1. copyright © michael.roberson@eStudy.us 2010, All rights reserved eStudy.us Oligopoly

2. copyright © michael.roberson@eStudy.us 2010, All rights reserved eStudy.us Market Structure – A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry and exit Oligopoly only a few firms (firms have market power, can change price) offer identical (homogeneous) or similar (differentiated) products difficult to enter or exit the industry Oligopoly Interdependent unlike participants in perfect competition where firms don’t need to consider actions of other producers in the short run, in oligopoly actions of each firm will impact other firms in the market

3. copyright © michael.roberson@eStudy.us 2010, All rights reserved eStudy.us Market Structure Economists who study industrial organization divide markets into four types: monopoly, oligopoly, monopolistic competition, and perfect competition. Number of Firms Monopoly Oligopoly Monopolistic Competition Perfect Competition One Firm Few Firms Product Type Many Firms Differentiated Identical ½ ton trucks Wireless phones Novels Movies Wheat Corn Tap Water Sewer Services Imperfect Competition

4. copyright © michael.roberson@eStudy.us 2010, All rights reserved eStudy.us Imperfect competition – between perfect competition and monopoly Oligopoly Monopolistic competition Produce a quantity where price is greater then marginal cost Price will be higher than Perfect Competition Quantity produced will be less can Perfect Competition Oligopoly

5. eStudy.us Oligopoly Definition Homogeneous Oligopoly – Steel (U.S. Steel, Arcelor Mittal, Nuco) – Copper (Phelps Dodge, Arasco, Freeport-McMoRan, Southwire) GE or GM both needing Steel and Copper will write specification and no matter which producer wins the business GE and GM will get an identical product. Differentiated Oligopoly – ½ Ton Truck Market (Ford, GM, Chrysler, Toyota) – Commercial Airline Market (America, United, Southwest, Delta, _________, ___________ Even if you don’t know a thing about ½ ton trucks you can identify every truck producer. How? Trucks are different and each one has the brand name on the vehicle.

6. eStudy.us Markets with Few Sellers Two types of Oligopoly Collusive – market participants work together to greater a better profit outcome Non-collusive – act as competitors in the market place A small group of sellers – Tension between cooperation and self-interest – Best to cooperate with other firms to create monopoly profit – However, each firm cares only about its own profit which creates a powerful incentive not to cooperate Duopoly – Oligopoly with only two members

7. eStudy.us Non-collusive Oligopoly firms participate in non-price completion – Unique product features (iPhone, iPad) – Increase transaction cost of switching Contracts (Wireless phones, insurance, etc…) Lock-in (FirstName.LastName@yahoo.com)

8. eStudy.us Non-collusion results in: – Higher quantity – lower price – lower profit Equilibrium Theory – Game Theory: how people or firms behave in strategic situations Choose among alternative courses of action Must consider how others might respond to the action they take – Nash equilibrium: economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen Non-collusive

9. eStudy.us The prisoners’ dilemma – Particular “game” between two captured prisoners – Illustrates why cooperation is difficult to maintain even when it is mutually beneficial Dominant strategy – A strategy that is best for a player in a game regardless of the strategies chosen by the other players Pay-off Table quantifies the value of each outcome in game theory based on participant choices Non-collusive

10. eStudy.us Bonnie’s decision ConfessRemain silent Clyde’s Decision Confess Remain silent Bonnie gets 8 years Bonnie gets 20 years Bonnie goes freeBonnie gets 1 year Clyde gets 20 yearsClyde gets 8 yearsClyde gets 1 year Clyde goes free Prisoners’ dilemma In this game between two criminals suspected of committing a crime, the dominate strategy for each is to confess. Why because no matter what the other does confession is the best choice.

11. eStudy.us Oligopolies as a prisoners’ dilemma – In trying to reach the monopoly outcome – Firms have self-interest and do not cooperate even though cooperation would increase profits each firm has incentive to cheat to maximize profit Example Ford and GM (1/2 ton pick-up trucks) – Differentiated oligopoly – Ford is low cost producer – Discounting vs. Free Features Prisoners’ dilemma

12. eStudy.us GM Decision Free OptionsNo Free Options Ford Decision Rebate No Rebate Ford gets $3 million profit Ford gets $4 million profit Ford gets $5 million profit Ford gets $6 million profit GM earns $4 million profit GM earns $3 million profit GM earns $6 million profit GM earns $5 million profit In the ½ ton truck market, using the above payoff table, Ford will choice to Rebate and GM to offer free options. While each could earn more by cooperating, cooperation is not a sustainable equilibrium in the ½ ton truck market. Prisoners’ dilemma

13. eStudy.us Collusion is an agreement among firms in a market Cartel – a group of firms acting in unison Cartels act as a monopoly to maximize profit – Produce monopoly quantity – Charge monopoly price – Same impacts to society Collusion for self-interest unlikely to work – Difficult to reach & enforce an agreement – Antitrust laws Collusive Oligopoly

14. eStudy.us Economics of Cooperation Why firms sometimes cooperate Game of repeated prisoners’ dilemma – Repeat the game – Agree on penalties if one cheats – Both need an incentive to cooperate Encouraging cooperation Penalty for not cooperating Return to cooperative outcome after a period of noncooperation

15. eStudy.us Organization of Petroleum Exporting Countries (OPEC) – Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela – By 1973: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon – Control about three-fourths of the world’s oil reserves – Tries to raise the price of its product Via a coordinated reduction in quantity produced Cheating Problem: Each member of the cartel – Tempted to increase its production – Get a larger share of the total profit – Cheat on agreement Collision Example

16. eStudy.us OPEC was successful at maintaining cooperation and high prices from 1973 to 1985: increase in price Mid-1980s - member countries began arguing about production levels – OPEC became ineffective at maintaining cooperation – Decrease in price 2007 to 2008 – significant increase in price primarily caused by increased world demand Booming World economy Collision Example

17. eStudy.us Restraint of trade and the antitrust laws – The Sherman Antitrust Act, 1890 Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy – The Clayton Act, 1914 Further strengthened the antitrust laws – The Federal Trade Commission Act, 1914 Created the Federal Trade Commission (FTC) Can prevent mergers that impede competition Can prevent oligopolists from colluding Public Policy

18. eStudy.us Robert Crandall – president of American Airlines Howard Putnam – president of Braniff Airways CRANDALL: I think it’s dumb as hell... to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime. PUTNAM: Do you have a suggestion for me? CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent. I’ll raise mine the next morning. PUTNAM: Robert, we... CRANDALL: You’ll make more money, and I will, too. PUTNAM: We can’t talk about pricing! CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we want to talk about. An illegal phone call – Collusion Example Public Policy

19. eStudy.us Require retailers to charge customers a given price Might seem anticompetitive – Prevents the retailers from competing on price Defenders: – Not aimed at reducing competition – Legitimate goal Some retailers offer service Public Policy Resale price maintenance (fair trade)

20. eStudy.us Charge prices that are too low – Anticompetitive because price cuts are intended to drive other firms out of the market Skeptics – Predatory pricing (not a profitable strategy) – Price war (to drive out a rival) – Pricing below cost Public Policy Predatory pricing

21. eStudy.us Tying Public Policy Offer two goods together at a single price – Expands market power Skeptics – Cannot increase market power by binding two goods together Form of price discrimination – Tying may increase profit

22. eStudy.us U.S. government case against Microsoft Central issue: tying Should Microsoft be allowed to integrate its Internet browser into its Windows operating system The government’s claim: – Microsoft was bundling to expand market power into the market of Internet browsers – Would deter other software companies from entering the market and offering new products Public Policy Example

23. eStudy.us Microsoft responded – New features into old products - natural part of technological progress Cars - include CD players, air conditioners Cameras - built-in flashes Operating systems - added many features to Windows – Previously stand-alone products – Computers - more reliable and easier to use – Integration of Internet technology, The next natural next step Microsoft Case

24. eStudy.us Disagreement about the extent of Microsoft’s market power The government – More than 80% of new personal computers Use a Microsoft operating system Substantial monopoly power Microsoft – Software market is always changing – Competitors: Apple Mac & Linux operating systems – Low price illustrates limited market power Microsoft Case

25. eStudy.us November 1999 ruling Microsoft illegally abused market power June 2000 Ruling to break Microsoft into two companies Operating system & Applications software 2001 appeal Overturned the breakup order September 2001 Justice Department - wanted to settle the case quickly November 2002 settlement Microsoft accepted some restrictions and the browser remains part of the Windows operating system Microsoft Case