1. R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN FIFTH EDITION © 2015 Pearson Education, Inc.

2. 2 Chapter Outline and Learning Objectives 14.1Oligopoly and Barriers to Entry 14.2Using Game Theory to Analyze Oligopoly 14.3Sequential Games and Business Strategy 14.4The Five Competitive Forces Model CHAPTER 14 CHAPTER Oligopoly: Firms in Less Competitive Markets

3. 3 © 2015 Pearson Education, Inc. Oligopoly: A Very Different Market Structure In the previous chapters, we examined perfect and monopolistic competition. We were able to use similar logic to argue how those firms would behave: they would produce until their marginal cost was equal to marginal revenue, and the low barriers to entry would result in profit being competed away in the long run. Oligopoly, a market structure in which a small number of interdependent firms compete, will require completely different tools to analyze. Why? 1.Oligopolists are large, and know that their actions have an effect on one another. 2.Barriers to entry exist, preventing firms from competing away profits.

4. LEARNING OBJECTIVE 4 © 2015 Pearson Education, Inc. Oligopoly and Barriers to Entry 14.1 Show how barriers to entry explain the existence of oligopolies.

5. 5 © 2015 Pearson Education, Inc. Which Markets Are Oligopolistic? Before we analyze how oligopolists behave, it is useful to know which firms/markets we are discussing. A useful tool for identifying the type of market structure is the four-firm concentration ratio: the fraction of an industry’s sales accounted for by its four largest firms. A four-firm concentration ratio larger than 40% tends to indicate an oligopoly. Although there are limits to how useful four-firm concentration ratios can be, they are a useful tool in discussing the concentration of market power within an industry.

6. 6 © 2015 Pearson Education, Inc. Examples of Oligopolies Examples of oligopolies in retail trade and manufacturing Table 14.1 Retail TradeManufacturing Industry Four-Firm Concentration RatioIndustry 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%

7. 7 © 2015 Pearson Education, Inc. Why Do Oligopolies Exist? Oligopolies often exist because of barriers to entry: anything that keeps new firms from entering an industry in which firms are earning economic profits. One example of a barrier to entry is economies of scale: the situation when a firm’s long-run average costs fall as the firm increases output. This can make it difficult for new firms to enter a market, because new firms usually have to start small, and will hence have substantially higher average costs than established firms.

8. 8 © 2015 Pearson Education, Inc. Economies of Scale and the Extent of Competition An industry will be competitive if the minimum point on the typical firm’s long-run average cost curve (LRAC 1 ) occurs at a level of output that is a small fraction of total industry sales, such as Q 1. The industry will be an oligopoly if the minimum point comes at a level of output that is a large fraction of industry sales, such as Q 2. Economies of scale help determine the extent of competition in an industry Figure 14.1

9. 9 © 2015 Pearson Education, Inc. Why Else Do Oligopolies Exist? Ownership of a key input If control of a key input is held by one or a small number of firms, it will be difficult for additional firms to enter. Examples: Alcoa—bauxite for aluminum production De Beers—diamonds Ocean Spray—cranberries Government-imposed barriers Governments might grant exclusive rights to some industry to one or a small number of firms. Examples:Occupational licensing for dentists and doctors Patents Tariffs and quotas imposed on foreign companies Patent: The exclusive right to a product for a period of 20 years from the date the patent is filed with the government.

10. LEARNING OBJECTIVE 10 © 2015 Pearson Education, Inc. Using Game Theory to Analyze Oligopoly 14.2 Use game theory to analyze the strategies of oligopolistic firms.

11. 11 © 2015 Pearson Education, Inc. Why Do We Need a Special Theory for Oligopoly? Perfect and monopolistic competitors were easily analyzed using a graph of their own costs and revenues. But remember that each of these firms were small relative to the market, so their actions were essentially insignificant to other firms. This is not true for oligopolies. Oligopolists are large relative to the market, and the actions of one oligopolist make large differences in the profits of another. Oligopolies are best analyzed using a specialized field of study called game theory. Game theory: The study of how people make decisions in situations in which attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of a firm depend on its interactions with other firms.

12. 12 © 2015 Pearson Education, Inc. Game Theory Game theory was developed during the 1940s and advanced by mathematicians and social scientists like economists. All “games” share certain 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 interactions among the players’ strategies For example, we can model firm production as a “game”: Rules: the production functions and market demand curve Strategies: Firms’ production decisions Payoffs: Firms’ profits

13. 13 © 2015 Pearson Education, Inc. A Duopoly Game: Price Competition Between Two Firms In this payoff matrix, Sony’s profits are in blue, and Microsoft’s profits are in red. Sony and Microsoft would each make profits of $10 million per month on sales of video game consoles if they both charged $499. If one charges $499 and the other charges $399, the one with a low price earns $15 million per month, while the other earns only $5 million per month. If both firms charge $399, they would each make a profit of only $7.5 million per month. How would you “play” this duopoly game? Duopoly: An oligopoly with two firms A duopoly gameFigure 14.2

14. 14 © 2015 Pearson Education, Inc. A Dominant Strategy for Sony Suppose you are Sony in this duopoly game. If Microsoft charges $499, you earn more profit by charging $399. If Microsoft charges $399, you earn more profit by charging $399. Either way, charging $399 seems makes the most profit. It is a dominant strategy for Sony. Dominant strategy: A strategy that is the best for a firm, no matter what strategies other firms use. A duopoly gameFigure 14.2

15. 15 © 2015 Pearson Education, Inc. A Dominant Strategy for Microsoft Also Now suppose you are Microsoft: If Sony charges $499, you earn more profit by charging $399. If Sony charges $399, you earn more profit by charging $399. Either way, charging $399 seems makes the most profit. It is a dominant strategy for Microsoft to charge $399 also! Each firm charging $399 is a Nash equilibrium: a situation in which each firm chooses the best strategy, given the strategies chosen by the other firms. A duopoly gameFigure 14.2

16. 16 © 2015 Pearson Education, Inc. Could the Firms Do Better? Notice that this outcome is not good for Sony or Microsoft; if they could cooperate somehow, they could each earn more profit. This is the benefit of collusion: an agreement among firms to charge the same price or otherwise not to compete. Collusion is against the law in the United States, but you can see why firms might be tempted to collude: their profits could be substantially higher. A duopoly gameFigure 14.2

17. 17 © 2015 Pearson Education, Inc. Prisoner’s Dilemma Economists and other social scientists refer the situation with Sony and Microsoft as a prisoner’s dilemma: a game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off. The name comes from a problem faced by two suspects the police arrest for a crime. The police offer each suspect a suspended prison sentence in exchange for confessing to the crime and testifying against the other suspect. Each suspect has a dominant strategy to confess; but if both confess, they both go to jail for a long time, while they both could have gone to jail for a minimal length if they had both remained silent.

18. 18 © 2015 Pearson Education, Inc. Making the Connection Is There a Dominant Strategy for Bidding on eBay? Standard eBay auctions function as second-price auctions: the high bidder wins the item, and pays the price bid by the second- highest bidder. An intuitive strategy for bidding on eBay is to shade your bid: bidding somewhat less than your valuation. But this intuition is incorrect. In fact, eBay bidders have a dominant strategy: bid exactly how much they value the object. How can this be?

19. 19 © 2015 Pearson Education, Inc. Making the Connection A Dominant Strategy for Bidding on eBay Suppose you are bidding on a concert ticket worth $200 to you. If you bid less than $200, then either: You win—but you pay the same as if you had bid $200, so there was no advantage to bidding less; or You lose; if someone bids more than $200, then you would have lost anyway. But if the winning bid was less than $200, you will wish you had bid $200. Similar logic applies if you bid more than $200. Bidding $200 is a dominant strategy!

20. 20 © 2015 Pearson Education, Inc. Can Firms Escape the Prisoner’s Dilemma? Suppose Domino’s and Pizza Hut are deciding how to price a pizza: $12 or $10. This game gets played not once, but every day. A clever way to avoid the low- profit Nash equilibrium is to advertise a price-match guarantee. Then if either firm cuts prices, the other has guaranteed to do so as well. Now neither firm will have an incentive to cut prices. Price-match guarantees aren’t as good for consumers as they appear. Changing the payoff matrix in a repeated game Figure 14.3

21. 21 © 2015 Pearson Education, Inc. Other Methods for Avoiding Price Competition A price-match guarantee is an enforcement mechanism, making automatic the decision about whether to punish a competing firm for charging a low price. Another method is price leadership, a form of implicit collusion in which one firm in an oligopoly announces a price change and the other firms in the industry match the change. Example: In the 1970s, General Motors would announce a price change at the beginning of a model year, and Ford and Chrysler would match GM’s price change. Such forms of implicit collusion are desirable for firms, because explicit collusion is illegal, resulting in government fines and penalties, along with a possible public backlash.

22. 22 © 2015 Pearson Education, Inc. Making the Connection With Price Collusion, More Is Not Merrier Airlines are a good example of an oligopoly. Airlines often implicitly collude, having unspoken understandings with one another not to compete on price. If one airline cuts prices, the others will retaliate, decreasing industry profits for all (since airline travel is relatively price- inelastic). Thus, the same route is often identically priced by several different airlines. Implicit understandings like this are easier to enforce with fewer competitors, which helps to explain why price competition often results when new firms enter a market.

23. 23 © 2015 Pearson Education, Inc. Cartels: The Case of OPEC A cartel is a group of firms that collude by agreeing to restrict output to increase prices and profits. This form of explicit collusion is illegal in the United States; but not in some other locations. The most well-known cartel is OPEC, the Organization of the Petroleum Exporting Countries. OPEC members colluded to restrict output and raise prices in the 1970s and 1980s. But collusion has proved difficult to maintain over time. Oil prices, 1972 to mid-2013Figure 14.4

24. 24 © 2015 Pearson Education, Inc. Analyzing the OPEC Cartel with Game Theory Because Saudi Arabia can produce much more oil than Nigeria, its output decisions have a much larger effect on the price of oil. Saudi Arabia has a dominant strategy to cooperate and produce a low output. Nigeria, however, has a dominant strategy not to cooperate and instead produce a high output. In order to punish Nigeria for defecting, Saudi Arabia would have to hurt itself substantially. Would it be worth it to you? The OPEC cartel with unequal members Figure 14.5

25. LEARNING OBJECTIVE 25 © 2015 Pearson Education, Inc. Sequential Games and Business Strategy 14.3 Use sequential games to analyze business strategies.

26. 26 © 2015 Pearson Education, Inc. Simultaneous vs. Sequential Games The game theory models we have analyzed so far have been simultaneous: the players have made their decisions at the same time. But some games are sequential in nature: one firm makes a decision, and the other makes its decision having observed the first firm’s decision. We analyze such games using a decision tree, indicating who gets to make a decision at what point, and what the consequences of their decision will be.

27. 27 © 2015 Pearson Education, Inc. The Decision Tree for an Entry Game In this game, Apple decides whether to charge $1000 or $800 for its new ultra light laptop; then Dell decides whether or not to enter the market. Apple “looks ahead”, and realizes that if it charges the high price, Dell will enter and compete with Apple. If Apple charges the low price, Dell’s rate of return will not be sufficient to warrant entry. So Apple can deter Dell from entering the market by preemptively charging the low price. The decision tree for an entry game Figure 14.6

28. 28 © 2015 Pearson Education, Inc. The Decision Tree for a Bargaining Game Dell is deciding whether to offer $20 or $30 per copy for TruImage’s software. Then TruImage will have the opportunity to accept or reject the offer. Dell will look ahead, and realize that TruImage is better off accepting Dell’s offer, no matter what price Dell offers. Therefore Dell should offer the low price, anticipating that TruImage will accept the offer. The decision tree for a bargaining game Figure 14.7

29. 29 © 2015 Pearson Education, Inc. Can TruImage Threaten Not to Accept the Offer? Notice that TruImage would like to threaten to reject an offer of $20. If Dell believed the threat, its best action would be to offer $30. But Dell shouldn’t believe the threat; it is not credible, since it would involve TruImage hurting itself with no opportunity for redemption. Only the original outcome is a subgame-perfect equilibrium: a Nash equilibrium in which no player can improve their outcome by changing their decision at any decision node. The decision tree for a bargaining game Figure 14.7

30. LEARNING OBJECTIVE 30 © 2015 Pearson Education, Inc. The Five Competitive Forces Model 14.4 Use the five competitive forces model to analyze competition in an industry.

31. 31 © 2015 Pearson Education, Inc. The Five Competitive Forces Model Michael Porter of Harvard Business School identifies five separate competitive forces that determine the overall level of competition in an industry: 1.Existing firms Example: Educational Testing Service administers the SAT ($51) and GRE ($150) tests. The SAT has competition from the ACT, helping keep its price low. The GRE has no similar competitor. 2.Threat from new entrants Example: In the previous section, Apple charged a low price to deter Dell from entering its market.

32. 32 © 2015 Pearson Education, Inc. The Five Competitive Forces Model—continued 3.Competition from substitutes Example: Printed encyclopedia sets used to cost well over $1000, but parents would buy them because there were no good substitutes. But the advent of cheap computer-based encyclopedias helped drive printed encyclopedia producers out of business. 4.Bargaining power of buyers Example: Large companies like Wal-Mart can threaten to buy goods from competitors, forcing suppliers to keep their prices low. 5.Bargaining power of suppliers Example: As a start-up, Microsoft couldn’t force IBM to pay a high price for its operating system. But as Microsoft became the dominant player in operating systems, it could charge much more to computer manufacturers.

33. 33 © 2015 Pearson Education, Inc. Making the Connection Predicting Which Firms Will Continue to be Successful It is generally very difficult to predict which companies will be successful long-term. For example, in 2002 a best-selling business book identified Circuit City as a company that might “achieve enduring greatness”. But in 2009, Circuit City filed for bankruptcy. “Enduring greatness” and continued economic profits require a firm to constantly work to maintain its advantage. A good dose of luck goes a long way, too.

34. 34 © 2015 Pearson Education, Inc. Common Misconceptions to Avoid When analyzing game-theoretic situations in class, stick to the rules of the game. For example, many students disbelieve the prisoner’s dilemma story, and try to use undescribed motivations to decide what to do. “Obvious answers” are often not correct when analyzing strategic situations. For example, price-match guarantees are actually good for firms, and much less good for consumers.