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OLIGOPOLY Chapter 27


Price and Output Cartel Theory To maximize industry profit, ... (Cartel) Drug Cartel in Mexico . ... (continued war/Iraq) ... – PowerPoint PPT presentation

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Title: OLIGOPOLY Chapter 27

OLIGOPOLY Chapter 27
  • What determines how much market power a firm has?
  • How do firms in an oligopoly set prices and
  • What problems does an oligopoly have in
    maintaining price and profit?

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
  • 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.

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

Defending the Lead World-wide PC vender market
share for third quarter. DMN- 10/16/08
Company HP Dell Acer Lenova Toshiba Others Market Share 18.4 13.6 12.5 7.3 4.6 43.7 Sales Chg from year ago 15.1 11.6 47.3 8.1 25.8 9.4
(No Transcript)
Who is sharing?
  • What about the auto industry now. Government
    motors (adv./Ford) Yet Ford 8/2010 sees first
    monthly increase in sales in 2 years. 10/2010-
    Ford up 39. Is auto industry still oligopoly?
  • 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.

ATT and Verizon
  • October 19, 2012
  • Communiqué from ATT management that they would
    continue to provide retirement benefits,
    including pensions, to employees and retirees.
  • Where many other Fortune 500 companies are not
    doing this. ATT wanted to make a statement ---
    because of market share position, VZ will no
    doubt follow.

  • Most firms are part of oligopoly or monopolistic
    competition, with few monopolies or perfect
  • These two market structures are called imperfect
  • In these structures, you can find both intense
    competition and some evidence of monopoly.

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

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

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

Oligopoly (cont'd)
  • Why oligopoly occurs
  • Economies of scale
  • Barriers to entry
  • Mergers
  • Vertical mergers
  • Horizontal mergers

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.

Characteristics of Market Structures
More Examples
Why are certain industries composed of only a few
  • Because cost economies and other barriers to
    entry keep the numbers small (plus mergers keep
    out the smaller guys) (enter the political key on
    who decides if mergers are not eliminating
  • Where 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.

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

The following nonprice competition
  • http//www.youtube.com/watch?vxD6ghskNKa8
  • Advertising - Convince the consumer that firm As
    product is a better buy than those of its rivals.
  • Product differentiation.
  • Firm A could modify its products to make them
    appealingly different in order to sell more.

Examples of Oligopolies
  • Aluminum
  • Automobile
  • Film
  • Television
  • Cell phone
  • Gas
  • Beer
  • Petroleum
  • Tire
  • Airline

soft drinks, batteries, cigarettes, computer
printers, Internet browsers, baby food, cereal,
and credit cards.
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.
  • Reason - 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.

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

Measuring Market Power
  • Concentration ratio the proportion of total
    industry output produced by the largest firms.
  • If the industry produces 1 million products and
    the four biggest firms produce 700,000 of them,
    the concentration ratio is 70.

Ways to measure degree of Oligopolization
  • Concentration Ratio
  • Sometimes the market share of one company in
    the oligopoly is so great that it nearly
    resembles a monopoly.

Table 27-1 Computing the Four-Firm Concentration
Add up top 4 or perhaps 6- divide by total sales
in industry. Note This is calculated by Annual
E-Commerce Example Market Concentration in the
Personal Computer Industry
  • The computer printer industry generated 201.1
    billion in revenues in a recent year, and several
    firms had a high market share.
  • Of the four Hewlett-Packard earned 35.0
    billion, Dell 27.9 billion, Lenovo 14.1 billion
    and Acer 13.7 billion.
  • These four firms had a concentration ratio for
    the computer printer industry of 45.1

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)

Key Point
  • Concentration ratio is a quantitative measure of
  • 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 35 of market share
    Then continue on HHI calculation.

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.

HHI again
  • The Herfindahl-Hirshman Index of market equals
    the sum of the squares of the market shares of
    each firm in an industry.

Market Power
Market Power
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.

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?)
  • 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.)

Oligopoly Behavior
  • Firm A could lower its price and undercut its
  • At the lower price, sales would increase and firm
    A would increase its market share.
  • However, others in the oligopoly would
    immediately notice this ploy. Since they do not
    want to lose market share to firm A, they would
    retaliate by lowering their prices also.

What is the objective here?
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Then what happens???
  • Retaliation
  • Oligopolists respond to aggressive marketing by
  • 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! ?

The Kinked Demand Curve Confronting an Oligopolist
Demand curve facing oligopolist if rivals match
price changes
Demand curve facing oligopolist if rivals match
price cuts but not price hikes
Demand curve facing oligopolist if rivals don't
match price changes
How does Gateway respond if Dell cuts prices?
  • Rivals Response to Price Reductions
  • The degree to which sales increase when the price
    is reduced depends on the response of rival
  • We expect oligopolists to match any price
    reductions by rival oligopolists.
  • Rivals Response to Price Increases
  • Rival oligopolists may not match price increases
    in order to gain market share.

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
  • The demand curve will be kinked if rival
    oligopolists match price reductions but not price

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.

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.

Moves in the economy
  • Pepsi meets to decide how to gain market share
  • If they reduce Pepsi 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?

Price and Output Cartel Theory
  • 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
  • .

Allocation of Market Shares
  • One way to distribute output is a cartel
  • 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/

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
  • 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.

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
  • 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.

  • The examples are plentiful. The Ivy League
    schools in 2001 were caught by Justice Dept for
    fixing prices in biding for students who
    qualified for financial aid which they had been
    doing for over 30 years.

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.

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

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.

  • Whirlpool, rivals face price fixing probe
  • Michigan business news in brief Whirlpool,
    rivals face price fixing probe February 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

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

  • FTC Settles Price-Fixing Charges Against San
    Francisco Bay Area Doctors Group

Auto parts investigation the largest of any
investigations in the Antitrust Division.
  • The following corporate fines have been obtained
    in the auto parts investigation since the
    beginning of fiscal year 2011
  • Furukawa Electric Company Ltd., 200 million
  • Yazaki Corporation, 470 millionthe second
    largest criminal fine ever for an antitrust
  • DENSO Corporation, 78 million

How do we know?
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.
  • What happens if AA lowers airline fares?

Graph for a price-fixing oligopolist
  • The graph for a price-fixing oligopolist will
    look exactly like the monopolist.
  • There is no kink in the demand curve.

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

Predatory Pricing
  • 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)

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

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