1. Chapter 25 Oligopoly 25-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives Concentration Ratios The Herfindahl-Hirschman index The competitive spectrum The kinked demand curve Administered prices 25-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Oligopoly Defined An oligopoly is an industry with just a few sellers How few? So few that at least one firm is large enough to influence price 25-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

4. Oligopoly is the prevalent type of industrial competition in the United States as well as in most of the noncommunist industrial west In terms of production, the vast majority of our GDP is accounted for by firms in oligopolistic industries 25-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Oligopoly

5. The crucial factor under oligopoly is the small number of firms Because there are so few firms, every competitor must think continually about the actions of its rivals –What each does could make or break the others Thus, there is a kind of interdependance among oligopolists 25-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Oligopoly

6. When we talk about big business in the United States,we’re talking about oligopolies. Some examples are –GM, Ford, ExxonMobil, IBM, Boeing, CBS, NBC, Kellog, and General Mills –We can also include all the other industrial giants that have become household names 25-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Oligopoly

7. The graph of the oligopolist is similar to that of the monopolist –The oligopolist is analyzed in the same manner as the monopolist with respect to price, output, profit, and efficiency –Price is higher than the minimum point of the ATC curve, therefore the oligopolist is not as efficient as the perfect competitor –The oligopolist has a higher price and a lower output than does the perfect competitor –The oligopolist, like the monopolist, makes a profit 25-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Oligopoly

8. Concentration Ratios The concentration ration is the percentage share of industry sales of the four leading firms in the industry –Industries with high concentration ratios are very oligopolistic 25-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

9. Calculate the Concentration Ratio FirmPercent of sales A14 % B 4 C 23 D 5 E 2 F 8 G 17 H 10 I 2 J 15 Total100 % 25-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The concentration ratio is 23 + 17 + 15 + 14 = 69

10. Concentration Ratio Shortcomings Concentration ratios do not include imports –This ignores 2 million Japanese imports as well as the hundreds of thousands of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royces the United States imports Concentration ratios tell us nothing about the competitive structure of the rest of the industry –Are all the firms relatively large or are they small? –When the remaining firms are large, they are not as easily dominated by the top four as are dozens of relatively small firms 25-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

11. Concentration Ratio Shortcomings Concentration rations have become less meaningful as imports have increased –The United States gets 80% of its consumer electronics and 53% of its oil from abroad Imports tend to make the automobile industry’s concentration ration less relevant –Transplants reduce this ratio –As a result, the American car buyers have reaped the benefits of lower prices and much higher quality 25-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12. The HHI is the sum of the squares of the market shares of each firm in the industry –A monopoly has 100 percent of the market share 25-12 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Herfindahl- Hirschman Index (HHI) 100 = (100 X 100) = 10,000 2 You can’t get a bigger HHI number than 10,000. Every monopoly would have an HHI of 10,000

13. The HHI is the sum of the squares of the market shares of each firm in the industry 25-13 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Herfindahl- Hirschman Index (HHI) Find the HHI in an industry with just two firms Each firm has 50 percent of the market 50 + 50 = 2,500 + 2,500 = 5,000 2 2

14. The HHI is the sum of the squares of the market shares of each firm in the industry 25-14 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Herfindahl- Hirschman Index (HHI) Find the HHI in an industry that has four firms Each firm has 25 percent of the market 25 + 25 + 25 + 25 2222 625 + 625 + 625 + 625 2500

15. The Competitive Spectrum 25-15 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The possible degrees of competition in an oligopolistic market

16. Cartels A cartel is a combination of firms that acts as if it were a monopoly –The leading firms in an industry band together to restrict output, share out markets and, consequently, increase prices and profits –If the demand is there, oligopolistic firms can openly collude to control supply and, to a large degree, market price –OPEC did this in 1973 when the price of oil quadrupled –A cartel is the most extreme case of oligopoly 25-16 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

17. Withholding Supply to Raise Price 25-17 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. When supply is lowered from S 1 to S 2, price rises from P 1 to P 2

18. Open Collusion 25-18 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Open collusion operates like the alleged Mafia –This would be some type of territorial division of the market among the firms in the industry This type of arrangement gives each firm in the market a regional monopoly The firm may have only 15 or 20% of the market, but under this type of arrangement, its pricing behavior is that of the monopolist –Open collusion is slightly less extreme than a cartel

19. The Colluding Oligopolist 25-19 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. This graph could also belong to the monopolist or the monopolistic competitor in the short run

20. Covert Collusion This usually involves price-fixing –In the late 1950s General Electric, Westinghouse, Allis-Chalmers and other leading electrical firms conspired to fix the price of electrical transformers, turbines, and other electrical equipment –They rigged government bids by taking turns making (high) low bids bilking the public of hundreds of millions of dollars In 1961 the U.S. Supreme court found 7 high ranking corporate officials guilty of illegal price fixing and market sharing agreements Their employers paid their fines They got short jail sentences Their employers paid their salaries while in jail, and they got their old job back after they got out 25-20 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21. Other Cases of Collusion In 1996 Archer Daniels Midland Company pleaded guilty and paid a $100 million criminal fine for its role in two international price-fixing conspiracies In 1999 an arrangement was uncovered that fixed worldwide vitamin prices as much as 25% above the market level A worldwide price-fixing conspiracy led by Swiss and German companies was prosecuted by the U.S Department of Justice 25-21 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22. 25-22 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Price Leadership Price leadership is playing follow the leader –One company raises prices and shortly after, the other companies in the same market do the same The prime rate set by the big banks is a form of price leadership Collusion is most likely to succeed when there are few firms and high barriers to entry

23. Cutthroat Competition Cutthroat competition is an extreme case The cutthroat competitor’s actions are based on assumptions about their rivals behavior The cutthroat competitor assumes that if I raise my price my competitors won’t raise their price The cutthroat competitor assumes that if I lower my price, my competitors will also lower their price Therefore the cutthroat competitor keeps the price just where it is 25-23 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

24. The Cutthroat Oligopolist 25-24 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. No cutthroat oligopolist will raise or lower price. It keeps the price just where it is and that is at the kink in the demand curve

25. The Cutthroat Oligopolist 25-25 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. How much is the price and output for this firm? Price is $27 Output is 4 At an output of 4 MC=MR

26. The Cutthroat Oligopolist 25-26 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Price is $27 Output is 4 At an output of 4 MC=MR ATC is $24 Total Profit = (Price – ATC) X Output = ($27 – 24) X 4 = 3 X 4 = 12

27. Conclusion 25-27 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. At one of the spectrum we have the cartel, which no longer operates within the American economy, although it may be found in world markets At the other end of the spectrum, we have the cutthroat competitor, the firm that will stop at nothing to beat out its rivals Near the middle are the mildly competing oligopolists and the occasionally cooperating oligopolists.

28. Conclusion 25-28 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Where is the spectrum in American industry? The answer is that there is no answer. First, there is no one place where American industry is located because different industries have different competitive situations. Second, there is widespread disagreement about the degree of competition in any given industry