Microeconomics ECON 2302 Spring 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 13

Reminder: 2nd paper due April 15

Chapter 13. Oligopoly: Firms in Less Competitive Markets

After studying this chapter, you should be able to: In an oligopoly, a firm’s profitability depends crucially on its interactions with other firms. After studying this chapter, you should be able to: Show how barriers to entry explain the existence of oligopolies. Use game theory to analyze the actions of oligopolistic firms. Use a sequential games to analyze business strategies. Use the five competitive forces model to analyze competition in an industry. 1 2 LEARNING OBJECTIVES 3 4

Oligopoly Oligopoly A market structure in which a small number of interdependent firms compete. The approach we use to analyze competition among oligopolists is called game theory.

Oligopoly and Barriers to Entry LEARNING OBJECTIVE 1 Oligopoly and Barriers to Entry Barriers to Entry Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits.

RETAIL TRADE MANUFACTURING INDUSTRY 13 - 1 Examples of Oligopolies in Retail Trade and Manufacturing RETAIL TRADE MANUFACTURING INDUSTRY FOUR-FIRM CONCENTRATION RATIO Warehouse Clubs and Superstores 90% Cigarettes 99% Discount Department Stores 88% Beer Hobby, Toy, and Game Stores 70% Aircraft 85% Radio, Television, and Other Electronic Stores 62% Breakfast Cereal 83% Athletic Footwear Stores Automobiles 80% College Bookstores 58% Dog and Cat Food Pharmacies and Drugstores 47% Computers 45%

Oligopoly and Barriers to Entry Economies of scale Economies of scale exist when a firm’s long-run average costs fall as it increases output.

13 - 1 Economies of Scale Help Determine the Extent of Competition in an Industry

Oligopoly and Barriers to Entry In addition to economies of scale, other barriers to entry include: Ownership of a key input Government-imposed barriers Patent The exclusive right to a product for a period of 20 years from the date the product was invented. Other government barriers?

Using Game Theory to Analyze Oligopoly LEARNING OBJECTIVE 2 Using Game Theory to Analyze Oligopoly Game theory The study of how people make decisions in situations where attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms.

Game Theory Key characteristics of all games: Rules that determine what actions are allowable. Strategies that players employ to attain their objectives in the game. Payoffs that are the results of the interaction among the players’ strategies. Business strategy Actions taken by a business firm to achieve a goal, such as maximizing profits.

Game Theory A Duopoly Game: Price Competition between Two Firms Payoff matrix A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Collusion An agreement among firms to charge the same price, or to otherwise not compete.

13 - 2 A Duopoly Game

Game Theory A Duopoly Game: Price Competition between Two Firms Dominant Strategy A strategy that is the best for a firm, no matter what strategies other firms use. Nash equilibrium A situation where each firm chooses the best strategy, given the strategies chosen by other firms.

A Beautiful Mind: Game Theory Goes to the Movies 13 - 1 A Beautiful Mind: Game Theory Goes to the Movies In the film, “A Beautiful Mind,” Russell Crowe played John Nash, winner of the Nobel Prize in Economics.

Game Theory Firm Behavior and the Prisoners’ Dilemma Cooperative equilibrium An equilibrium in a game in which players cooperate to increase their mutual payoff. Noncooperative equilibrium An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoners’ dilemma A game where pursuing dominant strategies results in noncooperation that leaves everyone worse off.

13 - 1 Is Advertising a Prisoners’ Dilemma for Coca-Cola and Pepsi? LEARNING OBJECTIVE 2 Is Advertising a Prisoners’ Dilemma for Coca-Cola and Pepsi? Advertising is the optimal decision for both firms, given the decision by the other firm.

Is There a Dominant Strategy for Bidding on eBay? 13 - 2 On eBay, bidding the maximum value you place on an item is a dominant strategy.

Game Theory Can Firms Escape the Prisoners’ Dilemma? 13 - 3 Changing the Payoff Matrix in a Repeated Game 13 - 3 Can Firms Escape the Prisoners’ Dilemma?

American Airlines and Northwest Airlines Fail to Cooperate on a Price Increase 13 - 3 The airlines have trouble raising the price this business traveler pays for a ticket.

Game Theory Cartels: The Case of OPEC Cartel A group of firms that colludes by agreeing to restrict output to increase prices and profits.

13 - 4 World Oil Prices Sustaining high prices has been difficult because members often exceed their output quotas.

Game Theory Cartels: The Case of OPEC 13 - 5 The OPEC Cartel with Unequal Members The equilibrium of this game will occur with Saudi Arabia producing a low output and Nigeria producing a high output.

Sequential Games: Deterring Entry LEARNING OBJECTIVE 3 Sequential Games: Deterring Entry 13 - 6 The Decision Tree for an Entry Game The best decision for Wal-Mart is to build a large store to deter Target’s entry.

13 - 1 Is Deterring Entry Always a Good Idea? LEARNING OBJECTIVE 4 Is Deterring Entry Always a Good Idea? In this case, Wal-Mart will build a small store and Target will enter. Deterrence is only worth pursuing if its costs are not too high.

Sequential Games: Bargaining 13 - 7 The Decision Tree for a Bargaining Game

The Five Competitive Forces Model LEARNING OBJECTIVE 4 The Five Competitive Forces Model 13 - 7 The Five Competitive Forces Model

13 - 4 Is Business Strategy More Important Than the Structure of the Airline Industry? Southwest’s business strategy allowed it to remain profitable when many other airlines faced heavy losses.

Game theory Nash equilibrium Noncooperative equilibrium Oligopoly Patent Payoff matrix Prisoners’ dilemma Barrier to entry Business strategy Cartel Collusion Cooperative equilibrium Dominant strategy Economies of scale

Assignments for April 13: Pre-read Ch. 14, including: Review Questions: p. 498, 1.1; p. 499, 2.1, 2.2 & 2.4; p. 500, 3.1 & 3.2; p. 501,4.1, 4.2, 5.1, 5.2 & 5.3 (1st edition: 1-4, & 6-12 on pp. 468-469); and Problems and Applications: p. 498: 1.4; p. 499: 2.6 & 2.8; p. 500, 3.6; p. 501, 4.6; p. 502, 5.4, 5.5 & 5.6 (1st edition: 3, 4, 8, 9, 10, 11, 20 & 28 on pp. 469-472); and Use game theory to explain why: (a) sometimes an innocent person will confess to a crime; (b) OPEC members don’t always cooperate; and (c) countries build stockpiles of nuclear weapons to avoid nuclear war.