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Oligopoly

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Profit Maximization Under Oligopoly (Kinked Demand Curve and Sticky Prices) ... Music CDs In 2001, the FTC charged AOL-Time Warner and Universal Music with ... – PowerPoint PPT presentation

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Title: Oligopoly


1
Oligopoly
  • Chapter 10

2
In This Chapter
  • 10.1. Revisit Market Structure and Market
    Power
  • What determines how much market power a firm has?
  • 10.2. Profit Maximization Under Oligopoly
    (Kinked Demand Curve and Sticky Prices)
  • How do firms set prices and outputs?
  • 10.3. Coordination, Problems and the Government
  • What problems oligopolists have in maintaining
    price and output levels?

3
  • 10.1. Revisiting Market Structure
  • and
  • Market Power

4
Market Structure and Market Power
  • We classify firms into specific market structures
    based on the number and relative size of firms in
    an industry.
  • Market structure The number and relative size
    of firms in an industry.
  • Most firms possess some market power.

5
Degrees of Power
  • In imperfect competition, individual firms have
    some power in a particular product market.
  • Oligopoly is a market in which a few firms
    produce all or most of the market supply of a
    particular good or service.

6
Degrees of Power
  • Oligopoly is a market in which a few firms
    produce all or most of the market supply of a
    particular good or service.
  • Examples
  • Sports Shoes
  • Cereals Producer
  • Auto Manufacturers

7
Characteristics of Market Structures
8
Characteristics of Market Structures
One
Unique
9
Determinants of Market Power
  • Market power of a firm is a function of
  • The Number of producers
  • The Size of each firm
  • The Barriers to entry
  • The Availability of substitute goods

10
Determinants of Market Power
  • Market power increases
  • The fewer the number of firms in the market.
  • The larger the relative size of the firms in the
    market.
  • The higher the entry barriers.
  • The fewer the substitutes.

11
Determinants of Market Power
  • Barriers to entry determine to what extent the
    market is a contestable market.
  • Contestable market An imperfectly competitive
    industry subject to potential entry if prices or
    profits increase.

12
Measuring Market Power
  • The standard measure of market power is the
    concentration ratio.
  • It relates the size of firms to the size of the
    market.
  • What proportion of the market supply is
    concentrated in the hands a few firms?

13
Concentration Ratio
  • Concentration Ratio
  • is the proportion of total industry output
    produced by the largest firms (usually the four
    largest).
  • Market power isnt necessarily associated with
    firm size.
  • .because a small firm could possess a lot of
    power in a relatively small market.

14
The Herfindahl-Hirshman Index
  • The Herfindahl-Hirshman Index (HHI)
  • is a measure of the concentration of market only
    on some of the firms in the market.
  • equals the sum of the squares of the market
    shares of each firm in an industry.

15
The Herfindahl-Hirshman Index
  • HHI

16
Measurement Problems
  • HHI doesnt tell it all
  • Concentration ratios do not convey the extent to
    which market power may be concentrated in a local
    market.
  • That is, many smaller firms acting in unison can
    achieve market power.

17
Summary Note
  • Oligopoly is a market in which a few firms supply
    significant amount of the market supply
  • and thus can have market power ( the ability to
    alter prices/outputs) to maximize profits

18
  • 10.2 Profit Maximization Under Oligopoly
    (Price and Output Decisions under Oligopoly)
  • Kinked Demand Curve
  • and
  • Sticky Prices

19
Oligopoly Behavior
  • Like all other markets, under Oligopoly as well,
    the Profit Maximizing Output is the level of
    output at which MRMC

20
Maximizing Oligopoly Profits
MC
ATC
Profit- Max. price
Market demand
Profits
ATC at profit- Max. Q
J
Marginal Revenue
Profit-max Q


21
Oligopoly Behavior
  • However, market structure affects market behavior
    (strategic actions) and outcomes (Profit and
    Utility Max).
  • As there are only a few firms in the market,
    Oligopolies Might
  • Cut/raise prices even if it is not warranted by
    Costs of production
  • Not respond to changes in Costs of Production

22
Oligopoly Behavior
  • Assume that the computer market has three
    oligopolists
  • Universal Electronics
  • World Computers
  • International Semiconductor

23
Initial Conditions in Computer Market
Industry output
24
Initial Equilibrium
  • Market share - The percentage of total market
    output produced by a single firm.
  • Consider that the data in the following table
    describes each firms market share

25
Initial Market Shares of Microcomputer Producers
26
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


27
Battle for Market Shares
  • Given the above graph
  • Will the profit be equally shared among the three
    markets?
  • If so, which producer will have higher share of
    the profit?
  • What would those with the lower profit share do?
  • How?

28
Increased Sales at Reduced Prices
  • It is possible that lowering price may expand
    total market sales and increase the sales of an
    individual firm without affecting the sales of
    its competitors.
  • There is no way that a firm can do so without
    causing alarms to go off in the industry.
  • There are few firms in the market, and they
    closely follow each others action

29
Increased Sales at Reduced Prices
  • In an oligopoly, increased sales on the part of
    one firm will be noticed immediately by the other
    firms.
  • because increase in the market share of one
    oligopolist necessarily reduces the shares of the
    remaining oligopolists

30
Retaliation
  • Oligopolists respond to aggressive marketing by
    competitors by either of the following methods.
  • 1. Non-Price Competition
  • Step up marketing efforts
  • 2. Price Competition
  • Cut prices on their product(s).

31
RetaliationNon-Price
  • One way oligopolists market their products is
    through product differentiation.
  • Product differentiation Features that make one
    product appear different from competing products
    in the same market.
  • This Could be Virtual (Artificial) or Real

32
Retaliation-Prices
  • Price War
  • However, an attempt by one oligopolist to
    increase its market share by cutting prices may
    lead to a general reduction in the market price.
  • !
  • This is why oligopolists always want to avoid
    price competition and thus pursue nonprice
    competition.

33
Rivals Response to Price Reductions/Increases
  • A typical characteristic of oligopoly is thus the
    presence of close interdependence in the
    activities and decisions of firms in the market.
  • The presence of such close interdependence
    imposes limitations on price and output decisions
    of Oligopoly firms

34
Rivals Response to Price Reductions/Increases
  • The degree to which sales increase when the price
    is reduced by one Oligopolist thus depend on the
    response of the rival oligopolists.
  • We expect Oligopolists to match any price
    reductions by the rival oligopolist.
  • However, rival Oligopolists may not match a
    price increase .why?
  • ..in order to gain market share.

35
The Kinked Demand Curve Confronting an Oligopolist
  • The shape of the demand curve facing an
    oligopolist thus depends on how its rivals
    responded 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.

36
RecallThe Starting Point
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


37
The Demand Curve Confronting an Oligopolist.
Demand curve facing oligopolist if rivals match
price changes
M
B
1100
A
D
900
C
Demand curve facing oligopolist if rivals match
price cuts but not price hikes
Demand curve facing oligopolist if rivals don't
match price changes
8000
38
The Kinked Demand Curve Confronting an Oligopolist
B
Kinked Demand Curve
8000
39
Game Theory
  • Oligopoly Price and Output Decisions are thus
    strategic!
  • Game theory is the study of decision making in
    situations where strategic interaction (moves and
    countermoves) between rivals occurs.
  • Each oligopolist considers the potential
    responses of rivals when formulating price or
    output strategies.
  • The payoff to an oligopolists price cut/increase
    depends on how its rivals respond.

40
Game Theory
  • Each oligopolist is uncertain about its rivals
    behavior.
  • The payoff to an oligopolists price cut depends
    on how its rivals respond.
  • The collective interests of the oligopoly are
    protected if no one cuts the market price.
  • But an individual oligopolist could lose if it
    holds the line on price when rivals reduce price.

41
The Payoff Matrix
  • The decision to initiate a price cut requires a
    risk assessment.

42
Oligopoly Payoff Matrix
43
Oligopoly vs. Competition
  • Thus oligopolists would want to coordinate their
    behavior in a way that maximizes industry
    profits.
  • There is a Motive for Coordination
  • An oligopoly will want to behave like a monopoly,
    choosing a rate of industry output that maximizes
    total industry profit

44
Price and Output
  • To maximize industry profit, the firms in an
    oligopoly must agree
  • 1. on a monopoly price and maintain it,
  • by limiting production and allocating market
    shares.
  • Cartel
  • is a group of firms with an explicit agreement
    to fix prices and output shares in a particular
    market.
  • Example OPEC

45
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


46
Sticky Prices
  • Prices in oligopoly industries tend to be stable.
  • Like all producers, oligopolists want to maximize
    profits by producing where MR MC.

47
Sticky Prices
  • The kinked demand curve is really a composite of
    two separate demand curves.
  • Creates a gap in an oligopolists marginal
    revenue (MR) curve.
  • Marginal revenue The change in total revenue
    that results from a one-unit increase in the
    quantity sold.

48
Sticky Prices
  • As a result, modest shifts of the cost curve will
    have no impact on the production decision of an
    oligopolists.

49
An Oligopolists Marginal Revenue Curve
The kink in the demand curve
The MR gap
50
The Cost Cushion
51
  • 10.3. Coordination, Problems and the Government
  • What problems oligopolists have in maintaining
    price and output levels?

52
Some Problems
  • There is an inherent conflict in the joint and
    individual interests of oligopolists.
  • Each oligopolist wants the industry profits to be
    maximized.
  • Each oligopolist also wants to maximize its own
    market share.

53
Coordination Problems
  • To avoid self-destructive behavior, each
    oligopolist must coordinate production decisions
    so that
  • Industry output and price are maintained at
    profit-maximizing levels.
  • Each oligopolistic firm is content with its
    market share.

54
Price Fixing---Collusion
  • The most explicit form of coordination among
    oligopolists is called price fixing.
  • Price fixing is an explicit agreement among
    producers regarding the price(s) at which a good
    is to be sold.
  • Such an action is however, illegal (stifling
    competition)

55
Examples of Price Fixing
  • 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.

56
Examples of Price Fixing
  • Vitamins Seven firms from four nations were
    accused of fixing global prices on bulk vitamins
    from 1990 - 1998.
  • Baby Formula Two makers of baby formula agreed
    to pay 5 million in 1992 to settle Florida
    charges that they had fixed prices on baby
    formula.
  • Cola The Coca-Cola Bottling Co. of North
    Carolina agreed to pay a fine and give consumers
    discount coupons to settle charges of conspiring
    to fix soft-drink prices from 1982 to 1985.

57
Examples of Price Fixing
  • Music CDs In 2001, the FTC charged AOL-Time
    Warner and Universal Music with fixing prices on
    the Three Tenors CD.
  • Laser Eye Surgery The FTC charged VISX and
    Summit Technology with price-fixing that raised
    the price of surgery by 500 per eye.
  • Memory chips In 2004, prosecutors claimed the
    worlds largest memory-chip (DRAM) makers
    (Samsung, Micron, and Infineon) fixed prices in
    the 16 billion-a-year market

58
Allocation of Market Shares
  • One way to allocate market share 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.

59
Price Leadership
  • Price leadership is an oligopolistic pricing
    pattern that allows one firm to establish the
    market price for all firms in the industry.

60
Allocation of Market Shares
  • An oligopolist may resort to predatory pricing
    when market shares are not being divided in a
    satisfactory manner.
  • Predatory pricing - temporary price reductions
    designed to alter market shares or drive out
    competition.

61
  • The Role of the Government

62
Antitrust Enforcement
  • Market failure is an imperfection in the market
    mechanism that prevents optimal outcomes.
  • Market power contributes to market failure when
    it leads to resource misallocations or greater
    inequity.
  • Antitrust law is government intervention designed
    to alter market structure or prevent abuse of
    market power.

63
Industry Behavior
  • There are several problems with the behavioral
    approach to antitrust law
  • Limited government resources.
  • Public apathy.
  • Difficulty of proving collusion.

64
Industry Structure
  • Public efforts to alter market structure have
    been less frequent than efforts to alter market
    behavior.

65
Objections to Antitrust
  • Some argue that we shouldnt punish those who
    achieved monopolies through hard work and
    innovation.
  • Noncompetitive behavior, not industry structure,
    should be the only concern of antitrust.

66
The Herfindahl-Hirshman Index
  • For policy purposes, the Justice Department
    decided it would draw the line at a value of
    1,800.

67
Contestability
  • If entry barriers were low enough, even a highly
    concentrated industry might be compelled to
    behave more competitively.

68
Behavioral Guidelines Cost Savings
  • The FTC now also looks to see if a proposed
    merger will allow for greater efficiencies and
    lower costs.
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