OLIGOPOLY Chapter 27

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OLIGOPOLYChapter 27

• What determines how much market power a firm has?
• How do firms in an oligopoly set prices and
  output?
• What problems does an oligopoly have in
  maintaining price and profit?

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Maximizing Oligopoly Profits
Industry marginal cost
Industry average cost
Profit- maximizing price
Market demand
Profits
Average cost at profit- maximizing output
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Industry marginal revenue
Profit-maximizing output


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What does market power really mean?

• Market power is the key to control.
• Monopoly is a type of power that all firms dream
  of, yet pure monopoly is not permitted in our
  economy.
• The next best thing is to PUSH the power base to
  the very edge of government acceptance. Gaining
  market share is a common term we hear from
  businesses and Wall Street.

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MARKET POWER

• Tom Thumb wants to gain market share from
  Albertsons.
• Wal-Mart wants market share from Kmart boy did
  they get it!
• Central Market wants market share from Whole
  Foods
• Google wants market share from Facebook.

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• Top 5 Worldwide PC Vendors, Market Share 4Q12
  (unit shipment) World-wide quarterly report
  1/2013

• Defending the LeadWorld-wide PC vender market
  share for third quarter. DMN- 10/16/08

• HP 18.4
• Dell 13.6
• Acer 12.5
• Lenova 7.3
• Toshiba 4.6
• Others 43.7

• http//www.icharts.net/chartchannel/top-5-worldwid
  e-pc-vendors-market-share-4q12-unit-shipment_m37bz
  spdc

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Share of market- pizza and Iphones
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Who is sharing?

• Oligopoly is no exception Outstanding feature of
  Oligopoly is fewness
• OLI (derivation actually means few.. (do you
  remember your Oligarchy in government?)
• Oligopoly has few sellers- so few that at least
  one firm is large enough to INFLUENCE PRICE
• The vast amount of GDP is accounted for by firms
  in oligopolistic industries.

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Oligopoly (cont'd)

• Oligopoly
• A market situation in which there are very few
  sellers.
• Each seller knows that the other sellers will
  react to its changes in prices and quantities.

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Oligopoly (cont'd)

• Strategic Interdependence
• A situation in which one firms actions with
  respect to price, quality, advertising, and
  related changes may be strategically countered by
  the reactions of one or more other firms in the
  industry
• Such dependence can exist only when there are a
  limited number of firms in an industry.

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Oligopolist

• The oligopolist is a price searcher.
• It produces the quantity of output at which MR
  MC.

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Characteristics of Oligopoly

1. Few firms control the market
2. High barriers to entry
3. Produce either differentiated or homogeneous
   products
4. Lack of available substitutes
5. Name some examples!

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Barriers to entry

• Patents
• Control distribution outlets (ticketmaster)(shelf-
  space for Fritos)
• Mergers and acquisitions
• Government regulation

• Nonprice Competition (big buck advertising)
• Training (technology know-how-training employees
  to use a certain product..changing is difficult
• Network Economies-get there first with the most
  (dont buy a phone if your friends dont have
  one.)

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Industries that are oligopolies

• Steel industry
• Aluminum
• Film
• Television
• Cell phone
• Gasoline
• Airline

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Companies - oligopolies

• Four music companies control 80 of the market -
  Universal Music Group, Sony Music Entertainment,
  Warner Music Group and EMI Group
• Six major book publishers - Random House,
  Pearson, Hachette, HarperCollins, Simon
  Schuster and Holtzbrinck
• Four breakfast cereal manufacturers - Kellogg,
  General Mills, Post and Quaker
• Two major producers in the beer industry -
  Anheuser-Busch and Miller/Coors (reason why it is
  not FTC watched)
• Two major providers in the healthcare insurance
  market - Anthem and Kaiser Permanente
• Small transportation UPS, Fed X

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Oligopoly (cont'd)

• Why oligopoly occurs
• Economies of scale
• Barriers to entry
• Mergers
• Vertical mergers
• Horizontal mergers

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Price and Output Under 3 Oligopoly Theories

• Cartel Theory - oligopolistic firms act as if
  there were only one firm in the industry.
• Kinked Demand Curve Theory - assumes that if a
  single firm in the industry cuts prices, other
  firms will do likewise, but if it raises price,
  other firms will not follow suit. The theory
  predicts price stickiness or rigidity.
• Price Leadership Theory - the dominant firm in
  the industry determines price, and all other
  firms take their price as given.

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Why are certain industries composed of only a few
firms?

• cost economies and other barriers to entry keep
  the numbers small
• mergers keep out the smaller guys) (enter the
  political key on who decides if mergers are not
  eliminating competition)
• if economies of scale are substantial, reasonably
  efficient production will be possible only with a
  small number of producers efficiency requires
  that the productive capacity of each firm be
  large relative to the total market. (large market
  share)

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Continued

• Technological progress has made more and more
  economies of scale attainable over time.
• Other barriers such as
• patents,
• control of strategic raw materials,
• in some cases prodigious advertising (Budweiser)
  outlays which add a financial barrier to entry
  for other firms.

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What does prodigious mean?

• http//www.youtube.com/watch?vo-r4Z1K_LDc

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What do we see in the 21St Century?

• Many big corporations seeking more market share
  have been following a simple rule.
• Dont build what you can buy.
• WSJ, February13,2006
• Part of this zeal to purchase is to fill some of
  the empty production space created in the
  building boon of late 90s. This will allow for
  movement to capacity production which is more
  efficient. (translated- full employment.)

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Oligopoly (cont'd)

• Vertical Merger
• The joining of a firm with another to which it
  sells an output or from which it buys an input
• Horizontal Merger
• The joining of firms that are producing or
  selling a similar product

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Oligopoly (cont'd)

• Measuring industry concentration
• Concentration Ratio
• The percentage of all sales contributed by the
  leading four or leading eight firms in an
  industry
• Sometimes called the industry concentration ratio

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Ways to measure degree of Oligopolization

• Concentration Ratio
• This ratio tells the share of output (or combined
  market share) accounted for by the largest firms
  in an industry OR the total percentage share of
  industry sales that each firm possesses.
• Sometimes the market share of one company in
  the oligopoly is so great that it nearly
  resembles a monopoly. (remember the cell phone
  chart?)

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Computing the Four-Firm Concentration
RatioReferred as HHI Index
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Are their other ways to get market power?

• Sure several smaller firms can act in unison in
  the amount they supply and price they charge..
• Even in small towns firms can have market power
  (ACE Hardware, Krispy Kreme, or the DunkinDonut
  store in Eastjapip, NJ)

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Key Point

• Concentration ratio is a quantitative measure of
  oligopoly
• The total percentage share of industry SALES of
  the four leading firms is the industry
  concentration ratio. (who has higher of sales
  Ford, GM, or Chrysler?) (the increased foreign
  trade has minimized the impact of the HHI ratio.)
• Obviously, the total aggregate sales are compiled
  Then the sales for each firm is calculated.
  Come up with certain of market share

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Herfindahl-Hirschman Index HHI

• This is the sum of the square of the market
  shares of each firm in the industry.
• Example.. Monopolist one company controls
  entire industry 100 market share. HHI would be
  100 (squared) 100x100 10,000 (All monopolies
  have 10,000 HHI)
• If firm A has 25 and firms B,C,D also have 25
• Take 25 x 25 625 Add them up (625625625625
  2,500 or the total number of squares for
  industry power is 2,500
• Each firm has 625 squares.

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Market Power
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Market Power
Kroger
Albertsons
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Oligopoly (cont'd)

• The more U.S. firms face competition from the
  rest of the world, the less any current oligopoly
  will be able to exercise market power.
• Any ideas that come to mind on this concept?

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So, where does government enter in this equation?

• The Anti-trust division of the Justice Department
  and the applicable IRC has to decide if a gain of
  X of the market share is destroying competition
  or not when a merger is suggested.
• HP/Compaq (will this destroy the competitive edge
  for Dell?)
• AMR/U.S. Air ????
• 2. In 1992 the Justice Dept decided to use
  other parameters in determining anti-trust and
  destructive competition---- barrier to entry. If
  low, then highly concentrated industry might be
  compelled to behave more competitively. (hence,
  contestability and structure were now added to
  the merger equation.)a) does it look like a
  monopoly?b) does it behave like a monopoly?

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What happens if one increases sales?

• Increased Sales at the Prevailing Market Price
• Increases in the market share of one oligopolist
  necessarily reduce the shares of the remaining
  oligopolists.

• It is possible that an increase in sales by
  lowering the price may expand total market sales
  and increase the sales of an individual firm
  without affecting the sales of its competitors.
  But it doesnt happen without setting off alarms
  within the industry..(Delta lowers its price-
  Southwest follows) (Pepsi lowers price to sell
  more.. Coke follow? Kinked Demand Curve concept

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What is the objective here?
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Then what happens???

• Retaliation
• Oligopolists respond to aggressive marketing by
  competitors.
• Step up marketing efforts.
• Cut prices on their product(s).
• Rather than cut prices which causes a general
  off the cliff for all concept. (hence kinked
  demand curve) Oligopolists will engage in
  non-price competition. Hint
• their products are differentiated for the most
  part.- American Airlines- more leg room LOL! ?

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The Kinked Demand Curve Confronting an Oligopolist

• The shape of the demand curve facing an
  oligopolist depends on the responses of its
  rivals to a change in the price of its own
  output.
• The demand curve will be kinked if rival
  oligopolists match price reductions but not price
  increases.

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Game Theory

• A mathematical technique used to analyze the
  behavior of decision makers who try to reach an
  optimal position for themselves through game
  playing or the use of strategic behavior, are
  fully aware of the interactive nature of the
  process at hand, and anticipate the moves of
  other decision makers.

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Game Theory

• Each oligopolist has to consider the potential
  responses of rivals when formulating price or
  output strategies.
• The payoff to an oligopolists price cut depends
  on how its rivals respond.
• Game theory is the study of decision making in
  situations where strategic interaction (moves and
  countermoves) between rivals occurs.

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Game Theory
0

• Game theory the study of how people behave in
  strategic situations
• Dominant strategy a strategy that is best for a
  player in a game regardless of the strategies
  chosen by the other players
• Prisoners dilemma a game between two
  captured criminals that illustrates why
  cooperation is difficult even when it is mutually
  beneficial

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Prisoners Dilemma Example
0

• The police have caught Bonnie and Clyde, two
  suspected bank robbers, but only have enough
  evidence to imprison each for 1 year.
• The police question each in separate rooms,
  offer each the following deal
• If you confess and implicate your partner, you
  go free.
• If you do not confess but your partner implicates
  you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.

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Prisoners Dilemma Example
0
Confessing is the dominant strategy for both
players.
Nash equilibrium both confess
Bonnies decision
Confess
Remain silent
Bonnie gets 8 years
Bonnie gets 20 years
Confess
Clyde gets 8 years
Clyde goes free
Clydes decision
Bonnie gets 1 year
Bonnie goes free
Remain silent
Clyde gets 1 year
Clyde gets 20 years
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Prisoners Dilemma Example
0

• Outcome Bonnie and Clyde both confess, each
  gets 8 years in prison.
• Both would have been better off if both remained
  silent.
• But even if Bonnie and Clyde had agreed before
  being caught to remain silent, the logic of
  self-interest takes over and leads them to
  confess.

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Moves in the economy

• Pepsi meets to decide how to gain market share
• If they reduce Pepsi cost in Plano, and have
  increased promotion, what will Coke respond with?
  Are they looking over their shoulder?
• Will any of that strategy be applied throughout
  the U.S. or is it effective only regionally.
• Dr. Pepper what would strategy be in NE?

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Price and OutputChecking the corporate pie for
profit!

• Price and Output
• Price discounting can destroy oligopoly profits.
• When it occurs, rival oligopolists seek to end it
  as quickly as possible.

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Price and Output

• To maximize industry profit, the firms in an
  oligopoly must agree on a monopoly price and
  agree to maintain it by limiting production and
  allocating market shares.Illegal in U.S.
  OPEC is example of how this works (Cartel)
• Drug Cartel in Mexico
• .

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Allocation of Market Shares

• One way to distribute output is a cartel
  agreement.
• A cartel is a group of firms with an explicit
  agreement to fix prices and output shares in a
  particular market.
• Cartels are illegal in the United States
• OPEC (Organization of Petroleum Exporting
  Countries) is the most famous now.(11 countries)
• http//www.opec.org

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Lets Look at Cartels

• Each producer is assigned a they may produce in
  the market. These are explicit production-sharing
  agreements. (most cheat due to high oil prices in
  market)
• Saudi Arabia has increasingly violated the they
  were assigned by OPEC several times to increase
  their market share and to help out the U.S.
• They may be less willing to do this in the future
  (continued war/Iraq)(new terrorism problems)
  (other countries join to ostracize any Arab
  nation that cooperates with U.S.) (supply/demand)
  (U.S. reduces dependency on oil OPEC wont want
  to stray too far.

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The Cooperative Game A Collusive Cartel

• Cartel
• An association of producers in an industry that
  agree to set common prices and output quotas to
  prevent competition.

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PRICE FIXING IS ILLEGAL Price Fixing
Examples

• Electric Generators - In 1961, General Electric
  and Westinghouse were convicted of fixing prices
  on electrical generators.
• They were charged again in 1972 for continued
  price fixing.

• School Milk Between 1988 and 1991, the U.S.
  Justice Department filed charges against 50
  companies for fixing the price of milk sold to
  public schools in 16 states.

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So, you think they dont fix prices?

• Gasoline Mobil, Chevron and Shell paid 77
  million in 1993 to settle charges that they
  conspired to fix gasoline prices.
• Music CDs In 2001, the FTC charged AOL-Time
  Warner and Universal Music with fixing prices on
  the Three Tenors CD.
• The airline industry is being investigated as of
  3/8/06 to see if they fixed prices on jet fuel
  purchases.

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WSJ- November 13, 2008

• LCD Makers Plead Guilty to Price Fixing
• Sharp, LG Display, Chunghwa Fined 585 million
  for schemes affecting TV sets, other products.
• Criminal charge
• Consumers paid higher prices for TVs, cellphones,
  and other products using liquid-crystal displays.

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• Whirlpool, rivals face price fixing probe
• Michigan business news in brief Whirlpool,
  rivals face price fixing probeFebruary 19, 2009,
  Detroit Free Press
• Wired PR News Microsoft Corp. has been fined
  for alleged price-fixing. As reported by the
  Associated Press (AP), the companys German
  subsidiary was fined 9 million euros, which is
  the equivalent of 11.8 million, for purportedly
  illegally influencing the retail prices for their
  Microsoft Office 2007 software programs.April
  13, 2009

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TX Doctors agree to settle price-fixing (2006)

• The FTCs complaint alleges that Health Care
  Alliance of Laredo, LC (HAL), a multi-specialty
  IPA with about 80 physician members, restrained
  competition among the members in violation of
  Section 5 of the FTC Act. HAL claimed it employed
  a messenger model process to negotiate
  contracts. If properly orchestrated, a messenger
  model process does not restrain competition. HAL
  engaged in collective bargaining, however, and
  did nothing that might justify its challenged
  conduct.

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2009

• FTC Settles Price-Fixing Charges Against San
  Francisco Bay Area Doctors Group
• For Release 02/28/2013
• Eight Puerto Rico Kidney Doctors Settle FTC
  Price-Fixing Charges
• Nephrologists Will No Longer Boycott Insurers and
  Patients to Obtain Higher Prices

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April 11, 2012

• Justice Department sues Apple, publishers over
  e-book prices
• The Justice Department on Wednesday accused five
  of the nations largest publishing houses and
  Apple of fixing prices on e-books, forcing
  consumers to pay tens of millions of dollars more
  for their favorite titles.

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How do we know?
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Price Leadership or Fixing?

• Leadership is acceptable.. Fixing is not.
• Sometimes they send up smoke signals to alert
  their rivals about a price increase in hopes the
  rivals will follow.
• Whenever oligopolist successfully raises prices,
  unit sales will decline. (old theory)
• This has become theory since Delta began charging
  for baggage. Now carry-ons are being charged by
  Spirit
• What happens if AA lowers airline fares?

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Graph for a price-fixing oligopolist

• The graph for a price-fixing oligopolist will
  look exactly like the monopolist.

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The Benefits of Cheating on the Cartel Agreement I

• The situation for a representative firm of a
  cartel in long-run competitive equilibrium, it
  produces q1 and charges P1, earning zero economic
  profits.
• As a consequence of the cartel agreement, it
  reduces output to qC and charges PC.
• Its profits are the area CPCAB.
• If it cheats on the cartel agreement and others
  do not, the firm will increase output to qCC and
  reap profits of FPCDE.

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The Benefits of Cheatingon the Cartel Agreement
II

• Note, however, that if this firm can cheat on
  the cartel agreement, so can others. Given the
  monetary benefits gained by cheating, it is
  likely that the cartel will exist for only a
  short time.

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Predatory Pricing - illegal

• A company decides to lower its prices for a short
  period of time to force a competitor out of
  business. After the competitor leaves, the
  company then raises price again.
• (BroadBand Cable/Internet)
• Utah Pie company (forced out by Mrs. Smiths pies)

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• http//www.youtube.com/watch?vnGx4E8w5VHgNR1

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Maximizing Oligopoly Profits
Industry marginal cost
Industry average cost
Profit- maximizing price
Market demand
Profits
Average cost at profit- maximizing output
J
Industry marginal revenue
Profit-maximizing output


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Reality of this

• Coordination Problems
• There is an inherent conflict in the joint and
  individual interests of oligopolists.
• Each oligopolist wants industry profits to be
  maximized.
• Each oligopolist wants to maximize its own
  market share.
• To avoid self-destructive behavior, each
  oligopolist must coordinate production decisions.

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Table 27-3 Comparing Market Structures
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QUESTIONS?