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Economics of the Firm

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Title: Economics of the Firm


1
Economics of the Firm
  • Strategic Pricing Techniques

2
Recall that there is an entire spectrum of market
structures
Market Structures
  • Perfect Competition
  • Many firms, each with zero market share
  • P MC
  • Profits 0 (Firms earn a reasonable rate of
    return on invested capital)
  • NO STRATEGIC INTERACTION!
  • Monopoly
  • One firm, with 100 market share
  • P gt MC
  • Profits gt 0 (Firms earn excessive rates of
    return on invested capital)
  • NO STRATEGIC INTERACTION!

3
Most industries, however, dont fit the
assumptions of either perfect competition or
monopoly. We call these industries oligopolies
  • Oligopoly
  • Relatively few firms, each with significant
    market share
  • STRATEGIES MATTER!!!

Wireless (2002) Verizon 30 Cingular 22 ATT
20 Sprint PCS 14 Nextel 10
Voicestream 6
US Beer (2001) Anheuser-Busch 49 Miller 20
Coors 11 Pabst 4
Heineken 3
Music Recording (2001) Universal/Polygram 23
Sony 15 EMI 13
Warner 12
BMG 8
4
Market shares are not constant over time in these
industries!
Airlines (1992)
Airlines (2002)
American
American
United
United
Delta
Delta
Northwest
Northwest
Continental
Continental
US Air
SWest
While the absolute ordering didnt change, all
the airlines lost market share to Southwest.
5
Another trend is consolidation
Retail Gasoline (1992)
Retail Gasoline (2001)
Shell
Exxon/Mobil
Chevron
Shell
Texaco
BP/Amoco/Arco
Exxon
Amoco
Chev/Texaco
Mobil
Total/Fina/Elf
BP
Conoco/Phillips
Citgo
Marathon
Sun
Phillips
6
The key difference in oligopoly markets is that
price/sales decisions cant be made independently
of your competitors decisions
Your Price (-)
Monopoly
Oligopoly
Your N Competitors Prices ()
Oligopoly markets rely crucially on the
interactions between firms which is why we need
game theory to analyze them!
Strategy Matters!!!!!
7
Prisoners DilemmaA Classic!
Two prisoners (Jake Clyde) have been arrested.
The DA has enough evidence to convict them both
for 1 year, but would like to convict them of a
more serious crime.
Jake
Clyde
  • The DA puts Jake Clyde in separate rooms and
    makes each the following offer
  • Keep your mouth shut and you both get one year in
    jail
  • If you rat on your partner, you get off free
    while your partner does 8 years
  • If you both rat, you each get 4 years.

8
Jake is choosing rows Clyde is choosing
columns
Clyde
Confess Dont Confess
Confess -4 -4 0 -8
Dont Confess -8 0 -1 -1
Jake
9
Suppose that Jake believes that Clyde will
confess. What is Jakes best response?
If Clyde confesses, then Jakes best strategy is
also to confess
Clyde
Confess Dont Confess
Confess -4 -4 0 -8
Dont Confess -8 0 -1 -1
Jake
10
Suppose that Jake believes that Clyde will not
confess. What is Jakes best response?
If Clyde doesnt confesses, then Jakes best
strategy is still to confess
Clyde
Confess Dont Confess
Confess -4 -4 0 -8
Dont Confess -8 0 -1 -1
Jake
11
Dominant Strategies
Jakes optimal strategy REGARDLESS OF CLYDES
DECISION is to confess. Therefore, confess is a
dominant strategy for Jake
Clyde
Confess Dont Confess
Confess -4 -4 0 -8
Dont Confess -8 0 -1 -1
Jake
Note that Clydes dominant strategy is also to
confess
12
Nash Equilibrium
The Nash equilibrium is the outcome (or set of
outcomes) where each player is following his/her
best response to their opponents moves
Clyde
Confess Dont Confess
Confess -4 -4 0 -8
Dont Confess -8 0 -1 -1
Jake
Here, the Nash equilibrium is both Jake and Clyde
confessing
13
Winston tastes good like a cigarette should!
Us Tareyton smokers would rather fight than
switch!
Advertise Dont Advertise
Advertise 10 10 30 5
Dont Advertise 5 30 20 20
14
How about this game?
Acme and Allied are introducing a new product to
the market and need to set a price. Below are
the payoffs for each price combination.
Acme
.95 1.30 1.95
1.00 3 6 7 3 10 4
1.35 5 1 8 2 14 7
1.65 6 0 6 2 8 5
Allied
What is the Nash Equilibrium?
15
Iterative Dominance
Note that Allied would never charge 1 regardless
of what Acme charges (1 is a dominated
strategy). Therefore, we can eliminate it from
consideration.
Acme
With the 1 Allied Strategy eliminated, Acmes
strategies of both .95 and 1.30 become
dominated.
.95 1.30 1.95
1.00 3 6 7 3 10 4
1.35 5 1 8 2 14 7
1.65 6 0 6 2 8 5
Allied
With Acmes strategies reduced to 1.95, Allied
will respond with 1.35
16
Repeated Games
Jake
Clyde
The previous example was a one shot game.
Would it matter if the game were played over and
over?
Suppose that Jake and Clyde were habitual (and
very lousy) thieves. After their stay in prison,
they immediately commit the same crime and get
arrested. Is it possible for them to learn to
cooperate?
0
1
2
3
4
5
Time
Play PD Game
Play PD Game
Play PD Game
Play PD Game
Play PD Game
Play PD Game
17
Repeated Games
Jake
Clyde
We can use backward induction to solve this.
0
1
2
3
4
5
Time
Play PD Game
Play PD Game
Play PD Game
Play PD Game
Play PD Game
Play PD Game
Confess Confess
Confess Confess
Confess Confess
Confess Confess
Confess Confess
Confess Confess
Similar arguments take us back to period 0
However, once the equilibrium for period 5 is
known, there is no advantage to cooperating in
period 4
At time 5 (the last period), this is a one shot
game (there is no future). Therefore, we know the
equilibrium is for both to confess.
18
Infinitely Repeated Games
Jake
Clyde
0
1
2
Play PD Game
Play PD Game
Play PD Game

Suppose that Jake knows Clyde is planning on NOT
CONFESSING at time 0.
Option 1 Dont confess, get 1 year in jail
(rather than 0 if he confesses), but establish
trust for the next time
Option 2 Confess, get 0 years in jail (rather
than 1 if he doesnt confess), but ruins trust
for the next time
You need to value the future for this option to
be viable
19
Suppose that McDonalds is currently the only
restaurant in town, but Burger King is
considering opening a location. Should
McDonald's fight for its territory?
0
Fight
0
IN
2
Cooperate
2
5
Out
1
20
Now, suppose that this game is played repeatedly.
That is, suppose that McDonald's faces possible
entry by burger King is 20 different locations.
Can entry deterrence be a credible strategy?
Enter
Enter
Enter
Dont Fight
Dont Fight
Dont Fight
2
2
2
Total 220 40
OR
Enter
Dont Enter
Dont Enter
Fight
Dont Enter
Dont Enter
0
5
5
5
5
Total 195 95
21
Now, suppose that this game is played repeatedly.
That is, suppose that McDonald's faces possible
entry by burger King is 20 different locations.
Can entry deterrence be a credible strategy?
Enter Dont Enter
Enter Dont Enter
Enter Dont Enter
Fight Dont Fight
Fight Dont Fight
Fight Dont Fight
End of Time
Does McDonalds have an incentive to fight here?
What will Burger King do here?
If there is an end date then McDonald's threat
loses its credibility!!
22
Ever Cheat on your taxes?
In this game you get to decide whether or not to
cheat on your taxes while the IRS decides whether
or not to audit you
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
What is the equilibrium to this game?
23
If the IRS never audited, your best strategy is
to cheat (this would only make sense for the IRS
if you never cheated)
If the IRS always audited, your best strategy is
to never cheat (this would only make sense for
the IRS if you always cheated)
The Equilibrium for this game will involve mixed
strategies!
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
24
A quick detour Expected Value
Suppose that I offer you a lottery ticket This
ticket has a 2/3 chance of winning 100 and a 1/3
chance of losing 100. How much is this ticket
worth to you?
Suppose you played this ticket 6 times
Attempt Outcome
1 100
2 100
3 -100
4 100
5 -100
6 100
Total Winnings 200 Attempts 6 Average
Winnings 200/6 33.33
25
A quick detour Expected Value
Given a set of probabilities, Expected Value
measures the average outcome
Expected Value A weighted average of the
possible outcomes where the weights are the
probabilities assigned to each outcome
Suppose that I offer you a lottery ticket This
ticket has a 2/3 chance of winning 100 and a 1/3
chance of losing 100. How much is this ticket
worth to you?
26
Cheating on your taxes!
Suppose that the IRS Audits 25 of all returns.
What should you do?
Cheat
Dont Cheat
If the IRS audits 25 of all returns, you are
better off not cheating. But if you never cheat,
they will never audit,
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
27
The only way this game can work is for you to
cheat sometime, but not all the time. That can
only happen if you are indifferent between the
two!
Suppose the government audits with probability
Doesnt audit with probability
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
Cheat
Dont Cheat
If you are indifferent
(83)
(17)
28
We also need for the government to audit
sometime, but not all the time. For this to be
the case, they have to be indifferent!
Suppose you cheat with probability
Dont cheat with probability
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
Audit
Dont Audit
If they are indifferent
(91)
(9)
29
Now we have an equilibrium for this game that is
sustainable!
The government audits with probability
Doesnt audit with probability
Suppose you cheat with probability
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
Dont cheat with probability
(1.5)
(7.5)
We can find the odds of any particular event
happening.
(15)
(75)
You Cheat and get audited
(1.5)
30
The Airline Price Wars
Suppose that American and Delta face the given
demand for flights to NYC and that the unit cost
for the trip is 200. If they charge the same
fare, they split the market
500
220
American
P 500 P 220
P 500 9,000 9,000 3,600 0
P 220 0 3,600 1,800 1,800
60
180
What will the equilibrium be?
Delta
31
The Airline Price Wars
If American follows a strategy of charging 500
all the time, Deltas best response is to also
charge 500 all the time
If American follows a strategy of charging 220
all the time, Deltas best response is to also
charge 220 all the time
American
P 500 P 220
P 500 9,000 9,000 3,600 0
P 220 0 3,600 1,800 1,800
This game has multiple equilibria and the result
depends critically on each companys beliefs
about the other companys strategy
Delta
32
The Airline Price Wars Mixed Strategy Equilibria
Suppose American charges 500 with probability
Charges 220 with probability
Charge 500
American
Charge 220
P 500 P 220
P 500 9,000 9,000 3,600 0
P 220 0 3,600 1,800 1,800
Delta
(19)
(6)
(56)
(19)
(75)
(25)
33
Suppose that we make the game sequential. That
is, one side makes its decision (and that
decision is public) before the other
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
Dont Cheat
Cheat
Dont Audit
Audit
Dont Audit
Audit
(-25, 5)
(5, -5)
(-1, -1)
(0, 0)
Your reward is on the left
34
If the IRS observes you cheating, their best
choice is to Audit
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
Dont Cheat
Cheat
Dont Audit
Audit
Dont Audit
Audit
(-25, 5)
(5, -5)
(-1, -1)
(0, 0)
Your reward is on the left
vs
35
If the IRS observes you not cheating, their best
choice is to not audit
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
Dont Cheat
Cheat
Dont Audit
Audit
Dont Audit
Audit
(-25, 5)
(5, -5)
(-1, -1)
(0, 0)
Your reward is on the left
vs
36
Knowing how the IRS will respond, you never cheat
and they never audit!!
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
(0)
(0)
Dont Cheat
Cheat
(0)
(100)
Dont Audit
Audit
Dont Audit
Audit
(-25, 5)
(5, -5)
(-1, -1)
(0, 0)
Your reward is on the left
vs
37
Now, lets switch positionssuppose the IRS
chooses first
Dont Audit Audit
Cheat 5 -5 -25 5
Dont Cheat 0 0 -1 -1
(0)
(0)
Dont Audit
Audit
(100)
(0)
Dont Cheat
Cheat
Dont Cheat
Cheat
(-25, 5)
(-1, -1)
(5, -5)
(0, 0)
Your reward is on the left
38
Again, we could play this game sequentially
P 500 P 220
P 500 9,000 9,000 3,600 0
P 220 0 3,600 1,800 1,800
(0)
(100)
500
220
(0)
(0)
500
220
220
500
(9,000, 9,000)
(3,600, 0)
(0, 3,600)
(1,800, 1,800)
Deltas reward is on the left
39
Note Even if the moves are made sequentially, if
one party is not aware of the others move, we
are back to the simultaneous move game
i.e., Al Capone might have cheated all the time,
but if the IRS is unaware, they might not audit
all the time!
Dont Cheat
Cheat
Dont Audit
Audit
Dont Audit
Audit
(-25, 5)
(5, -5)
(-1, -1)
(0, 0)
40
In the Movie Air Force One, Terrorists hijack Air
Force One and take the president hostage. Can we
write this as a game? (Terrorists payouts on left)
Terrorists
Take Hostages
Dont Take Hostages
President
(0, 1)
Dont Negotiate
Negotiate
In the third stage, the best response is to kill
the hostages
(1, -.5)
Terrorists
Given the terrorist response, it is optimal for
the president to negotiate in stage 2
Kill
Dont Kill
Given Stage two, it is optimal for the terrorists
to take hostages
(-.5, -1)
(-1, 1)
41
Terrorists
Take Hostages
The equilibrium is always (Take
Hostages/Negotiate). How could we change this
outcome?
Dont Take Hostages
President
(0, 1)
Suppose that a constitutional amendment is passed
ruling out hostage negotiation (a commitment
device)
Dont Negotiate
Negotiate
(1, -.5)
Terrorists
Kill
Without the possibility of negotiation, the new
equilibrium becomes (No Hostages)
Dont Kill
(-.5, -1)
(-1, 1)
42
Player A
A bargaining exampleHow do you divide 20?
Offer
Player B
Day 1
Accept
Reject
Player B
Two players have 20 to divide up between them.
On day one, Player A makes an offer, on day two
player B makes a counteroffer, and on day three
player A gets to make a final offer. If no
agreement has been made after three days, both
players get 0.
Offer
Player A
Day 2
Accept
Reject
Player A
Offer
Player B
Day 3
Accept
Reject
(0,0)
43
Player A
Offer
Player A knows what happens in day 2 and wants to
avoid that!
Player B
Day 1
Player A 19.99 Player B .01
Accept
Reject
Player B
Offer
Player B knows what happens in day 3 and wants to
avoid that!
Player A 19.99 Player B .01
Player A
Day 2
Accept
Reject
Player A
Offer
If day 3 arrives, player B should accept any
offer a rejection pays out 0!
Player B
Day 3
Player A 19.99 Player B .01
Accept
Reject
(0,0)
44
Player A
Lets consider a couple variations
Offer
Player B
Day 1
  • Variation 1 Negotiations take a lot of time
    and each player has an opportunity cost of
    waiting
  • Player A has an investment opportunity that pays
    20 per year.
  • Player B has an investment strategy that pays 10
    per year

Accept
Reject
Player B
Offer
Player A
Day 2
Accept
Reject
Player A
Offer
Player B
Day 3
Accept
Reject
(0,0)
45
Player A
If player B rejects, she gets 3.35 in one year.
Thats worth 3.35/1.10 today
Offer
Player A 16.95 Player B 3.05
Player B
Year 1
Accept
Reject
Player B
Offer
If player A rejects, she gets 19.99 in one year.
Thats worth 19.99/1.20 today
Player A 16.65 Player B 3.35
Player A
Year 2
Accept
Reject
Player A
Offer
If year 3 arrives, player B should accept any
offer a rejection pays out 0!
Player B
Year 3
Player A 19.99 Player B .01
Accept
Reject
(0,0)
46
Continuous Choice Games
  • Consider the following example. We have two
    competing firms in the marketplace.
  • These two firms are selling identical products.
  • Each firm has constant marginal costs of
    production.

What are these firms using as their strategic
choice variable? Price or quantity?
Are these firms making their decisions
simultaneously or is there a sequence to the
decisions?
47
Cournot Competition Quantity is the strategic
choice variable
There are two firms in an industry both facing
an aggregate (inverse) demand curve given by
D
Total Industry Production
Both firms have constant marginal costs equal to
20
48
From firm ones perspective, the demand curve is
given by
Treated as a constant by Firm One
Solving Firm Ones Profit Maximization
49
In Game Theory Lingo, this is Firm Ones Best
Response Function To Firm 2
If firm 2 drops out, firm one is a monopolist!
0
50
What could firm 2 do to make firm 1 drop out?
51
Firm 2 chooses a production target of 3
3
1
Firm 1 responds with a production target of 1
52
The game is symmetric with respect to Firm two
Firm 2 responds with a production target of 2
Firm 1 chooses a production target of 1
53
Eventually, these two firms converge on
production levels such that neither firm has an
incentive to change
Firm 1
We would call this the Nash equilibrium for this
model
Firm 2
54
Recall we started with the demand curve and
marginal costs
55
The markup formula works for each firm
56
Had this market been serviced instead by a
monopoly,
57
Had this market been instead perfectly
competitive,
58
Monopoly
Perfect Competition
2 Firms
59
One more point
Monopoly
Duopoly
If both firms agreed to produce 1.25M chips (half
the monopoly output), they could split the
monopoly profits (62.5 apiece). Why dont these
firms collude?
60
Suppose we increase the number of firmssay, to 3
Demand facing firm 1 is given by (MC 20)
The strategies look very similar!
61
Expanding the number of firms in an oligopoly
Cournot Competition
  • Note that as the number of firms increases
  • Output approaches the perfectly competitive level
    of production
  • Price approaches marginal cost.

Lets go back to the previous example
62
Recall, we had an aggregate demand and a constant
marginal cost of production.
CS (.5)(120 70)(2.5) 62.5
Monopoly
120
62.5
70
D
2.5
What would it be worth to consumers to add
another firm to the industry?
63
Recall, we had an aggregate demand for computer
chips and a constant marginal cost of production.
CS (.5)(120 53)(3.33) 112
Two Firms
112
53
D
3.33
64
With three firms in the market
CS (.5)(120 45)(3.75) 140
Three Firms
140
45
D
3.75
65
Increasing Competition
66
Increasing Competition
67
Now, suppose that there were annual fixed costs
equal to 10
How many firms can this industry support?
Solve for N
68
With a fixed cost of 10, this industry can
support 7 Firms
69
The previous analysis was with identical firms.
Suppose Firm 2s marginal costs increase to 30
Firm 1
50
Firm 2
50
70
Suppose Firm 2s marginal costs increase to 30
If Firm ones production is unchanged
Firm 2
71
Firm 1
Firm 2
42
Firm 2s market share drops
58
72
The Process
With a rise in marginal costs, Firm 2s profit
margins shrink
To bring profit margins back up, Firm 2 lowers
production levels which lowers industry output
and raises the price
A higher price raises Firm 1s profit margins.
This causes them to expand production
Firm 1
Firm 2
42
Firm 2s market share drops
58
73
The previous analysis (Cournot Competition)
considered quantity as the strategic variable.
Bertrand competition uses price as the strategic
variable.
Should it matter?
P
D
Q
Just as before, we have an industry demand curve
and two competing duopolies both with marginal
cost equal to 20.
Industry Output
74
Firm level demand curves look very different when
we change strategic variables
Bertrand Case
Quantity Strategy
If you are underpriced, you lose the whole market
At equal prices, you split the market
If you are the low price you capture the whole
market
D
D
75
Price competition creates a discontinuity in each
firms demand curve this, in turn creates a
discontinuity in profits
As in the cournot case, we need to find firm
ones best response (i.e. profit
maximizing response) to every possible price set
by firm 2.
76
Firm Ones Best Response Function
Case 1 Firm 2 sets a price above the pure
monopoly price
Case 2 Firm 2 sets a price between the monopoly
price and marginal cost
Case 3 Firm 2 sets a price below marginal cost
Case 4 Firm 2 sets a price equal to marginal
cost
Whats the Nash equilibrium of this game?
77
2 Firms
Monopoly
Perfect Competition
  • However, the Bertrand equilibrium makes some very
    restricting assumptions
  • Firms are producing identical products (i.e.
    perfect substitutes)
  • Firms are not capacity constrained

78
An examplecapacity constraints
Consider two theatres located side by side.
Each theatres marginal cost is constant at 10.
Both face an aggregate demand for movies equal to
Each theatre has the capacity to handle 2,000
customers per day.
What will the equilibrium be in this case?
79
If both firms set a price equal to 10 (Marginal
cost), then market demand is 5,400 (well above
total capacity 2,000)
Note The Bertrand Equilibrium (P MC) relies on
each firm having the ability to make a credible
threat
If you set a price above marginal cost, I will
undercut you and steal all your customers!
At a price of 33, market demand is 4,000 and
both firms operate at capacity
80
With competition in price, the key is to create
product variety somehow! Suppose that we have two
firms. Again, marginal costs are 20. The two
firms produce imperfect substitutes.
Product Differentiation
D
81
Recall Firm 1 has a marginal cost of 20
Each firm needs to choose price to maximize
profits conditional on the other firms choice of
price.
Firm 1 profit maximizes by choice of price
Firm 2 sets a price of 50
Firm 1s strategy
D
30
Firm 1 responds with 55
82
With equal costs, both firms set the same price
and split the market evenly
Firm 1
Firm 2
83
2 Firms
Monopoly
Perfect Competition
84
Suppose that Firm twos costs increase. What
happens in each case?
Bertrand
With higher marginal costs, firm 2s profit
margins shrink. To bring profit margins back up,
firm two raises its price
Firm 2
30
85
Suppose that Firm twos costs increase. What
happens in each case?
With higher marginal costs, firm 2s profit
margins shrink. To bring profit margins back up,
firm two raises its price
Firm 1
A higher price from firm two sends customers to
firm 1. This allows firm 1 to raise price as
well and maintain market share!
Firm 2
86
  • Cournot (Quantity Competition) Competition is
    for market share
  • Firm One responds to firm Bs cost increases by
    expanding production and increasing market share
  • Best response strategies are strategic substitutes
  • Bertrand (Price Competition) Competition is for
    profit margin
  • Firm One responds to firm Bs cost increases by
    increasing price and maintaining market share
  • Best response strategies are strategic complements

Bertrand
Cournot
Firm 1
Firm 1
Firm 2
Firm 2
87
Stackelberg leadership
In the previous example, firms made
price/quantity decisions simultaneously. Suppose
we relax that and allow one firm to choose first.
Both firms have a marginal cost equal to 20
Firm A chooses its output first
Firm B chooses its output second
Market Price is determined
88
Firm B has observed Firm As output decision and
faces the residual demand curve
89
Knowing Firm Bs response, Firm A can now
maximize its profits
Firm 1 produces the monopoly output!
90
2 Firms
Monopoly
Perfect Competition
(67)
(33)
91
Sequential Bertrand Competition
We could also sequence events using price
competition.
Product Differentiation
Both firms have a marginal cost equal to 20
Firm 2 chooses its price first
Firm 2 chooses its price second
Market sales are determined
92
Sequential Bertrand Competition
2 Firms
Monopoly
Perfect Competition
93
Cournot vs. Bertrand Stackelberg Games
  • Cournot (Quantity Competition)
  • Firm One has a first mover advantage it gains
    market share and earns higher profits. Firm B
    loses market share and earns lower profits
  • Total industry output increases (price decreases)
  • Bertrand (Price Competition)
  • Firm Two has a second mover advantage it
    charges a lower price (relative to firm one),
    gains market share and increases profits.
  • Overall, production drops, prices rise, and both
    firms increase profits.

94
Market Dominance
Campbells Soup has accounted for 60 of the
canned soup market for over 50 years
Sothebys and Christies have controlled 90 of
the auction market for two decades (each holds
50 of its own domestic market)
Intel has held 90 of the computer chip market
for 10 years.
Microsoft has held 90 of the operating system
market over the last 10 years
On average, the number one firm in an industry
retains that rank for 17 28 years!
95
Entry/Exit and Profitability
Bananas
Apples
S
S
D
D
D
D
Its normally assumed that as demand patterns
shift, resources are moved across sectors as
the price of bananas rises relative to apples,
there is exit in the apple industry and entry in
the banana industry (bananas are more profitable)
THIS IS INCONSISTANT WITH THE FACTS!!
96
Evolving Market Structures.Some Facts
Entry is common Entry rates for industries in
the US between 1963 1982 averaged 8-10 per
year.
Entry occurs on a small scale Entrants for
industries in the US between 1963 1982 averaged
14 of the industry.
Survival Rates are Low 61 of entrants will
exit within 5 years. 79.6 exit within 10 years.
Entry is highly correlated with exit across
industries Industries with high entry rates
also have high exit rates
Entry/Exit Rates vary considerably across
industries Clothing and Furniture have high
entry/exit, chemical and petroleum have low
entry/exit.
97
The data suggests that most industries are like
revolving doors there is always a steady supply
of new entrants trying to survive.
Market Dominated by Incumbents
Entrants
Exits
The key source of variation across industries is
the rate of entry (which controls the rate of
exit)
Is this a result of predatory practices by the
incumbents?
98
Predatory Pricing vs. Profit Maximizing
Predatory pricing describes actions that are
optimal only if they drive out rivals or
discourage potential rivals!
Recall the previous exampleeach firm has a
marginal cost of 20
With limit pricing, firm 1 chooses a production
level to drive price down to marginal cost
99
Entry deterrence generally involves overproducing
today to drive your opponent out of business!
Profit maximizing output
Firm 1
Firm 1s entry deterring output
Firm 2
Overproduction by firm 1.
100
There have been numerous cases involving
predatory pricing throughout history.
  • Standard Oil
  • American Sugar Refining Company
  • Mogul Steamship Company
  • Wall Mart
  • ATT
  • Toyota
  • American Airlines

There are two good reasons why we would most
likely not see predatory pricing in practice
  1. It is difficult to make a credible threat
    (Remember the Chain Store Paradox)!
  1. A merger is generally a dominant strategy!!

101
Capacity as a Commitment Device in Predatory
Pricing
In 1945, the US Court of Appeals ruled that Alcoa
was guilty of anti-competitive behavior. The
case was predicated on the view that Alcoa had
expanded capacity solely to keep out competition
Alcoa had expanded capacity eightfold from 1912
1934!!
In the 1970s Safeway increased the number of
stores in the Edmonton area from 25 to 34 in an
effort to drive out new chains entering the area
(It did workthe competition fell from 21 stores
to 10)
In the 1970s, there were 7 major firms in the
titanium dioxide market (A whitener used in paint
and plastics). Dupont held 34 of the market but
had a proprietary production technique that
generated less pollution. When stricter
pollution controls were imposed, Dupont increased
its market share to 60 while the rest of the
industry stagnated.
102
The Bottom Line
There have been numerous cases over the years
alleging predatory pricing. However, from a
practical standpoint we need to ask three
questions
  1. Can predatory pricing be a rational strategy?
  2. Can we distinguish predatory pricing from
    competitive pricing?
  3. If we find evidence for predatory pricing, what
    do we do about it?

103
Price Fixing and Collusion
Prior to 1993, the record fine in the United
States for price fixing was 2M. Recently, that
record has been shattered!
Defendant Product Year Fine
F. Hoffman-Laroche Vitamins 1999 500M
BASF Vitamins 1999 225M
SGL Carbon Graphite Electrodes 1999 135M
UCAR International Graphite Electrodes 1998 110M
Archer Daniels Midland Lysine Citric Acid 1997 100M
Haarman Reimer Citric Acid 1997 50M
HeereMac Marine Construction 1998 49M
In other wordsCartels happen!
104
Antitrust Criminal Division Fines ( Millions)
105
Cartel Formation
In a previous example, we had three firms, each
with a marginal cost of 20 facing a market
demand equal to
If we assume that these firms engage in Cournot
competition, then we can calculate price,
quantities, and profits
Firm Output
Industry Output
Total industry profit is 93
Market Price
Firm Profits
106
Cartel Formation
In a previous example, we had three firms, each
with a marginal cost of 20 facing a market
demand equal to
If these three firms can coordinate their
actions, they could collectively act as a
monopolist
Splitting the profits equally gives each firm
profits of 41.67!!
107
Cartel Formation
  • While it is clearly in each firms best interest
    to join the cartel, there are a couple problems
  • With the high monopoly markup, each firm has the
    incentive to cheat and overproduce. If every
    firm cheats, the price falls and the cartel
    breaks down
  • Cartels are generally illegal which makes
    enforcement difficult!

Note that as the number of cartel members
increases the benefits increase, but more members
makes enforcement even more difficult!
108
Cartels - The Prisoners Dilemma
The problem facing the cartel members is a
perfect example of the prisoners dilemma !
Clyde
Cooperate Cheat
Cooperate 20 20 10 40
Cheat 40 10 15 15
Jake
109
But we know that cartels do happen!!
We can assume that cartel members are interacting
repeatedly over time
Cartel agreement made at time zero.
0
1
2
3
4
5
Time
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Cartel members might cooperate now to avoid being
punished later
However, weve already shown that if there is a
well defined endpoint in which the game ends,
then the collusive strategy breaks down (threats
are not credible)
110
Cooperation also occurs with an infinite horizon
(i.e. the game never ends!!)
Cartel agreement made at time zero.
0
1
2
3
4
5
Time
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Firms will cooperate when its in their best
interest to do so!
Cartels are easier to maintain when there are
higher annual profits and interest rates are low!
111
Where is collusion most likely to occur?
High profit potential
The more profitable a cartel is, the more likely
it is to be maintained
  • Inelastic Demand (Few close substitutes,
    Necessities)
  • Cartel members control most of the market
  • Entry Restrictions (Natural or Artificial)

Its common to see trade associations form as a
way of keeping out competition (Florida Oranges,
Got Milk!, etc)
112
April 15,1996 (Grape Nut Monday) Post Cereal,
the third largest ready-to-eat cereal
manufacturer announced a 20 cut in its cereal
prices
Kelloggs eventually cut their prices as well
(after their market share fell from 35 to 32)
The breakfast cereal industry had been a stable
oligopoly for years.what happened?
  • Supermarket generic cereals created a more
    competitive pricing atmosphere
  • Changing consumer breakfast habits (bagels,
    muffins, etc)

113
Where is collusion most likely to occur?
Low cooperation costs
If it is relatively easy for member firms to
coordinate their actions, the more likely it is
to be maintained
  • Small Number of Firms with a high degree of
    market concentration
  • Similar production costs
  • Little product differentiation

Some cartels might require explicit side payments
among member firms. This is difficult to do when
cartels are illegal!
114
Detecting Collusion
In general, it is difficult to distinguish cartel
behavior from regular competitive behavior
(remember, the government does not know each
firms costs, the nature of demand, etc)
Signs of Potential Collusion
  • Little relationship between price and costs
  • Little relationship between price and information
    sets
  • Excess Capacity (as a means of retaliation)
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