© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 13 Oligopoly: Firms in Less Competitive Markets

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 30 Competing with Wal-Mart 13.1Show how barriers to entry explain the existence of oligopolies. 13.2Use game theory to analyze the strategies of oligopolistic firms. 13.3Use sequential games to analyze business strategies. 13.4Use the five competitive forces model to analyze competition in an industry. Learning Objectives In an oligopoly, a firm’s profitability depends on its interactions with other firms.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 29 Oligopoly: Firms in Less Competitive Markets Oligopoly A market structure in which a small number of interdependent firms compete.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 29 Oligopoly and Barriers to Entry Learning Objective 13.1 Table 13-1 Examples of Oligopolies in Retail Trade and Manufacturing RETAIL TRADEMANUFACTURING INDUSTRY FOUR-FIRM CONCENTRATION RATIO INDUSTRY FOUR-FIRM CONCENTRATION RATIO Discount Department Stores95%Cigarettes95% Warehouse Clubs and Supercenters 92%Beer91% Hobby, Toy, and Game Stores72%Breakfast Cereal82% Athletic Footwear Stores71%Aircraft81% College Bookstores70%Automobiles76% Radio, Television, and Other Electronic Stores 69%Dog and Cat Food76% Pharmacies and Drugstores53%Dog and Cat Food64%

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 29 Oligopoly and Barriers to Entry Learning Objective 13.1 Barriers to Entry Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits. Economies of Scale Economies of scale The situation when a firm’s long-run average costs fall as it increases output.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 29 Learning Objective 13.1 FIGURE 13.1 Economies of Scale Help Determine the Extent of Competition in an Industry Oligopoly and Barriers to Entry Barriers to Entry Economies of Scale

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 29 Learning Objective 13.1 If production of a good requires a particular input, then control of that input can be a barrier to entry. Government-Imposed Barriers Patent The exclusive right to a product for a period of 20 years from the date the product is invented. Oligopoly and Barriers to Entry Barriers to Entry Ownership of a Key Input

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 29 Using Game Theory to Analyze Oligopoly Learning Objective 13.2 Game theory The study of how people make decisions in situations in which 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.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 29 Using Game Theory to Analyze Oligopoly Learning Objective 13.2 All games share three key characteristics: 1 Rules that determine what actions are allowable 2 Strategies that players employ to attain their objectives in the game 3 Payoffs that are the results of the interaction among the players’ strategies Business strategy Actions taken by a firm to achieve a goal, such as maximizing profits.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 29 Using Game Theory to Analyze Oligopoly Learning Objective 13.2 A Duopoly Game: Price Competition between Two Firms FIGURE 13.2 A Duopoly Game

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 29 Learning Objective 13.2 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 otherwise not to compete. Using Game Theory to Analyze Oligopoly 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 in which each firm chooses the best strategy, given the strategies chosen by other firms. Don’t Let This Happen to YOU! Don’t Misunderstand Why Each Manager Ends Up Charging a Price of $400

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 29 Learning Objective 13.2 A Beautiful Mind: Game Theory Goes to the Movies Making the Connection In the film A Beautiful Mind, Russell Crowe played John Nash, winner of the Nobel Prize in Economics.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 29 Learning Objective 13.2 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 in which pursuing dominant strategies results in noncooperation that leaves everyone worse off. Using Game Theory to Analyze Oligopoly Firm Behavior and the Prisoners’ Dilemma

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 29 Solved Problem 13-2 Is Advertising a Prisoners’ Dilemma for Coca-Cola and Pepsi? Learning Objective 13.2

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 29 Learning Objective 13.2 Is There a Dominant Strategy for Bidding on eBay? Making the Connection On eBay, bidding the maximum value you place on an item is a dominant strategy.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 29 Learning Objective 13.2 FIGURE 13.3 Changing the Payoff Matrix in a Repeated Game Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoners’ Dilemma?

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 29 Learning Objective 13.2 Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoners’ Dilemma? Price leadership A form of implicit collusion where one firm in an oligopoly announces a price change, which is matched by the other firms in the industry.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 29 Learning Objective 13.2 American Airlines and Northwest Airlines Fail to Cooperate on a Price Increase Making the Connection The airlines have trouble raising the price this business traveler pays for a ticket.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 29 Learning Objective 13.2 FIGURE 13.4 World Oil Prices, 1972–2006 Cartel A group of firms that collude by agreeing to restrict output to increase prices and profits. Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 29 Learning Objective 13.2 FIGURE 13.5 The OPEC Cartel with Unequal Members Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 29 Learning Objective 13.3 FIGURE 13.6 The Decision Tree for an Entry Game Sequential Games and Business Strategy Deterring Entry

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 29 Solved Problem 13-3 Is Deterring Entry Always a Good Idea? Learning Objective 13.3

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 29 Learning Objective 13.3 FIGURE 13.7 The Decision Tree for a Bargaining Game Sequential Games and Business Strategy Bargaining

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 29 Learning Objective 13.4 FIGURE 13.8 The Five Competitive Forces Model

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 29 Learning Objective 13.4 Competition among firms in an industry can lower prices and profits. Competition in the form of advertising, better customer service, or longer warranties can also reduce profits by raising costs. Firms face competition from companies that currently are not in the market but might enter. We have already seen how actions taken to deter entry can reduce profits. The Five Competitive Forces Model Competition from Existing Firms The Threat from Potential Entrants

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 29 Learning Objective 13.4 Firms are always vulnerable to competitors introducing a new product that fills a consumer need better than their current product does. If buyers have enough bargaining power, they can insist on lower prices, higher-quality products, or additional services. If many firms can supply an input and the input is not specialized, the suppliers are unlikely to have the bargaining power to limit a firm’s profits. The Five Competitive Forces Model Competition from Substitute Goods or Services The Bargaining Power of Buyers The Bargaining Power of Suppliers

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 29 Learning Objective 13.4 Is Southwest’s Business Strategy More Important Than the Structure of the Airline Industry? Making the Connection Southwest’s business strategy allowed it to remain profitable when many other airlines faced heavy losses.

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 29 An Inside LOOK Can Target Compete with Wal-Mart in the Market for Generic Drugs? Target Says It Will Match Wal-Mart’s $4 Generic Drug Price

Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 29 Barrier to entry Business strategy Cartel Collusion Cooperative equilibrium Dominant strategy Economies of scale Game theory K e y T e r m s Nash equilibrium Noncooperative equilibrium Oligopoly Patent Payoff matrix Price leadership Prisoners’ dilemma