Oligopoly

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Oligopoly

• Chapter 10

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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?

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• 10.1. Revisiting Market Structure
• and
• Market Power

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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.

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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.

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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

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Characteristics of Market Structures
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Characteristics of Market Structures
One
Unique
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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

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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.

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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.

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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?

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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.

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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.

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The Herfindahl-Hirshman Index

• HHI

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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.

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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

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

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Oligopoly Behavior

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

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


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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

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Oligopoly Behavior

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

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Initial Conditions in Computer Market
Industry output
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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

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Initial Market Shares of Microcomputer Producers
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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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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?

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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

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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

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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).

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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

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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.

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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

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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.

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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.

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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


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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
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The Kinked Demand Curve Confronting an Oligopolist
B
Kinked Demand Curve
8000
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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.

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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.

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The Payoff Matrix

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

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Oligopoly Payoff Matrix
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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

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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

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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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Sticky Prices

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

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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.

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Sticky Prices

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

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

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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.

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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.

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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)

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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.

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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.

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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

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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.

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Price Leadership

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

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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.

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• The Role of the Government

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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.

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Industry Behavior

• There are several problems with the behavioral
  approach to antitrust law

• Limited government resources.
• Public apathy.
• Difficulty of proving collusion.

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Industry Structure

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

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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.

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The Herfindahl-Hirshman Index

• For policy purposes, the Justice Department
  decided it would draw the line at a value of
  1,800.

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Contestability

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

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Behavioral Guidelines Cost Savings

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