1 Chapter 11 Oligopoly

2 Define market structures Number of sellers Product differentiation Barrier to entry

3 Types of Market Structure

4 Oligopoly: A small number of firms mutually dependent on one another, and each has a substantial market share

5 Characteristics of Oligopoly mutual dependence (or interdependence) each firm has a substantial market share, thus is big enough to affect market price barriers to entry

6 Barriers to entry: Entry limiting pricing Capacity barrier Economies of scope New product development

7 Barriers to entry: strategic deterrence Entry limiting pricing Capacity barrier Economies of scope New product development

8 Entry limiting pricing if cost situation allows, set P< min LAC of the potential entrant

9 Capacity barrier Keep excess capacity as a threat for larger Q and lower P.

10 Other barriers: Economies of scope (multi-product cost barrier) new product development

11 Economic Theories General Equilibrium theory Mechanism Design theory Decision theory

12 General Equilibrium theory a relatively large number of individual consumers and producers, how the combined individual efforts help define the environment trade and production (markets) macroeconomic analysis –monetary or tax policy –stock markets –interest and exchange rates –trade policy and the role of international trade agreements

13 Mechanism Design theory the consequences of different types of rules the design of compensation and wage agreements that effectively spread risk while maintaining incentives, and the design of actions to maximize revenue, or achieve other goals.

14 Decision theory theory of one person behavior, or a single player against a big environment. preferences among alternatives, maximization of benefits and minimization of costs **how best to acquire information before making a decision.

15 Game Theory Psychologists: the theory of social situations focus on how groups of people interact study of behavior in situations of interdependence Key characteristic: Interdependence

16 Interdependencies In making choices, people must consider the effect of their behavior on others. In making decisions, firms may consider how rivals will respond to their price changes or new advertising.

17 Basic Elements of a Game The players Their strategies The payoffs

18 The Prisoners’ Dilemma

19 Nash Equilibrium Dominant vs. Dominated Strategy: dominant: a strategy that yields a higher payoff no matter what the other players in a game choose dominated: Any other strategy available Nash equilibrium occurs when each player has a dominant strategy and follows that strategy There can be an equilibrium when players do not have a dominant strategy Prisoner’s dilemma: A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

20 Raise ad spendingKeep same ad spending Raise ad spending Same spending $5,500 for $5,500 for American $5,500 United $5,500 for United American’s Choices $2,000 for American $8,000 for United $6, for American $6,000 for American $6, for United $6,000 for United $8,000 for $8,000 for American $2,000 for United United’s Choices The Payoff Matrix for an Advertising Game

21 Dominant Strategies United: increase ad spending American: increase ad spending

22 Equilibrium When One Player Lacks a Dominant Strategy Raise ad spending Leave ad spending same Raise ad spending Leave ad spending the same $4,000 for American $3,000 for United $3,000 for American $8,000 for United $2,000 for American $5,000 for United $5,000 for American $4,000 for United American’s Choices United’s Choices

23 Strategies: American: dominant – increase ad spending United: no dominant strategy: –If American increases ad spending, United should not increase ad spending –If American does not increase ad spending, United should increase ad spending Nash Equilibrium: American increases ad spending (dominant strategy), and United does not increase ad spending

24 Exercise 11.1, P. 287 Does each company have a dominant strategy? What each company should do?

25 Two main branches of game theory cooperative: all parties involved cooperate (collude) to achieve best result for all non-cooperative: how intelligent individuals interact with one another in an effort to achieve their own goals.

26 With Mutual Dependence uncertainty in D and MR –decisions have to take into account of reactions from others. Cooperative: follow changes initiated by rivals Non-cooperative: do not accommodate price changes of other firms

27 Recall: The Prisoners’ Dilemma

28 Non-Cooperative Oligopoly Each acts for its own benefit, not for the benefits of all players

29 The desire for non-cooperation: The Prisoners’ Dilemma

30 Raise ad spendingKeep same ad spending Raise ad spending Leave ad spending the same $5,500 for $5,500 for American $5,500 United $5,500 for United American’s Choices $2,000 for American $8,000 for United $6, for American $6,000 for American $6, for United $6,000 for United $8,000 for $8,000 for American $2,000 for United United’s Choices The desire for non-cooperation: The Prisoners’ Dilemma

31 The desire for non-cooperation: Advertiser ’ s Dilemma Gp = 600 Gc = 600 Gp = 900 Gc = -400 Gp = -400 Gc = 900 Gp = 200 Gc = 200 Low BudgetHigh Budget Low Budget High Budget Pepsi Coke

32 Cooperation The best result for all players

33 Cooperative: Openly or secretly enter into contract to act for the best result for all members Partners of a game Tendency to cheat

34 Cooperative Oligopoly: in general With homogenous products: behave as monopoly With differentiated products: –harder to cooperate; –specific agreement in difference in price or quality;

35 Cooperative Methods Price Leadership: one firm sets a price that the other firms follow Tacit Collusion: agreement without explicit communication cooperation without explicit agreement Cartel: an extreme case

36 Cooperative Oligopoly: Cartel A group of firms with the objective of limiting competitive forces within a market A coalition of firms that agrees to restrict output for the purpose of earning an economic profit A collusive agreement by several producers that increases their combined profits by deciding how much each firm should produce example: OPEC

37 Cartel: Output Allocation among Members – market sharing Pre-cartel sales Production capacity Bargaining power Importance Marginal cost

38 Market Sharing based on MC In order to produce the profit maximizing output, a cartel should allocate production among its members so that MC for all member producers are equal, which is also equal to the common MR. That is, MR=MC1=MC2=MC3...

39 Figure 11.1 Assume 2 firms (Aquapure & Mountain Spring) MC = 0 Cartel is formed & agree to split output and profits Impact of Cartel Q = 1,000 bottles/day P = $1/bottle Each firm makes $500/day The Market Demand for Mineral Water

40 Figure 11.2 Aquapure lowers P P = $.90/bottle Q = 1,100 bottles/day Mountains Spring retaliates P = $.90/bottle Both firms split 1,100 $.90 Profit for each firm = $495/day The Temptation to Violate a Cartel Agreement

41 Charge $1/bottleCharge $0.90/bottle Charge $1/bottle Charge $0.90/bottle Mountain Spring Aquapure $990/day for Mt. Spring $0 for Aquapure $500/day for each $0 for Mt. Spring $990 for Aquapure $495/day for each The Payoff Matrix for a Cartel Agreement

42 Cartel: There is intention to cheat Cooperation between players will increase the payoff in a prisoner ’ s dilemma With time there is a motive to enforce cooperation Explicit agreement is illegal (antitrust; anti price-fixing)

43 Policy Implication: Cigarette Advertising Advertise on TVDon’t advertise on TV Advertise on TV Don’t Advertise on TV $5 million/yr for Philip Morris $10 million/yr for for each $35 million/yr for RJR for RJR Philip Morris RJR $ million/yr $20 million/yr for each for each $35 million/yr for Morris for Philip Morris $5 /yr $5 million/yr for RJR for RJR