Chapter 9 Market Structure: Oligoploy

Examples of Oligopolistic Industries Airlines Soft Drinks Doughnuts Parcel and Express Delivery Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 2

Oligopoly Models Noncooperative oligopoly models are models of interdependent oligopoly behavior that assume that firms pursue profit- maximizing strategies based on assumptions about rivals’ behavior and the impact of this behavior on the given firm’s strategies. Cooperative oligopoly models are models of interdependent oligopoly behavior that assume that firms explicitly or implicitly cooperate with each other to achieve outcomes that benefit all the firms. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3

Noncooperative Oligopoly Models The Kinked Demand Curve Model Game Theory Models Strategic Entry Deterrence Predatory Pricing Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 4

Kinked Demand Curve The kinked demand curve model of oligopoly incorporates assumptions about interdependent behavior and illustrates why oligopoly prices may not change in reaction to either demand or cost changes. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5 MC $ Q D 2 : Rivals don’t follow D 1 : Rivals do follow MR 1 MR 2 P1P1 Q1Q1

Chapter 12 6 Price Rigidity Firms have strong desire for stability Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change – Fear lower prices will send wrong message to competitors leading to price war – Higher prices may cause competitors to raise theirs

Chapter 12 7 Price Rigidity Basis of kinked demand curve model of oligopoly – Each firm faces a demand curve kinked at the currently prevailing price, P* – Above P*, demand is very elastic If P>P*, other firms will not follow – Below P*, demand is very inelastic If P<P*, other firms will follow suit

Chapter 12 8 Price Rigidity With a kinked demand curve, marginal revenue curve is discontinuous Firm’s costs can change without resulting in a change in price Kinked demand curve does not really explain oligopolistic pricing – Description of price rigidity rather than an explanation of it

Chapter 12 9 The Kinked Demand Curve $/Q Quantity MR D If the producer lowers price, the competitors will follow and the demand will be inelastic. If the producer raises price, the competitors will not and the demand will be elastic.

Chapter The Kinked Demand Curve $/Q D P* Q* MC MC’ So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MR Quantity

Chapter Price Signaling and Price Leadership Price Signaling – Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Leadership – Pattern of pricing in which one firm regularly announces price changes that other firms then match

Chapter Price Signaling and Price Leadership The Dominant Firm Model – In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. – The large firm might then act as the dominant firm, setting a price that maximizes its own profits.

Game Theory Models A set of mathematical tools for analyzing situations in which players make various strategic moves and have different outcomes or payoffs associated with those moves. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13

Dominant Strategies and the Prisoner’s Dilemma This payoff matrix shows the various prison terms for Bonnie and Clyde that would result from the combination of strategies chosen when questioned about a crime spree. The Prisoner’s Dilemma Bonnie Clyde Don’t Confess Confess Don’t Confess 2 yr, 2 yr 10 yr, 0 yr Confess0 yr, 10 yr 5 yr, 5 yr Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 14

Prisoner’s Dilemma – Dominant Strategy A dominant strategy is one that results in the best outcome or highest payoff to a given player no matter what action or choice the other player makes. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 15 The Prisoner’s Dilemma Bonnie Clyde Don’t Confess Confess Don’t Confess 2 yr, 2 yr 10 yr, 0 yr Confess 0 yr, 10 yr 5 yr, 5 yr

Nash Equilibrium Nash equilibrium is a set of strategies from which all players are choosing their best strategy, given the actions of the other players. Cigarette Television Advertising Company A Company B Do not Advertise Do not Advertise 50,5020,60 Advertise60,2027,27 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 16

Strategic Entry Deterrence Limit pricing is a policy of charging a price lower than the profit-maximizing price to keep other firms from entering the market. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 17 $ Q D MR MC ATC P π max Q π max P LP = ATC EN Q LP

Predatory Pricing Pedatory pricing: – Japanese share of market QP - QUS = NM = RG – Loss per unit to Japanese firms PC - PP = NR – Total loss to Japanese firms NRGM Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 18 $ Q P US PJPJ PCPC P Q US QcQc QJQJ QPQP K L JG M N E RS T

Cooperative Oligopoly Models Cartels Tacit Collusion Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 19

Cartels - Examples OPEC Diamond Cartel Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 20

Cartel Behavior A cartel is an organization of firms that agree to coordinate their behavior regarding pricing and output decisions in order to maximize the joint profits for the organization. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 21

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 22 Model of Joint Profit Maximization MC 2 D MC 1 $$$ QQQ MC 2 MC c MC 1 PCPC MR QCQC Q 2* Q 1* Firm 1Firm 2Cartel

Success in Cartels A cartel is likely to be the most successful when: – It can raise the market price without inducing significant competition from noncartel members. – The expected punishment for forming the cartel is low relative to the expected gains. – The costs of establishing and enforcing the agreement are low relative to the gains. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 23

Tacit Collusion Because cartels are illegal in the United States due to the antitrust laws, firms may engage in tacit collusion, coordinated behavior that is achieved without a formal agreement. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 24

Practices that facilitate tacit collusion Uniform prices A penalty for price discounts Advance notice of price changes Information exchanges Swaps and exchanges Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 25

Chapter The Dominant Firm Model Dominant firm must determine its demand curve, D D. – Difference between market demand and supply of fringe firms To maximize profits, dominant firm produces Q D where MR D and MC D cross. At P*, fringe firms sell Q F and total quantity sold is Q T = Q D + Q F

Chapter Price Setting by a Dominant Firm Price Quantity D D QDQD P* At this price, fringe firms sell Q F, so that total sales are Q T. P1P1 QFQF QTQT P2P2 MC D MR D SFSF The dominant firm’s demand curve is the difference between market demand (D) and the supply of the fringe firms (S F ).

Chapter Cartels Producers in a cartel explicitly agree to cooperate in setting prices and output. Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels

Chapter Cartels Examples of successful cartels – OPEC – International Bauxite Association – Mercurio Europeo Examples of unsuccessful cartels – Copper – Tin – Coffee – Tea – Cocoa

Chapter Cartels – Conditions for Success 1. Stable cartel organization must be formed – price and quantity settled on and adhered to – Members have different costs, assessments of demand and objectives – Tempting to cheat by lowering price to capture larger market share

Chapter Cartels – Conditions for Success 2. Potential for monopoly power – Even if cartel can succeed, there might be little room to raise price if faces highly elastic demand – If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work

Chapter Analysis of Cartel Pricing Members of cartel must take into account the actions of non-members when making pricing decisions Cartel pricing can be analyzed using the dominant firm model – OPEC oil cartel – successful – CIPEC copper cartel – unsuccessful

Chapter The OPEC Oil Cartel Price Quantity MR OPEC D OPEC TDSCSC MC OPEC TD is the total world demand curve for oil, and S C is the competitive supply. OPEC’s demand is the difference between the two. Q OPEC P* OPEC’s profits maximizing quantity is found at the intersection of its MR and MC curves. At this quantity OPEC charges price P*.

Chapter Cartels About OPEC – Very low MC – TD is inelastic – Non-OPEC supply is inelastic – DOPEC is relatively inelastic

Chapter The OPEC Oil Cartel Price Quantity MR OPEC D OPEC TDSCSC MC OPEC Q OPEC P* The price without the cartel: Competitive price (P C ) where D OPEC = MC OPEC QCQC QTQT PcPc

Chapter The CIPEC Copper Cartel Price Quantity MR CIPEC TD D CIPEC SCSC MC CIPEC Q CIPEC P* PCPC QCQC QTQT TD and S C are relatively elastic D CIPEC is elastic CIPEC has little monopoly power P* is closer to P C

Chapter Cartels To be successful: – Total demand must not be very price elastic – Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic