1. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 29 Oligopoly: Firms in Less Competitive Markets Oligopoly A market structure in which a small number of interdependent firms compete. Oligopolists Recognize their interdependence Choose strategies to maximize profits Anticipate their rivals’ strategies One measure of the structure of an industry is the concentration ratio, the fraction of each industry’s sales accounted for by its four largest firms. A four-firm concentration ratio greater than 40 percent is generally accepted to indicate an oligopoly. Often economists prefer another measure of concentration, known as the Herfindahl-Hirschman Index.

2. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 292 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Retail TradeManufacturing Industry Four-Firm Concentration Ratio Industry Four-Firm Concentration Ratio Discount department stores 97%Cigarettes98% Warehouse clubs and supercenters 94%Beer90% College bookstores75%Computers87% Hobby, toy, and game stores 72%Aircraft81% Radio, television, and other electronic stores 70%Breakfast cereal80% Athletic footwear stores68%Dog and cat food71% Pharmacies and drugstores 63%Automobiles68% Examples of Oligopolies in Retail Trade and Manufacturing

3. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 29 Oligopoly and Barriers to Entry Learning Objective 13.1 Barriers to Entry Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits. Economies of Scale Economies of scale The situation when a firm’s long-run average costs fall as it increases output.

4. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 294 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ownership of a Key Input If production of a good requires a particular input, then control of that input can be a barrier to entry. Patent The exclusive right to a product for a period of 20 years from the date the patent is filed with the government. Government-Imposed Barriers Many large firms employ lobbyists to convince state legislators and members of Congress to pass laws favorable to the economic interests of the firms. Governments restrict competition through occupational licensing. Governments also impose barriers to entering some industries by imposing tariffs and quotas on foreign competition. A tariff is a tax on imports, and a quota limits the quantity of a good that can be imported into a country. In an oligopoly, barriers to entry prevent—or at least slow down—entry, which allows firms to earn economic profits over a longer period.

5. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 29 Economies of Scale Help Determine the Structure of an Industry Oligopoly and Barriers to Entry Barriers to Entry Economies of Scale

6. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 29 Using Game Theory to Analyze Oligopoly All games share three key characteristics: 1 Rules that determine what actions are allowable 2 Strategies that players employ to attain their objectives in the game 3 Payoffs that are the results of the interaction among the players’ strategies Game theory The study of how people make decisions when attaining their goals depends on their interactions with others; In economics, game theory is used to study of the decisions of firms when the profits of each firm in the industry depend on its interactions with other firms.

7. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 29 Payoff matrix A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Collusion An agreement among firms to charge the same price or otherwise not to compete. Using Game Theory to Analyze Oligopoly A Duopoly Game: Price Competition between Two Firms Dominant strategy A strategy that is the best for a firm, no matter what strategies other firms use. Nash equilibrium A situation in which each firm chooses its best strategy, given the strategies chosen by other firms.

8. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 29 A Beautiful Mind: Game Theory Goes to the Movies Making the Connection In the film A Beautiful Mind, Russell Crowe played John Nash, winner of the Nobel Prize in Economics.

9. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 29 Using Game Theory to Analyze Oligopoly A Duopoly Game: Price Competition between Two Firms A Duopoly Game

10. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 29 Cooperative equilibrium An equilibrium in a game in which players cooperate to increase their mutual payoff. Noncooperative equilibrium An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoners’ dilemma A game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off. Using Game Theory to Analyze Oligopoly Firm Behavior and the Prisoners’ Dilemma

11. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 29 Solved Problem Is Advertising a Prisoners’ Dilemma for Coca-Cola and Pepsi?

12. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 2912 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The payoff in winning an auction is equal to the difference between the subjective value you place on the product being auctioned and the amount of the winning bid. eBay is run as a second-price auction, where the winning bidder pays an amount equal to the bid of the second-highest bidder. Is There a Dominant Strategy for Bidding on eBay? Making the Connection It may seem that your best strategy when bidding on eBay is to place a bid well below the subjective value you place on the item in the hope of winning it at a low price. In fact, bidders on eBay have a dominant strategy of entering a bid equal to the maximum value they place on the item.

13. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 29 Changing the Payoff Matrix in a Repeated Game Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoners’ Dilemma?

14. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 29 Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoners’ Dilemma? Price leadership A form of implicit collusion where one firm in an oligopoly announces a price change, which is matched by the other firms in the industry.

15. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 2915 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall When JetBlue enters a market, other airlines often cut their ticket prices. As with other oligopolies, if all airlines cut prices, industry profits will decline. Airlines therefore continually adjust their prices while at the same time monitoring their rivals’ prices and retaliating against them either for cutting prices or failing to go along with price increases. In recent years, though, mergers in the airline industry have increased the possibility of implicit collusion by reducing the number of airlines flying between two cities. When more airlines enter the market, competition increases, ticket prices drop significantly, and the opportunities for price collusion are greatly reduced. With Price Collusion, More Is Not Merrier Making the Connection

16. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 2916 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Oil Prices, 1972 to mid-2011 Cartel A group of firms that collude by agreeing to restrict output to increase prices and profits. Cartels: The Case of OPEC The blue line shows the price of a barrel of oil in each year. The red line measures the price of a barrel of oil in terms of the purchasing power of the dollar in 2011. By reducing oil production, OPEC was able to raise the world price of oil in the mid-1970s and early 1980s. Sustaining high prices has been difficult over the long run, however, because OPEC members often exceed their output quotas.

17. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 29 The OPEC Cartel with Unequal Members Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC

18. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 2918 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Business situations where one firm will act first, and then other firms will respond can be analyzed using sequential games. Deterring Entry We can analyze a sequential game by using a decision tree. Decision nodes are points in a decision tree where the firms must make decisions. The decisions made are shown beside arrows that point to terminal nodes, which show the resulting rates of return. Sequential Games and Business Strategy

19. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 2919 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Decision Tree for an Entry Game Apple earns its highest return if it charges $1,000 for its very thin, very light laptop and Dell does not enter the market. But at that price, Dell will enter the market, and Apple will earn only 16 percent. If Apple charges $800, Dell will not enter because Dell will suffer an economic loss by receiving only a 5 percent return on its investment. Therefore, Apple’s best decision is to deter Dell’s entry by charging $800. Apple will earn an economic profit by receiving a 20 percent return on its investment. Note that the dashes(—) indicate the situation where Dell does not enter the market and so makes no investment and receives no return.

20. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 2920 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Is Deterring Entry Always a Good Idea? Solved Problem Like any other business strategy, deterring entry is a good idea only if it has a higher payoff than alternative strategies. Use the following decision tree to decide whether Apple should deter Dell from entering the market for very thin, very light laptops. Assume that each firm must earn a 15 percent return on its investment to break even.

21. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 29 The Decision Tree for a Bargaining Game Sequential Games and Business Strategy Bargaining

22. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 29 The Five Competitive Forces Model Michael Porter’s model identifies five forces that determine the level of competition in an industry.

23. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 29 Competition among firms in an industry can lower prices and profits. Competition in the form of advertising, better customer service, or longer warranties can also reduce profits by raising costs. Firms face competition from companies that currently are not in the market but might enter. We have already seen how actions taken to deter entry can reduce profits. The Five Competitive Forces Model Competition from Existing Firms The Threat from Potential Entrants

24. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 29 Firms are always vulnerable to competitors introducing a new product that fills a consumer need better than their current product does. If buyers have enough bargaining power, they can insist on lower prices, higher-quality products, or additional services. If many firms can supply an input and the input is not specialized, the suppliers are unlikely to have the bargaining power to limit a firm’s profits. The Five Competitive Forces Model Competition from Substitute Goods or Services The Bargaining Power of Buyers The Bargaining Power of Suppliers

25. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 2925 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Although its business strategy had once been widely admired, Circuit City declared bankruptcy in 2009. Is it possible to draw general conclusions about which business strategies are likely to be successful in the future? A number of business analysts have tried to identify strategies that have made firms successful and have recommended those strategies to other firms. Many successful strategies can be copied—and, often, improved on—by competitors. Even in oligopolies, competition can quickly erode profits and even turn a successful firm into an unsuccessful one. It remains difficult to predict which currently successful firms will maintain their success. Can We Predict Which Firms Will Continue to Be Successful? Making the Connection

26. Chapter 13: Oligopoly: Firms in Less Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 29 Is Southwest’s Business Strategy More Important Than the Structure of the Airline Industry? Making the Connection Southwest’s business strategy allowed it to remain profitable when many other airlines faced heavy losses.