Oligopoly

Assumptions Small number of sellers Identical or slightly different products Moderate barriers to entry

Market definition To determine the number of firms in a market, you must first define the market. A market definition can be broad or narrow. All footwear would be a broad definition Women’s dress shoes would be narrow.

Two questions The appropriate market definition depends on the answers to two questions: Do consumers treat the products as close substitutes, that is, would they switch from buying one to the other? Do producers treat the products as production substitutes, that is, would they switch from making one to the other?

One market or seven?

Men’s & women’s dress shoes in same market? Will consumers switch from buying men’s dress shoes to women’s dress shoes if the price of men’s dress shoes increases? Will producers of women’s dress shoes start making men’s dress shoes if price of men’s dress shoes increases?

No clear answer! As in this case, one group may switch while the other group does not. Bottles and cans (purchased by food and beverage companies). The buyers may be able to switch, but the producers of cans cannot easily start making bottles.

4-firm concentration CR4 = combined market share of the top four firms in a market If CR4 > 60% then the market is a tight oligopoly If CR4 < 40% then the market is a loose oligopoly

Rivalry With a small number of firms, what one does will have an effect on the others = mutual interdependence. If one firm sells more, other firms will sell less (unless the entire market increases). Each firm thinks of the other firms as its rivals (competing for the same customers).

Compared to other types of markets Does a firm in perfect competition think of other firms as its rivals? Does a firm in monopoly think of other firms as its rivals? Does a firm in monpolistic competition think of other firms as its rivals?

Rivalry and strategy If one firm’s actions will affect other firms, each firm must think about… how other firms will respond to it, and how it should respond to what other firms might do to it.

Cooperation One possibility is that firms will avoid competition to keep the price high. Collusion = an agreement to reduce total output and raise the price.

Problems with collusion Agreement Cheating Entry

Agreement Firms must agree on how to reduce total output and what price to charge. Everyone wants the higher price but nobody wants to produce less. Some firms, particularly those with higher cost of production, may want the price set too high for other firms.

Cheating Each firm is tempted to take advantage of other firms producing less, which creates a shortage and causes the price to increase, by producing more than they agreed to. If enough firms cheat, then the total quantity does not decrease and the price will not increase.

Entry If the firms are able to coordinate output and prices, resulting in higher profits, then other firms will want to enter. With new firms in the market, the existing firms must either produce even less or let the price decrease back down.

Conditions for success Small number of firms, which makes agreement easier and harder for cheaters to escape detection. Similar products and costs, which makes it easier to find an output and price that maximizes profits for everyone.

Conditions for success Price matching, which makes it more difficult for a cheater to sell its extra output undetected. Low fixed costs, which decreases the incentive to produce more (in violation of the agreement) to spread out high fixed costs.

Conjectural variation This is how one firm thinks other firms will respond to whatever it does. a conjecture is a guess variation refers to a change

Values of conjectural variation c.v. = 0 means that I think that the other firms will not respond when I make a change c.v. = 1 means that I think that the other firms will match any change I make In either case, this is just what I think; I may be wrong.

Pricing strategy for c.v. = 0 If I lower my price and the other firms do not respond, then many consumers will switch to my product and my profits will increase. If I raise my price and other firms do not respond, then most consumers will switch to other firms and my profit will decrease.

Pricing strategy for c.v. = 1 If I lower my price and other firms match it, then I do not gain any market share and make less profit. If I raise my price and the other firms match it, then I do not lose any market share and make more profit.

C.v. outcomes If c.v. = 0 then each firm lowers its price expecting to take customers from the other producers. The market will end up with low prices. If c.v. = 1 then each firm raises its price expecting that everyone else will follow. With all firms doing the same thing, the market will end up with high prices.

When does c.v. = 0 make sense? c.v. = 1? If there are more firms in the market, there is more chance that the other firms will NOT respond (c.v. = 0). However, with a smaller number of firms, it is very likely that they will match what you do (c.v. = 1).

Kinked demand model Another possibility is that c.v. = 0 for an increase in price and c.v. = 1 for a decrease in price. If you raise your price you think you will be the only one. If you lower your price everyone will match. What should you do?

Non-price competition The discussion above assumed that the only way to take customers from other firms is to lower price. In reality, firms can reach an understanding not to cut prices but still actively compete for customers with other methods, such as marketing.

Marketing Marketing = price, product, placement, promotion, (and personalization). Firms can introduce new products, adopt new distribution methods, advertise, and deliver products unique to each customer.

Why non-price? Price competition will not benefit a firm if the other firms can match the lower price. Non-price competition is more difficult for other firms to match. Customers may not respond to firms that try to copy another firm’s successful innovations. It also takes longer to implement than a price cut.

Game Theory Instead of asking how other firms will react to what you do, ask what they may do to you. Example: another firm may introduce a new product soon, or it may offer rebates. If you think that they will offer rebates, what should you do? What if you think they will not offer rebates?

Maximin strategy Assume the worst and make the best of it. Assume that whatever you do, your rival will do what gives you the smallest possible gain. Based on that assumption, choose the action that will give you the biggest gain.

#1 on left, #2 above High price Low price 80 100 20 40

Firm #1’s maximin If firm #1 announces a high price it will earn profits of $80 if firm #2 announces a high price and $20 if firm #2 announces a low price. It assumes the worst, or $20 If #1 announces a low price it will earn $100 or $40. It assumes the worst, or $40 It will pick a low price since $40 > $20

(Nash) Equilibrium Firm #1 charges a low price because it expects firm #2 will charge a low price. This is a defensive action. Firm #2 also charges a low price for the same reason. Each firm expects the other to charge a low price, and they are both correct.

Prisoners’ Dilemma The two firms would be better off (earn more profit) if they both charged a high price, but each one expects the other to charge a low price, forcing them to charge a low price too. They both lose profits because they cannot trust the other one to do what is best for them both. This is described as the Prisoners’ Dilemma.

You have been arrested You and your partner in crime have been arrested for robbing a jewelry store. They catch you with some of the stolen jewelry, but you claim that you bought it from a stranger. They cannot prove that you robbed the store and can charge you only with possession of stolen property.

The Offer The police put you and your partner in separate rooms and offer each a deal. If you confess to the robbery and your partner does not, you will receive probation only. Your partner will serve 10 years for the robbery. If your partner confesses but you do not, you will serve 10 years.

Deal or No Deal? If you both confess, you will each serve 5 years (a shorter sentence is common if you plead guilty). If neither confesses, you will each serve 2 years for the possession charge. What should you do?

Best of the worst You are a pessimist and ask what is the worst that will happen if I confess or do not confess. If you confess the worst is 5 years. If you do not confess the worst is 10 years. Confess to avoid the 10 year sentence

The Dilemma If you both confess out of fear that the other person will also confess, you both serve 5 years. If neither person confesses, you both serve 2 years. A Dilemma!

Solutions? Change the game! On the way to the police station, tell your partner that if he confesses and you do not, you will kill him. Suddenly, the worst that can happen to him if he confesses gets much worse. Because he is a pessimist like you (assuming the worst), he will choose to not confess.

Another solution Repeated games If you both know that you will be arrested again in the future (robbery is your profession), you can each offer to not confess, but if your partner confesses this time you will confess next time. This reduces your partner’s incentive to confess.

Back to Business Change the game Have a low price guarantee, so that your price will automatically be below their price. “If you can find a lower price, we will beat it by 10%.”

Repeated games Some competition take place infrequently, such as bidding on large construction projects. In these cases it is difficult to threaten your business rival. In many cases firms compete every day, so a firm that drops its price will gain for just one day. Tomorrow its rival will also charge a low price and profits will fall.