1. Chapter 12 PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1

2. Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2 The concentration ratio and the Herfindahl-Hirschman Index (HHI) Balanced and unbalanced oligopoly Horizontal, vertical and conglomerate mergers

3. Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3 Cartels Game theory Price leadership Kinked demand Brand multiplication Price discrimination

4. Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 4 For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few— oligopoly.

5. Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 5 An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic.

6. Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 6 Concentration ratio A measure of market power. It is the ratio of total sales of the leading firms in an industry (usually four) to the industry’s total sales.

7. Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 7 A criterion for determining whether an industry is an oligopoly: If the leading four firms in an industry account for 40 percent or more of total industry sales, then an industry is likely to be an oligopoly.

8. Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 8 Herfindahl-Hirschman index A measure of industry concentration, calculated as the sum of the squares of the market shares held by each of the firms in the industry.

9. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 9 EXHIBIT 1CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI Source: U.S. Bureau of the Census, 2002; Concentration Ratios in Manufacturing, 2004.

10. Exhibit 1: Concentration Ratios— Percentage of Total Industry Sales Produced by the Leading Four Firms, and HHI © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 10 How many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level? 13 of the 15 industries

11. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 11 EXHIBIT 2DISTRIBUTION OF MANUFACTURING INDUSTRIES BY FOUR-FIRM SALES CONCENTRATION Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission.

12. Exhibit 2: Distribution of Manufacturing Industries by Four-Firm Sales Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 12 How many industries had four-firms controlling 40-59 percent of the industry sales in 1982? 120 out of 448 total industries had four firms controlling 40-59 percent of the total industry sales.

13. Oligopoly and Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 13 Contrary to many people’s intuition, there is no convincing evidence that the share of industry sales controlled by the four leading firms in the US manufacturing economy is growing.

14. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 14 EXHIBIT 3PERCENTAGE OF TOTAL INDUSTRIAL SALES PRODUCED BY INDUSTRIES WITH FOUR-FIRM SALES CONCENTRATION RATIOS OF 50 PERCENT OR MORE: 1895–1982 Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission.

15. Exhibit 3: Percentage of Total Industrial Sales Produced by Industries with Four- Firm Sales Concentration Ratios of 50 Percent or More: 1895–1982 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 15 What is the trend in the percentage of industrial sales produced by the largest four firms since 1963? There is a downward trend in the percentage of industrial sales by the largest four firms from 1963 to 1982.

16. Oligopoly and Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 16 Market power A firm’s ability to select and control market price and output.

17. Oligopoly and Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 17 Unbalanced oligopoly An oligopoly in which the sales of the leading firms are distributed unevenly among them.

18. Oligopoly and Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 18 Balanced oligopoly An oligopoly in which the sales of the leading firms are distributed fairly evenly among them.

19. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 19 EXHIBIT 4BALANCED AND UNBALANCED OLIGOPOLY

20. Exhibit 4: Balanced and Unbalanced Oligopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 20 1. What percentage of their industry’s total sales do the leading four firms in Industry A and B control? The leading four firms in both industry A and B control 80 percent of their industry’s sales.

21. Exhibit 4: Balanced and Unbalanced Oligopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 21 2. Why is industry B considered an unbalanced oligopoly? The largest firm in industry B controls 50 percent of the industry’s sales. It’s market share is greater than the other three leading industries combined and more than four times greater than the next largest firm’s sales share.

22. Oligopoly and Concentration Ratios © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 22 The dominance of oligopolies in industry is not unique to the U.S. The concentration ratios for U.S. industries are similar to other modern industrialized economies.

23. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 23 EXHIBIT 5PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano Memorial Society, p. 162.

24. Exhibit 5: Production Concentration Ratios in Japanese Manufacturing Industries by Leading and Five Leading Firms © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 24 In how many Japanese industries do the five leading firms have greater than a 90 percent production concentration ratio? Four industries—beer, nylon, glass, and tires and tubes—are controlled by the five leading firms at a concentration of 90 percent or greater.

25. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 25 An oligopoly can build market power in two ways: Reinvesting its profit and painstakingly expanding its production capacity. Merging with and/or acquiring other firms.

26. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 26 There are three reasons why firms merge: 1.To exercise greater market control. 2.To increase control over the supplies of their inputs or the buyers of their goods. 3.To expand and diversify their asset holdings.

27. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 27 There are three types of mergers: 1.Horizontal merger 2.Vertical merger 3.Conglomerate merger

28. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 28 Horizontal merger A merger between firms producing the same good in the same industry.

29. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 29 A number of high-profile horizontal mergers occurred in the 1990s. Boeing and McDonnell Douglas in the aircraft industry. Staples and Office Depot in the office supply industry. Union Pacific and Southern Pacific Rail in the railroad industry.

30. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 30 Vertical merger A merger between firms that have a supplier- purchaser relationship.

31. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 31 An example of vertical merging is that of Anheuser-Busch. The firm has acquired malt plants, yeast plants, a corn-processing plant, beer can factories, and a railway that ships freight by rail and truck.

32. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 32 Conglomerate merger A merger between firms in unrelated industries.

33. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 33 The conglomerate merger is the most common type of merger.

34. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 34 One reason for conglomerate mergers is the desire to diversify operations. While horizontal and vertical mergers strengthen the firm’s position within the industry, the fate of the firm rests on the health of the industry. Acquiring unrelated firms insures the conglomerate against catastrophe if one industry faces severe problems.

35. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 35 Cartel A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares.

36. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 36 Collusion The practice of firms to negotiate price and market share decision that limit competition in a market.

37. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 37 Cartels are an example of a merger in which firms don’t have to actually buy each other’s assets, yet they enjoy the benefits of having market power.

38. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 38 While cartels are illegal in the United States, it is difficult to prove collusion. Some governments encourage cartels to form in their countries. OPEC is one example.

39. Concentrating the Concentration © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 39 Many studies support the contention that price and concentration ratios move in the same direction – an increase in one is associated with an increase in the other.

40. Mergers without Merging © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 40 Firms don’t have to merge or acquire each other to gain the advantages of merging. They can remain independent by creating a joint venture or joining a cartel.

41. Mergers without Merging © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 41 Joint venture A business arrangement in which two or more firms undertake a specific economic activity together.

42. Mergers without Merging © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 42 Cartel A group of firms that collude to limit competition in a market by negotiating and accepting agreed upon price and market shares.

43. Mergers without Merging © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 43 Collusion The practice of firms to negotiate price and market share decisions that limit competition in a market.

44. Cartel Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 44 A cartel determines price by acting as if it is a monopoly. Price and quantity are determined using the MR = MC rule.

45. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 45 EXHIBIT 6CARTEL PRICING AND OUTPUT ALLOCATIONS

46. Exhibit 6: Cartel Pricing and Output Allocations © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 46 Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned? The price and output decisions made by the cartel are determined by the MR = MC rule.

47. Exhibit 6: Cartel Pricing and Output Allocations © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 47 Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned? The price and quantity assigned to individual firms within the cartel may not coincide with where the firm would maximize profit using its own MR and MC curves.

48. Exhibit 6: Cartel Pricing and Output Allocations © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 48 Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned? There is an incentive for the firm to try to secretly increase quantity and thereby increase its own profit.

49. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 49 EXHIBIT 7RELATIONSHIP BETWEEN THE CONCENTRATION RATIO AND PRICE

50. Exhibit 7: Relationship Between the Concentration Ratio and Price © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 50 Where on the curve in Exhibit 7 does the concentration ratio have the strongest effect on price? The effect is the strongest in the middle of the S-shaped curve.

51. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 51 In monopoly, monopolistic competition and perfect competition, firms react only to the demand and cost structures they face. Prices tend toward equilibrium.

52. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 52 In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change.

53. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 53 Game theory A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent.

54. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 54 Nash equilibrium A set of pricing strategies adopted by firms in which none can improve its payoff outcome, given the price strategies of the other firm or firms.

55. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 55 Payoff matrix A table that matches the sets of gains (or losses) for competing firms when they choose, independently, various pricing options.

56. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 56 EXHIBIT 8FIRM PROFIT, GENERATED BY HIGH AND LOW PRICING

57. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 57 EXHIBIT 9PAYOFF MATRIX

58. Exhibits 8 & 9: Firm Profit Generated by High and Low Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 58 How does total profit change as Dell and Compaq change their prices? When both firms price high, total profit is 20. When one firm prices high and the other prices low, total profit is 18. When both firms price low, total profit is 12.

59. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 59 Price leadership A firm whose price decisions are tacitly accepted and followed by other firms in the industry. The theory explains pricing in unbalanced oligopolies.

60. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 60 Tit-for-tat A pricing strategy in game theory in which a firm chooses a price and will change its price to match whatever price the competing firm chooses.

61. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 61 EXHIBIT 10PRICE AND OUTPUT UNDER CONDITIONS OF GODFATHER OLIGOPOLY

62. Exhibit 10: Price and Output Under Conditions of Godfather Oligopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 62 How is the price of chocolate determined in Exhibit 10? Hershey is the “godfather” in the chocolate business. Hershey produces where its MR = MC. That is, 5 tons of chocolate at $5 per pound. The other firms in the chocolate industry accept the $5 per pound price.

63. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 63 EXHIBIT 11CONSTRUCTING AN OLIGOPOLIST’S DEMAND CURVE

64. Exhibit 11: Constructing an Oligopolist’s Demand Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 64 1. If Lipton were to raise its price above $0.80 per box, what would its competitors do, according to the curve in panel b ? Lipton’s competitors would not follow suit. Lipton’s demand curve above $0.80 ( NK ) is relatively elastic.

65. Exhibit 11: Constructing an Oligopolist’s Demand Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 65 2. If Lipton were to lower its price below $0.80 per box, then what would its competitors do? Lipton’s competitors would feel compelled to follow suit. Lipton’s demand curve below $0.80 (YK) is relatively inelastic.

66. Theories of Oligopoly Pricing © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 66 Kinked demand curve The demand curve facing a firm in oligopoly; the curve is more elastic when the firm raises price than when it lowers price.

67. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 67 EXHIBIT 12PRICE RIGIDITY IN OLIGOPOLIES WITH KINKED DEMAND CURVES

68. Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 68 The marginal revenue curve associated with a kinked demand curve is: i.Continuous ii.Discontinuous

69. Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 69 The marginal revenue curve associated with a kinked demand curve is: i.Continuous ii.Discontinuous

70. Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 70 As long as the MC curve crosses the gap created by the discontinuity in the MR curve, price will remain unchanged, as shown in panel b.

71. Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 71 If the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c.

72. Brand Multiplication © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 72 Brand multiplication Variations on essentially one good that a firm produces in order to increase its market share.

73. Brand Multiplication © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 73 A firm’s market share = (Number of brands) × (Brand market share). As the number of brands in the industry increases, market share per brand diminishes.

74. Price Discrimination © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 74 Price discrimination The practice of offering a specific good or service at different prices to different segments of the market.

75. Price Discrimination © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 75 Oligopolists sometimes segment the market in order to charge consumers what they are willing to pay for a good or service. Differences in airline ticket prices are a good example.

76. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 76 EXHIBIT 13DEMAND SCHEDULE FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK

77. Exhibit 13: Demand Schedule for a United Airlines Round-Trip Flight Between LA and NY © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 77 If United chose not to segment its market in Exhibit 13, what would be its total revenue? The maximum total revenue for United would be achieved at a ticket price of $318 each, for a total of $119,250.

78. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 78 EXHIBIT 14DEMAND BY MARKET SEGMENT FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK

79. Exhibit 14: Demand by Market Segment for a United Airlines Round- Trip Flight Between LA and NY © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 79 What is United’s total revenue when it segments its market into a multiple-fare system? United’s total revenue is $210,635. This is an increase of $91,385 over the unsegmented market.

80. Price Discrimination © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 80 Price discrimination exists in virtually every market. Some differences in price are not clear cases of price discrimination, however.

81. Why Oligopolists Sometimes Discriminate © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 81 For example, many would argue that upper balcony seats are not the same as front row seats at a concert. If the goods are different, then it is not necessarily price discrimination to charge more for the front row seats.