1. Different degrees of Competition How can we empirically (based on data) justify an oligopoly or any market structure of any type? The degree of competition can be approximately determined (with reservations) by the CONCENTRATION RATIO: percentage of sales (revenue) (market share) produced by the largest firms in the industry (or market) Eg. CR 5 = H/O CR 2 = and so on

3. Oligopoly

4. Oligopoly is the market structure with a few firms, as a result of which they can greatly influence price and other market factors. 1887, from Medieval Latin oligopolium, from Greek oligos "little, small," in plural, "the few" (see oligo-) + polein "to sell" (see monopoly)

5. Assumptions of Oligopoly There is a small number of large firms There are high barriers to entry – economies of scale, high start up costs, legal barriers, ads, threats of take over (M&A), etc. Differentiated or homogeneous products – differentiated includes cars, aircraft, pharmaceuticals, etc; homogenous include oil, steel, copper, etc.  the unique feature of Oligopoly: There is mutual interdependence among the few firms – decisions taken by one firm affect other firms in the industry and leads to strategic behavior

6. Some real life examples best explained by Oligopoly Car industry Aircraft industry Pharmaceutical industry Oil industry Financial industry

7. Interdependence Mutual interdependence has 2 important implications for the behavior of the oligopolistic firms – Strategic behavior: the plans of action which take into account a rival’s possible courses of action. Similar to games, chess, etc., where individual players’ actions are based on the expected actions and reactions of their rival(s). e.g. if or assume the rivals follow A, then the firm will follow B – Conflicting incentives: Incentives to collude – to agree among competitors to limit competition usually by fixing prices and therefore lowerng quantity produced. It reduces uncertainties and maximizes profits for the industry as a whole Incentives to compete – a firm also has the incentive to compete with its rivals in hope that it will capture a portion of their market share and profits

8. Nash Equilibrium

9. Game Theory JOHN NASH was a mathematician who developed GAME THEORY (  NOBEL prize for ECONOMICS) to explain how firms might behave in more realistic market forms than perfect competition Game theory is a mathematical technique analyzing the behavior of decision makers who are dependent on each other and who use strategic behavior as they try to anticipate the behavior of their rivals Used extensively in other areas: bargaining theory, contract theory, industrial organization, political science and business strategy making

10. A simple game…tell me what grade you would like: A or C RULES: If you and your “partner” (chosen randomly) both choose A, you both get F If you choose A and your partner chooses C, you get A and your partner gets F (and vice-versa) If you both choose C, you both get D Find the PAY-OFF matrix Is there a DOMINANT STRATEGY?

11. The Prisoner’s Dilemma Assumptions You have been caught with your partner with a stolen car. The police also suspect that you have committed a vicious robbery. Each one of you is held in a separate cell and it is not possible for you to communicate with your partner

12. The police interviews each partner separately and makes the following proposal to each of them “I have enough evidence about the stolen car on both of you to send you to prison for a year. But if you alone confess to the robbery then I’ll make a deal with you: You will get off with a 3- month prison sentence, while your partner will get the 10 years. But, if you both confess, you’ll both get 5 years in prison” Write down one of the following answers: Either “I WILL CONFESS” or “I WILL NOT CONFESS”

13. Pay-off Matrix and Strategies

14. A game in Economics: a duopoly Acme and AAA are two major firms in an industry. Each must decide whether to conduct an advertising campaign. The returns from the decision DEPEND on the decision of the other. The profits are shown in the payoff matrix  H/O ACME Advertises ACME Does NOT advertise AAA Advertises Acme: 150 AAA:150 Acme: -100 AAA: 400 AAA Does NOT advertise Acme: 400 AAA: -100 Acme: 0 AAA: 0

15. Game Theory & Oligopoly

16. Using game theory analysis Firms, which are the ‘players’, will make ‘moves’ (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors. If a large firm competing with other large firms understands the various ‘payoffs’ (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors.

17. Prisoner’s Dilemma and Nash Equilibrium REVIEW John Nash introduced the idea of a Prisoner’s dilemma which shows how two rational decision makers, who use strategic behavior to maximize profits by trying to guess the rival’s behavior, may end up being collectively worse off. The final position that results from the game is often called a Nash Equilibrium (dominant strategy equilibrium). Note: there is a difference between them, however, you do not need to know it. AP students should recognise a dominant strategy equilibrium which occurs if BOTH players have a dominant strategy.

18. Prisoner’s Dilemma and Nash Equilibrium Suppose there are two oligopolistic firms in the space travel industry (this market is also referred to as duopoly): Intergalactic Space Travel (IST) and Universal Space Line (USL) Each of these firms must decide on a pricing strategy i.e. what price to charge consumers for its space travel services. And we assume they have two pricing strategies: High price or Low price Each firm is interested in making its own profits as large as possible, but its profit will depend on the particular combination of pricing strategies that the two firms choose (mutual interdependence)

19. (continued) The four possible combinations of pricing strategies and their corresponding profit outcomes (‘payoffs’) for the two firms can be modeled as follow (this is called the ‘payoff matrix’ where Z is the currency name

20. Each box shows the profit outcomes of different pricing strategies by the two interdependent firms. If both agree on high price strategy, they earn 40 million Z but if they both set low price they earn 20 million. But if one sets low and other sets high, the firm setting the low price earns 70 million in comparison to the 10 million of the high price firm. This is because the low price firm captures a large portion of sales from its rival Now, suppose the two firms begin in box 1 where they are competing each other on the basis of price (charge low price), leading to a profit of 20 million Z each At this point, they realize that they will both be better off if they enter into an collusive agreement (eg a CARTEL)and charge a high price to earn 40 million Z each But now, each firm faces a dilemma… why?

21. (continued) Each firm faces a dilemma since each firm realizes that if they secretly break the high price agreement and charge low price, it can earn a much higher profit of 70 million Z In addition (as the collusive agreement is not necessarily binding by law), the firm realizes that their rival also has the same incentive to break the agreement in which case the firm will only obtain 10 million Z Now, what should they do? As each firm tries to “outguess” its rival it is likely to beat its rival by setting a low price (and also to avoid being beaten). Since the other firm is also thinking along the same lines, they will also do the same by setting a low price. As a result both firms adopt the low price strategy where they both earn low profits This is the Equilibrium where both firms become collectively worse off. It also demonstrates that COLLUSION (CARTELS) are inherently unstable.

22. More Equilibria: Dominant Strategy Equilibrium There are more and different types of equilibria in game theory. Moreover, there can be multiple equilibria in one game One equilibrium is called the dominant strategy equilibrium A strategy is dominant if, regardless of what any other players do, the strategy earns a player a larger payoff than any other. Hence, a strategy is dominant if it is always better than any other strategy, for any profile of other players' actions https://www.youtube.com/watch?v=3Y1WpytiHKE Do review worksheet

23. To Sum Game theory shows that there is sometimes a conflict between the pursuit of individual self interest and the collective firms’ interest. This conflict is the prisoner’s dilemma. Although the firms could be better off by cooperating (colluding); each firm, trying to make itself better off, ends up making both itself and its rival worse off

24. In the context of Oligopoly… Game Theory illustrates many of the key aspects of an oligopolistic firm: – Mutual interdependence – profits of one firm depend on the strategies adopted by other firms – Display of strategic behavior – each firm trying to speculate about the other firm’s actions and to outguess it – Conflicting incentives – firms face incentives to collude (agree, cooperate) and incentives to compete (cheat, break agreement) – Price competition and price wars – firms all become worse off if they match the price cuts of each other in order to capture more sales – Incentive to avoid price wars as all firms become worse off. Strong incentive to compete on the basis of factors other than price (non-price competition eg differentiated products, promotions, etc)

25. Different Types and Models of Oligopoly Using Economic Concepts and Analysis

26. Two Main Types of Oligopoly Models Collusive Oligopoly – Open/formal collusion: cartels – Tacit/informal collusion: price leadership and other approaches Non-Collusive Oligopoly – the kinked demand curve model

27. 1. Collusive Oligopoly

28. Collusive Oligopoly Collusion is an agreement between firms to limit competition, which increases monopoly power and profits The most common form involves price fixing arrangements such as: – holding prices constant at some level – raising prices by some fixed amount – Bid rigging (dango in Japan) Collusion is illegal in most countries as stipulated in competition law because it limits competition. But in some countries and depending on the case, collusion could be established either as: – Formal collusion: such as a cartel – Informal collusion: such as price leadership

29. Open/Formal Collusion: Cartels Cartel is a formal and agreement between firms to take actions to limit competition in order to increase profits The agreement may involve: – Limiting and fixing the quantity produced by each firm which results in increase in price – Fixing the price at which output can be sold (eg taxi fares in Japan) – Setting restrictions on non-price competition (such as advertising) – Dividing the market according to geographical or other factors – Agreeing to set up barriers to entry In all cases, the objective is to limit competition, increase the monopoly power of the firms, and increase profits  good for society??

30. Real Life Example An example of a cartel is OPEC (Organization of Petroleum Exporting Countries) composed of group of 13 oil producing countries OPEC periodically tries to change the world price of oil by altering the total output/supply of oil in order to maximize the profit of the cartel – However, the recent situation is that OPEC is not reducing the supply of oil to counter the decreasing price of oil. Why? Individual economies are trying to maximize their own profits. The cartel’s power is limited by the rising shale gas industry in the US, the rising popularity of non-gasoline based cars, etc. Each member country is assigned an output level (quota) that it is permitted to produce This restricted level of output results in high price and consumers of oil (and society at large) are made worse off

31. Led by Saudi Arabia 13 th member is Indonesia

33. How to Model Cartels ? Suppose the firms in an industry (market) decide to form a cartel by fixing price The cartel limits competition between the member firms and attempts to maximize joint profits Thus, the cartel members collectively and jointly behave like a monopoly as shown below

34. The diagram is identical to the case of monopoly But now the MR, AR, MC and ATC curves represent curves of the entire cartel The MC curve (or supply curve) is the sum of all the MC curves of the all the firms in the cartel The cartel, just like a monopolist, equates MR with MC to find the cartel’s profit maximizing output and determine the industry-wide price of Pe But allocative and productive inefficiency results

35. (continued) But the challenge now is how to divide the profit- maximizing industry output between the firms (deciding how much of the total quantity will be produced by each firm) i.e. setting quotas on the output of each firm. There are again multiple ways to do this (business strategy and negotiation becomes even more important) – Based on historical market share of the industry – To compete for market share based on non-price competition

36. Obstacles to Forming and Maintaining Cartels Many factors make it difficult for a cartel to be established and maintained: – The incentive to cheat – every firm faces the incentive to cheat by secretly lowering the price to increase its market share and profits at the expense of other firms (can demonstrate with Game Theory) – Cost differences between firms – as each firm faces different cost curves, the price agreed upon by the cartel is maybe higher or lower than the average cost curves of different firms. This leads to difficulty agreeing on a common price.

37. (continued) Firms face different demand curves – this is likely to happen as firms have different market shares and have product differentiation. This leads to difficulties in reaching agreement on common price Number of firms – the larger the number of firms, the more difficult it is to arrive at an agreement on price and allocation of output Possibility of a price war – if one or more firms cheat, it could lead to a price war where one firm’s price cut is matched by retaliatory price cuts by other firms and all firms collectively become worse off

38. (continued) Recessions – during recessions (periods when incomes and economic activities fall) sales fall and profits are reduced, which give firms greater incentives to cheat Potential entry into the industry – if the cartel earns large economic profits, this will encourage new firms to enter. If there are new entrants, increased industry supply will drive price down. The cartel needs high barriers to entry that block new entrants. Industry lacks a dominant firm – presence of dominant firms can facilitate reaching agreement e.g. for OPEC, the dominant member is Saudi Arabia. Lack of leadership can make agreement difficult

39. Group III Tacit/Informal Collusion: Price Leadership Tacit collusion (informal collusion) refers to cooperation that is implicit or understood between the cooperating firms, without a formal agreement Firms turn towards tacit collusion given the difficulties of establishing and maintaining cartels as well as their illegality The objectives of tacit collusion are also to: – Coordinate prices – Avoid competitive price cutting – Limit competition – Reduce uncertainties – Increase profits

40. Price Leadership One type of tacit/informal collusion is where a dominant firm (usually with the largest market share) sets a price and also initiates any price changes. The remaining firms become price-takers, accepting the price that has been established by the leader The implicit agreement binds the firms as far as the price goes, but they can engage in non-price competition (eg………………………….) One characteristic is that the price changes tend to be infrequent and are undertaken by the leader only when major demand or cost changes

41. Obstacles to Sustaining Price Leadership The obstacles to price leadership are similar to the ones faced by cartels: – Cost differences between firms, particularly when there is significant product differentiation – Some firms may follow and some may not follow in which case the leader risks losing sales if it initiates an increase in price – Firms still face incentives to cheat by lowering price which could lead to a price war – High industry profits can attract new firms that will cut into market shares and profits of the industry – Depending on where and how it is practiced, it can be considered illegal

42. 2. Non-Collusive Oligopoly

43. Non-Collusive Oligopoly: In the collusive oligopoly model, prices of oligopolistic industries tend to be rigid or “sticky” (relatively stable over long periods of time). Moreover, in situations when price do change, they tend to change together for all the firms in the industry BUT price rigidities also appear and can be modeled in situations of non-collusive oligopoly In non-collusive oligopoly, firms do not agree, whether formally or informally, to fix prices or collaborate in some way BUT suppose they make some assumptions about how other firms might react……………………………

44. Assuming…………. The firm thinks that, if it raises its prices, then other firms will probably NOT raise their prices--  It also thinks that if it lowers prices, then other firms will probably also lower prices   the KINKED demand curve Price Quantity Pe……………………………Z …………………………. Qe

45. (continued) And these expectations are reflected in the kinked demand curve To understand this demand curve, imagine three firms A, B, and C each producing output Qe selling at price Pe Now, say that firm A considers a price change, but before changing its price, it tries to predict how firms B and C will react and the consequences of their reaction – If A raise its price above P1, it thinks that B and C are unlikely to raise their prices to attract more customers  the demand curve for A is elastic above Pe. Therefore, A should not raise the price above Pe. Any price increase will lead to a relatively large decrease in sales and revenues and profits as customers switch to firms B and C – Now, if A drops the price below P1, it thinks that B and C are likely to drop their prices as well in order to maintain their customers. A will only capture a small increase in share with the decrease in price below Pe  the demand curve for A is inelastic below Pe. For any price decrease, A will obtain only a small increase in sales and revenues and profits will fall. Therefore, A should not decrease its price below Pe either This line of thought is the same of B and C and the three firms remain at point Z.

46. The Kinked Demand Curve

47. Consider the marginal revenue curve (GroupVI) The Kinked Demand Curve explains the price rigidities of oligopolistic firms (even if MC curves shift) that do not collude Under this model, the pricing behavior is strategic and is strongly influenced by their expectations of how firms will react if they undertake the price change (as a consequence of the interdependence between firms)

48. (continued) Non-Collusive Oligopoly with the Kinked Demand Curve (although that kink does not necessarily occur) illustrates these points: – Firms who do not collude are forced to take into account the actions of their rivals in making decisions. Otherwise they risk losing their revenue and profits. The kinked demand curve illustrates the interdependence of the firms – Even though the firms do not collude, there is still price stability and rigidity. Firms are reluctant to change price as there is a possibility of price war – Firms do not compete with each other on the basis of price again to avoid price war which results in lowering profits for all firms  firms use non-price competition

49. Some Limitations of the Model The non-collusive kinked demand curve model has some limitations: – It cannot explain how the firm arrived at point Z – It does not explain the pricing behavior of firms when the economy is subject to inflation and recession (when prices drop to the point they can set off price wars)

50. The Role of Non-Price Competition in Oligopoly Oligopolistic firms try to avoid price competition as they would like to avoid price wars, which make all firms collectively worse off with lower profits (shown by Game Theory) However, as they somehow fix prices, oligopolistic firms usually do engage in intense non-price competition (eg product development  product differentiation, advertising, and branding)

51. Summary Evaluation of Oligopoly - criticisms and benefits, comparisons with other market structures - Criticisms of Oligopoly: to the extent that oligopolistic firms succeed in avoiding price competition (collude), they achieve a considerable degree of monopoly power, and therefore face the same criticisms as monopoly: – Higher prices are charged and lower quantities of output are produced in comparison to competitive markets – Neither allocative nor productive efficiency is achieved – Whereas many countries have anti-monopoly laws, the informalities and difficulty of detecting collusion may allow them to get away with monopoly power BUT consider price stability versus price wars… which is preferable for the consumer?

52. (continued) Benefits of Oligopoly: the benefits of oligopoly are also similar to the benefits of monopoly – Economies of scale can be achieved due to the large size of the firms, leading to lower production costs to benefit the society and consumers (ie through lower prices) – Product development and innovation can be pursued due to the large economic profits and entry barriers. This is more likely to happen than in a monopoly since firms would like to avoid price wars and compete on a non-price basis – Technological innovations which improve efficiency and lower costs of production may be passed to consumers in the form of lower prices – Product development leads to increased product variety, providing consumers with greater choice and options (as also occurs in the case of monopolistic competition (not yet studied) but not monopoly)