1. Slide 1 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Price and Output Determination: Oligopoly Chapter 12 Oligopolistic Market Structures »Few Firms Consequently, each firm must consider the reaction of rivals to price, production, or product decisions These reactions are interrelated »Can be either Heterogeneous or Homogeneous Products Example – the athletic shoe market is an oligopoly »Nike has 43% of market »Adidas has 15% »Reebok has 10% (See Table 12.1 for other industries)

2. Slide 2 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Nokia’s Profit Margins on Cell Phones is Collapsing The market shares of oligopolists frequently change. In 1985, the market leader in cell phones was Motorola with 45% market share and Nokia second with 22% In 2005, leadership reversed: Nokia held 35% of the market and Motorola 15% However, technology in phones is changing, bringing wireless web, photos, and other high-speed 3G and 4G technologies Entry of other firms and new products, such as Dell, Palm, NEC, Panasonic, and Apple’s iPhone threatens Nokia’s profit margins Nokia must decide how much to invest in 3G & 4G technology. Being a leader in a oligopoly does not mean that you remain the leader for long, and profitability can and does diminish with new entry.

3. Slide 3 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ignoring Interdependencies: The Cournot Model of Oligopoly Models vary depending on assumptions of actions of rivals to pricing and output decisions. Augustin Cournot (1838) created a model that is the basis of Anti-trust Policy in the US. »Relatively simple assumption: ignore the interdependency with rivals »This makes the math relatively easy Cournot

4. Slide 4 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cournot Solution: Case of 2 Firms (Duopoly) Assume each firm maximizes profit Assume each firm believes the other will NOT change output as they change output. »The so-called: Cournot Assumption Find where each firm sets MR = MC

5. Slide 5 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A Numerical Example: Competition, Monopoly, and Cournot Oligopoly IN COMPETITION »P = MC, so 950 - Q = 50 »P C = $50 and Q M = 900 IN MONOPOLY »MR = MC, so 950 -2Q = 50 »Q M = 450 so »P M = 950 - 450 = $500 IN Cournot DUOPOLY »Let Q = q 1 + q 2 D P M P cournot P C Q M Q Cournot Q C 450 600 900 $500 $350 $50 Suppose that: P = 950 - Q and MC =50

6. Slide 6 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Q Let Q = q 1 + q 2 l P = 950 - Q = 950 - q 1 - q 2 and MC = 50 l TR 1 = P q 1 = ( 950 - q 1 -q 2 )q 1 =950q 1 - q 1 2 - q 1 q 2 and l TR 2 = P q 2 = ( 950 - q 1 -q 2 )q 2 =950q 2 - q 2 q 1 - q 2 2 l Set MR 1 = MC & MR 2 = MC 950 -2q 1 - q 2 = 50 950 - q 1 - 2q 2 = 50 2 equations & 2 unknowns

7. Slide 7 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. With 2 Equations & 2 Unknowns: Solve for Output 950 -2q 1 - q 2 = 950 - q 1 - 2q 2 So, q 2 = q 1 Then plug this into the demand equation we find: 950 - 2q 1 - q 1 = 950 - 3q 1 = 50. Therefore q 1 = 300 and Q = 600 The price is: P = 950 - 600 = $350 P Q Competition 50 900 Cournot 350 600 Monopoly 500 450 Cournot’s answer is between the other two.

8. Slide 8 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. N-Firm Cournot Model For 3 firms with linear demand and cost functions: »Q = q 1 + q 2 + q 3 »In linear demand and cost models, the solution is higher output and lower price Q Cournot = { N / (N+1) }Q Competition QCQC N N PCPC THEREFORE, Increasing the Number of Firms increases competition. This is the historical basis for Anti-trust Policies

9. Slide 9 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Example: Cournot as N the number of firms, increases, the price gets closer to competition. If N = 3 Triopoly P = 950 - Q & MC=50 Then, Q = (3/4)(900) Q = 675 P =$275 If N = 5 P = 950 - Q and MC = 50 Then Q = (5/6)(900) Q = 750 P = $200 N = 3 N = 5 Note: With more complex cost functions for both firms the solution involves different output amounts for each firm. See the Siemans and Lucent –Alcatel example in the textbook.

10. Slide 10 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Collusion versus Competition? Sometimes collusion succeeds in an oligopoly Sometimes forces of competition win out over collective action When will collusion tend to succeed? »There are six factors that influence successful collusion as follows:

11. Slide 11 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Factors Affecting Likelihood of Successful Collusion: 1.Number and Size Distribution of Sellers. Collusion is more successful with few firms or if there exists a dominant firm. 2.Product Heterogeneity. Collusion is more successful with products that are standardized or homogeneous 3.Cost Structures. Collusion is more successful when the costs are similar for all of the firms in the oligopoly. 4.Size and Frequency of Orders. Collusion is more successful with small, frequent orders. 5.Threat of Retaliation. Collusion is more successful when firms fear retaliation by the other firms to secret price cuts to its customers. 6.Percentage of External Output. Collusion is more successful when percentage of external suppliers is small.

12. Slide 12 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cartel Profit Maximization and the Allocation of Restricted Output Profits if sell more than F’s allocation

13. Slide 13 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Examples of Cartels Ocean Shipping -- maritime insurance is exempted from US Antitrust Laws DeBeers – diamond international cartel Coffee – Columbia, Brazil and Central African countries Late 1950’s Electrical Pricing Conspiracy -- GE, Westinghouse, and Allis Chalmers OPEC - oil cartel, with Saudi Arabia making up 33% of the group’s exports Siemens and Thompson-CSF -- airport radar systems NCAA - intercollegiate sports, also Major League Baseball

14. Slide 14 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PRICE LEADERSHIP Barometric : One (or a few firms) sets the price One firm is unusually aware of changes in cost or demand conditions The barometer firm senses changes first, or is the first to ANNOUNCE changes in its price list Find barometric price leader when the conditions unsuitable to collusion & firm has good forecasting abilities or good management Sometimes the barometric leader changes over time.

15. Slide 15 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Barometric Price Leader Example: American Airline and Continental Airlines With fuel cost increases, American announces a fare increase (by dropping a 3-day advance option). Other firms could follow or not. Continental followed, but Delta, United, US Airways, and Northwest didn’t. American returned to its 7-day policy in markets competing with the others. But in the Houston hub, Continental and American kept the de facto higher prices.

16. Slide 16 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Dominant Firm Price Leadership Dominant Firm: 40% share of market or more. No price or quantity collusion Dominant Firm (L) expects other firms (F) to follow its price leadership. Dominant firm concedes output to other firms (since absent collusion it cannot control) for price leadership.

17. Slide 17 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Graphical Approach to Dominant Firm Price Leadership Net Demand Curve: D L = D T -  MC F

18. Slide 18 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Implications of Dominant Firm Price Leadership Market Share of the Dominant Firm Declines Over Time (if  MC F increases, D L falls) if economic profits exist among other firms. Profitability of the Dominant Firm Declines Over Time Market Share of the Dominant Firm is PROCYCLICAL (rises in booms, declines in recessions)

19. Slide 19 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Dominant Firm Price Leadership Example Aerotek is the leader, with 6 other firms, given the following basic information 1.P = 10,000 – 10 Q T is the market demand 2.Q T = Q L + Q F is the sum of leader & followers 3.MC L = 100 + 3 Q L 4.and  MC F = 50 + 2 Q F Find price and output for Areotek and the industry. This case is discussed on pages 432-433.

20. Slide 20 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. What is Aerotek’s price and quantity? From equation 1, rearrange to: »Q T = 1,000 -.1P From 2 above, rearrange terms to: »Q L = Q T – Q F Since followers sell at P=MC, from 3, P = 50 + 2 Q F, which rearranged to be » Q F =.5P – 25 So, by substitution Q L = (1,000 -.1P) – (.5P - 25) = 1,025 -.6 P, which can be rearranged to be P = 1,708.3 – 1.67 Q L

21. Slide 21 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. What is Aerotek’s price and quantity? MR L = 1,708.3 – 3.34 Q L which is twice as steep (to check, find TR (as P*Q) first and then find MR Next set MR L = MC L where: 1,708.3 – 3.34 Q L = 100 + 3 Q L The optimal quantity for Aerotek, the leader is Q L  254 By substitution, P = 1,708.3 – 1.67 Q L = 1,708.3 – 1.67(254)  $1,284.

22. Slide 22 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Kinked Oligopoly Demand Curve Belief in price rigidity founded on experience in the Great Depression that oligopolies (like the cigarette industry) didn’t reduce prices, but competitive industries cut prices. Price cuts lead to everyone following »highly inelastic In price increases, no one follows »highly elastic everyone follows price cuts no one follows a price increase a kink at the current price P

23. Slide 23 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Kinked Oligopoly Demand Curve

24. Slide 24 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A Kink Leads to Breaks in the MR Curve Although MC rises, the optimal price remains constant (i.e, price rigidity). Yet we find in practice that some oligopolies have prices that change a lot. Kinked Model is incomplete. There is no explanation for how the existing price is determined..

25. Slide 25 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Why don’t all oligopolies have rigid prices? A kink is a barrier to profitability Firms are in business to make profits and avoid “barriers.” There exist simplier alternative explanations why some oligopolies have rigid prices: »Collusion leads firms to fix prices. »Costly and risky to renegotiate prices frequently in collusive agreements »Changing prices involves costly activities (catalogs, for example). Change prices only when MR > MC from the change. Price rigidity is profit maximizing.

26. Slide 26 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Avoiding Price Wars Generally, the optimal pricing strategy must involve the LONG RUN, including reactions of rival firms. Pricing to win short run market share may lead to disaster in the long run. The Sad Story of a price war. »Firm 1 sets price at P1 »Firm 2 lowers price to P2 »Firm 1 sets price below P2, etc. Cereal, beer, camera film, & DVDs have all experienced price wars. D P1 P2 P2- 

27. Slide 27 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Strategies to Avoid Price Wars Growing the Market »Rivals in oligopolies recognize perpetual rivalry. »Price cutting will not win »Learn to accommodate (Coke, Pepsi, Dr. Pepper) Customer Segmentation & Revenue Management »Segment price cutting into a small portion of the market “Fencing” restrictions to 7-day advance ticket sales Manage revenue from the various sources

28. Slide 28 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Strategies to Avoid Price Wars Reference Prices & Framing Effects » People are psychologically impacted by comparisons Their price is $49, but ours is just $29! Bewared that discounting in one period can make them reset their reference. The Role of Innovation » Differentiation through innovation is harder for competitors to match

29. Slide 29 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Stopping a Price War Best way is never to start one. If another firm starts a price then, Matching Price Cuts with Increased Advertising! »Example of a Phillip Morris’ price cut on Marlboro. Reynolds cut prices only on Winston and Salem cigarettes and launched a big advertising campaign for them. The result is that the initial price cut did not produce as much revenue as Phillip Morris had expected.