost producer in the industry Is this a form of “tacit” collusion?

What is an example nonprice competition? Brand multiplication when there are variations on one good to increase market share ©1999 South-Western College Publishing

Game Theory Approach to Oligopoly Is Oligopoly best analyzed as a strategic game like chess?

What is Game Theory? A theory of strategy ascribed to a firm’s behavior in oligopoly ©1999 South-Western College Publishing

For more information about Game Theory - http://www.pitt.edu/~alroth/alroth.html ©1999 South-Western College Publishing

Prisoner's Dilemma

If the 2 people could collude, would likely choose to not confess, but self interest may drive each to confess, hoping the other does not, end up both confessing, worse off for both—many similar situations perhaps for firms in oligopoly

Two firm game

What is a dominant strategy? A strategy that is best regardless of what the opposition does. For B, dominant strategy is to break the agreement, and also for A. Both firms avoid the worst case scenario in this manner.

What is a Nash equilibrium What is a Nash equilibrium? (named for Mathematician John Nash…did you see the film “A Beautiful Mind?) A situation where neither firm can improve its payoff, given what the other firm is doing…in this example, breaking the agreement is the Nash equilibrium

Is there any way to get to box 1 where both firms are better off short of outright collusion? Possibility of a tit-for-tat strategy….somehow indicate to the other firm that although you want to hold the agreement, you will switch to match what the other firm does.

For a forum that induces the interactive Prisoner’s Dilemma check out - http://serendip.brynmawr.edu/~ann/pd.html ©1999 South-Western College Publishing

What is Price Discrimination? The practice of offering a specific good or service at different prices to different segments of the market ©1999 South-Western College Publishing

Why would a firm want to price discriminate? Greater profits possible!!

Different types of Price Discrimination “Perfect” price discrimination: Charge each buyer the highest price they are willing to pay

More usual type of price discrimination Separate buyers into groups (based perhaps on age, sex, region of country, etc. Groups should have different elasticities of demand

Higher price to more inelastic group, lower to more elastic: must also be able to prevent resale of product

What is Oligopoly? What concentration ratio constitutes an Oligopoly? What is an Unbalanced Oligopoly? What is a Balanced Oligopoly? What is Collusion? What is a Cartel?

What is the distinguishing feature of Oligopoly? How do firms in an Oligopoly set price? What is Game Theory? What is the Prisoner’s Dilemma? What is Price Discrimination?

END ©1999 South-Western College Publishing