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Oligopoly and Strategic Behavior

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Chapter 27 Oligopoly and Strategic Behavior Introduction Learning Objectives Outline the fundamental characteristics of oligopoly Understand how to apply game theory ... – PowerPoint PPT presentation

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Title: Oligopoly and Strategic Behavior


1
Chapter 27
  • Oligopoly and Strategic Behavior

2
Introduction
3
Learning Objectives
  • Outline the fundamental characteristics of
    oligopoly
  • Understand how to apply game theory to evaluate
    the pricing strategies of oligopolistic firms
  • Explain the kinked demand theory of oligopolistic
    price rigidity

4
Learning Objectives
  • Describe theories of how firms may deter market
    entry by potential rivals
  • Illustrate why network effects and market
    feedback can explain why some industries are
    oligopolies

5
Chapter Outline
  • Oligopoly
  • Strategic Behavior and Game Theory
  • Price Rigidity and the Kinked Demand Curve

6
Chapter Outline
  • Strategic Behavior with Implicit Collusion A
    Model of Price Leadership
  • Deterring Entry into an Industry
  • Network Effects
  • Comparing Market Structures

7
Did You Know That...
  • Intel is the predominant seller of microprocessor
    chips, with a global market share of 80 percent?
  • Industries such as this, with one predominant
    seller and several smaller competitors, are not
    monopolies.
  • They are described by the term oligopoly.

8
Oligopoly
  • 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

9
Oligopoly
  • Characteristics of oligopoly
  • Small number of firms
  • Interdependence
  • Strategic dependence

10
Oligopoly
  • Strategic Dependence
  • 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

11
Oligopoly
  • Why oligopoly occurs
  • Economies of scale
  • Barriers to entry
  • Mergers
  • Vertical mergers
  • Horizontal mergers

12
Oligopoly
  • 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

13
Oligopoly
  • Measuring industry concentration
  • Concentration Ratio
  • The percentage of all sales contributed by the
    leading four or leading eight firms in an industry

14
Computing the Four-Firm Concentration Ratio
Annual Sales Firm ( Millions)
1 150 2 100 3 80 4 70 5 through 25 50
Total number of firms in Industry 25
Total 450
Table 27-1
15
E-Commerce Example Concentration in the
Search-Engine Industry
  • Internet search-engines collect revenue through
    advertisements posted on their websites.
  • To measure the concentration ratio in this
    industry, economists count the number of searches
    conducted on each site.

16
E-Commerce Example Concentration in the
Search-Engine Industry
  • The four most frequently used search-engines are
    Google, Yahoo, AOL Time Warner, and MSN.
  • The four-firm concentration ratio in this
    industry is 91 percent, indicating that it
    qualifies as an oligopoly.

17
Oligopoly, Inefficiency, and Resource Allocation
  • Oligopolistic firms have some degree of market
    power, which means each one can affect the market
    price.
  • This creates some inefficiency in resource
    allocation.
  • But to the extent that U.S. oligopolies must
    compete with firms from other countries, their
    market power is limited.

18
Strategic Behavior and Game Theory
  • Explaining the pricing and output behavior of
    oligopoly markets
  • Reaction Function
  • The manner in which one oligopolist reacts to a
    change in price, output, or quality made by
    another oligopolist in the industry

19
Strategic Behavior and Game Theory
  • Game Theory
  • A way of describing the various possible outcomes
    in any situation involving two or more
    interacting individuals when those individuals
    are aware of the interactive nature of their
    situation and plan accordingly

20
Strategic Behavior and Game Theory
  • Cooperative Game
  • A game in which the players explicitly cooperate
    to make themselves better off
  • Noncooperative Game
  • A game in which the players neither negotiate nor
    cooperate in any way

21
Strategic Behavior and Game Theory
  • Zero-Sum Game
  • A game in which any gains within the group are
    exactly offset by equal losses by the end of the
    game

22
Strategic Behavior and Game Theory
  • Negative-Sum Game
  • A game in which players as a group lose at the
    end of the game
  • Positive-Sum Game
  • A game in which players as a group are better off
    at the end of the game

23
Strategic Behavior and Game Theory
  • Strategies in noncooperative games
  • Strategy
  • Any rule that is used to make a choice
  • Any potential choice that can be made by players
    in a game
  • Dominant Strategies
  • Strategies that always yield the highest benefit

24
Example The Prisoners Dilemma
  • You and your partner rob a bank and get caught.

25
Prisoners Dilemma
  • You are separated and given these options
  • Both confess and get five years in jail
  • Neither confess and get two years
  • One confess and the other does not
  • Confessor goes free
  • One who does not confess gets ten years

26
Prisoners Dilemma
  • What would you do?
  • Remember
  • No cooperation

27
The Prisoners Dilemma Payoff Matrix
Figure 27-1
28
Strategic Behavior and Game Theory
  • Applying game theory to pricing strategies
  • Would you choose a high price or a low price?
  • Remember
  • No collusion

29
Strategic Behavior and Game Theory
Figure 27-2
30
Strategic Behavior and Game Theory
  • Opportunistic Behavior
  • Actions that ignore the possible long-run
    benefits of cooperation and focus solely on
    short-run gains
  • An example might be writing a check that you know
    will bounce

31
Strategic Behavior and Game Theory
  • Opportunistic behavior
  • Implies a noncooperative game
  • Not realistic
  • We make repeat transactions

32
Strategic Behavior and Game Theory
  • Tit-for-Tat Strategic Behavior
  • In game theory, cooperation that continues so
    long as the other players continue to cooperate

33
Price Rigidity and the Kinked Demand Curve
Panel (a)
d1 is relatively elastic if one firm raises
its price the others will not and it will lose
market share
Price and Marginal Revenue per Unit
d2 is relatively inelastic if one firm lowers
its price the others lower their price so gain
in sales is small
Quantity per Time Period
Figure 27-3, Panel (a)
34
Price Rigidity and the Kinked Demand Curve
Panel (b)
The kinked demand curve indicates the possibility
of price rigidity
Price and Marginal Revenue per Unit
Quantity per Time Period
Figure 27-3, Panel (b)
35
Price Rigidity and the Kinked Demand Curve
Price, Marginal Revenue, and Marginal Cost per
Unit
Changes in cost do not impact output and prices
as long as MC remains in the vertical portion of
MR
Quantity per Time Period
Figure 27-4
36
Strategic Behavior with Implicit Collusion A
Model of Price Leadership
  • Price Leadership
  • A practice in many oligopolistic industries in
    which the largest firm publishes its price list
    ahead of its competitors, who then match those
    announced prices
  • Price leadership behavior is apparent in the
    overnight package delivery industry

37
Strategic Behavior with Implicit Collusion A
Model of Price Leadership
  • Price War
  • A pricing campaign designed to drive competing
    firms out of a market by repeatedly cutting prices

38
Strategic Behavior with Implicit Collusion A
Model of Price Leadership
  • Markets where price wars are common
  • Cigarettes
  • Long-distance telephone companies
  • Airlines

39
Strategic Behavior with Implicit Collusion A
Model of Price Leadership
  • Markets where price wars are common
  • Diapers
  • Frozen foods
  • PC hardware and software

40
Example A Price War in Diapers
  • In 2001, the makers of Huggies disposable diapers
    reduced the size of its packages by one diaper,
    but left the package price unchanged.
  • This increased the effective diaper price by 5
    percent.

41
Example A Price War in Diapers
  • The response from Pampers, the main competitor,
    was to cut prices by 15 percent.
  • Huggies soon followed with a price reduction, and
    a price war ensued.
  • As would be expected, there was a benefit to
    consumers as package prices fell and coupons were
    made widely available.

42
Deterring Entry Into an Industry
  • Entry Deterrence Strategy
  • Any strategy undertaken by firms in an industry,
    either individually or together, with the intent
    or effect of raising the cost of entry into the
    industry by a new firm

43
Deterring Entry Into an Industry
  • Increasing entry cost
  • Threat of price wars
  • Government regulations
  • Environmental regulation
  • Safety standards

44
Deterring Entry Into an Industry
  • Limit-Pricing Strategies
  • A model that hypothesizes that a group of
    colluding sellers will set the highest common
    price they believe they can charge, without new
    firms seeking to enter the industry

45
Deterring Entry Into an Industry
  • Raising switching costs for customers
  • Examples
  • Non-compatible software
  • Non-transferability of college courses

46
Example QWERTY and High Switching Costs
  • The QWERTY keyboard was designed to solve a
    mechanical problem of the tendency for typewriter
    keys to jam.
  • Now that the mechanical problem no longer exists,
    why does this keyboard layout persist?

47
Network Effects
  • A network effect is a situation in which a
    consumers inclination to use an item depends on
    how many others use it.
  • For example, the value of a fax machine increases
    as there are more fax machines in use.

48
Network Effects
  • Positive Market Feedback
  • Potential for a network effect to arise when an
    industrys product catches on
  • Negative Market Feedback
  • The tendency for industry sales to spiral
    downward rapidly when the product falls out of
    favor

49
Network Effects and Industry Concentration
  • In an industry selling products subject to
    network effects, a small number of firms may be
    able to secure the bulk of the payoffs resulting
    from positive market feedback.
  • Oligopoly is likely to emerge as the prevailing
    market structure.

50
Comparing Market Structures
Long-Run Number Unrestricted Ability Econom
ic Market of Entry and to Set Profits Product Non
price Structure Sellers Exit Price Possible Diffe
rentiation Competition Examples
Perfect Numerous Yes None No None None Agricultur
e, competition roofing nails Monopolistic
Many Yes Some No Considerable Yes Toothpaste com
petition toilet paper, soap,
retail trade Oligopoly Few Partial Some Y
es Frequent Yes Recorded music, college
textbooks Pure One Not
Consider- Yes None Yes Some electric monopoly
for entry able (product is
companies, unique) some local
telephone companies
Table 27-3
51
Issues and Applications Oligopoly in the
Ground-Shipping Business
  • In the industry of shipping packages by ground,
    the four-firm concentration ratio in the U.S. is
    100 percent.
  • The four firms are UPS, FedEx Ground, the U.S.
    Postal Service, and DHL.
  • Among these four firms, there is strategic
    dependence regarding both prices and delivery
    schedules.

52
Issues and Applications Oligopoly in the
Ground-Shipping Business
  • FedEx Ground is willing to deliver on Saturdays.
  • Each of the four delivery services employs
    computer technology to speed the pace of delivery
    and to allow customers to track packages in
    shipment.
  • This industry fits the definition of oligopoly,
    with four firms competing interdependently.

53
Summary Discussion of Learning Objectives
  • The fundamental characteristics of oligopoly
  • Economies of scale
  • Barriers to entry
  • Strategic dependence
  • Applying game theory to evaluate the pricing
    strategies of oligopolistic firms
  • Game theory looks at competition for payoffs
  • That depends on the strategies that others employ

54
Summary Discussion of Learning Objectives
  • The kinked demand theory of oligopolistic price
    rigidity
  • If a firm believes that rivals will follow price
    cuts but not price increases, it will be
    reluctant to change price.
  • How firms may deter market entry by potential
    rivals
  • Raise entry costs
  • Limit pricing
  • Switching policies

55
Summary Discussion of Learning Objectives
  • Why network effects and market feedback encourage
    oligopoly
  • Network effects arise when a consumers demand
    for a good or service is affected by how many
    other consumers also use the item
  • Oligopoly can arise because a handful of firms
    may be able to capture all of the positive market
    feedback

56
End of Chapter 27
  • Oligopoly and Strategic Behavior
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