Oligopoly

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Oligopoly
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In this chapter, look for the answers to these
questions
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• What market structures lie between perfect
  competition and monopoly, and what are their
  characteristics?
• What outcomes are possible under oligopoly?
• Why is it difficult for oligopoly firms to
  cooperate?
• How are antitrust laws used to foster
  competition?

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Introduction Between Monopoly and Competition
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• Two extremes
• Competitive markets many firms, identical
  products
• Monopoly one firm
• In between these extremes
• Oligopoly only a few sellers offer similar or
  identical products.
• Monopolistic competition many firms sell
  similar but not identical products.

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Oligopoly

• The assumed characteristics of an oligopoly
• the dominance of the industry by a small number
  of firms
• the importance of interdependence
• differentiated or homogeneous products
• high barriers to entry.

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Explain why interdependence is responsible for
the dilemma faced by oligopolistic firms whether
to compete or to collude.

• Oligopoly models must account for
  interdependence in decision-making. That is, each
  individual firm weighs its potential rivals
  reactions when it chooses a business strategy.
  Oligopolists' strategies depend on their
  individual positions relative to those of current
  competitors and potential rivals.
• Strategic Behavior entails ascertaining what
  other people or firms are likely to do in a
  specific situation and then pursuing tactics that
  maximize your gains or minimize your losses.
• Mutual interdependence exists when firms consider
  their rivals' reactions while adjusting prices,
  outputs, or product lines.

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Measuring Market Concentration
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• Concentration ratio the percentage of the
  markets total output supplied by its four
  largest firms.
• The higher the concentration ratio, the less
  competition.
• This chapter focuses on oligopoly,a market
  structure with high concentration ratios.
• When the four largest firms in an industry
  control 40 or more of the market, that industry
  is considered oligopolistic.

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Concentration Ratios in Selected U.S. Industries
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Industry Concentration ratio
Video game consoles 100
Tennis balls 100
Credit cards 99
Batteries 94
Soft drinks 93
Web search engines 92
Breakfast cereal 92
Cigarettes 89
Greeting cards 88
Beer 85
Cell phone service 82
Autos 79
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Barriers to Entry

• Ownership of key resources. Ex OPEC
• Large economies of scales. Prevent new firms from
  entry due to large cost of entry.
• Ex. New soft drink company trys to compete with
  Coke and Pepsi.
• This allows firms to keep their economic profit
  in the long run.

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EXAMPLE Cell Phone Duopoly in Smalltown
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P Q
0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50

• Smalltown has 140 residents
• The good cell phone service with unlimited
  anytime minutes and free phone
• Smalltowns demand schedule
• Two firms T-Mobile, Verizon(duopoly an
  oligopoly with two firms)
• Each firms costs FC 0, MC 10

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EXAMPLE Cell Phone Duopoly in Smalltown
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Competitive outcome P MC 10 Q 120 Profit
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Monopoly outcome P 40 Q 60 Profit 1,800
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Collusion non-collusive behavior

• The term 'collusion' implies to 'play together'.
  When firms under oligopoly agree formally not to
  compete with each other about price or output, it
  is called collusive oligopoly. The firms may
  agree on setting output quota, or fix prices or
  limit product promotion or agree not to 'poach'
  in each other's market. The completing firms thus
  from a 'cartel'. The members of firms behave as
  if they are a single firm.
• Non-collusive behavior would mean that there is
  no cheating between firms but competition.

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Collusive Oligopoly

• formal (cartel) or informal agreement (tacit
  collusion) among producers to limit competition
  between themselves
• they act as if they were a monopoly
• discussion of the consequences of the firms
  acting as a monopoly
• impact on consumers
• members may compete against each other using
  non-price competition
• regulations to prevent collusion

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Non-Collusive Oligopoly

• no agreement exists between producers
• existence of non-price competition with the
  possibility of price wars
• the kinked demand curve as one model to describe
  oligopoly behavior
• game theory
• contestability of markets prevents firms from
  exploiting monopoly power

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EXAMPLE Cell Phone Duopoly in Smalltown
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• One possible duopoly outcome collusion
• Collusion an agreement among firms in a market
  about quantities to produce or prices to charge
  to restrict competition.
• T-Mobile and Verizon could agree to each produce
  half of the monopoly output
• For each firm Q 30, P 40, profits 900
• Cartel A group of producers who act together to
  fix price, output or conditions of sale
  e.g., T-Mobile and Verizon in the outcome
  with collusion

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Organization of the Petroleum Exporting Countries

• The Organization of the Petroleum Exporting
  Countries (OPEC) is a cartel of twelve countries
  made up of Algeria, Angola, Ecuador, Iran, Iraq,
  Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the
  United Arab Emirates, and Venezuela. OPEC has
  maintained its headquarters in Vienna since 1965.

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Organization of the Petroleum Exporting Countries

• According to its statutes, one of the principal
  goals is the determination of the best means for
  safeguarding the cartel's interests, individually
  and collectively. It also pursues ways and means
  of ensuring the stabilization of prices in
  international oil markets with a view to
  eliminating harmful and unnecessary fluctuations
  giving due regard at all times to the interests
  of the producing nations and to the necessity of
  securing a steady income to the producing
  countries an efficient and regular supply of
  petroleum to consuming nations, and a fair return
  on their capital to those investing in the
  petroleum industry.

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Organization of the Petroleum Exporting Countries
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Price fixing

• Price fixing is an agreement between participants
  on the same side in a market to buy or sell a
  product, service, or commodity only at a fixed
  price, or maintain the market conditions such
  that the price is maintained at a given level by
  controlling supply and demand. The group of
  market makers involved in price fixing is
  sometimes referred to as a cartel.
• The intent of price fixing may be to push the
  price of a product as high as possible, leading
  to profits for all sellers, but it may also have
  the goal to fix, peg, discount, or stabilize
  prices. The defining characteristic of price
  fixing is any agreement regarding price, whether
  expressed or implied.
• Price fixing requires a conspiracy between
  sellers or buyers the purpose is to coordinate
  pricing for mutual benefit of the traders.

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Price fixing

• In the United States, price fixing can be
  prosecuted as a criminal federal offense under
  section 1 of the Sherman Antitrust Act. Criminal
  prosecutions may only be handled by the U.S.
  Department of Justice, but the Federal Trade
  Commission also has jurisdiction for civil
  antitrust violations. Many State Attorneys
  General also bring antitrust cases and have
  antitrust offices.
• Colluding on price amongst competitors, also
  known as horizontal price fixing, is viewed as a
  per se violation of the Sherman Act regardless of
  the market impact or alleged efficiency of the
  action. In 2007, the U.S. Supreme Court ruled
  that vertical price fixing by a manufacturer and
  its retailers, also known as retail price
  maintenance, is not a per se violation.
• Under American law, exchanging prices among
  competitors can also violate the antitrust laws.
  This includes exchanging prices with either the
  intent to fix prices or if the exchange affects
  the prices individual competitors set. Proof that
  competitors have shared prices can be used as
  part of the evidence of an illegal price fixing
  agreement. Experts generally advise that
  competitors avoid even the appearance of agreeing
  on price.

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A C T I V E L E A R N I N G 1 Collusion vs.
self-interest
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P Q
0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50

• Duopoly outcome with collusionEach firm agrees
  to produce Q 30, earns profit 900.
• If T-Mobile reneges on the agreement and produces
  Q 40, what happens to the market price?
  T-Mobiles profits?
• Is it in T-Mobiles interest to renege on the
  agreement?
• If both firms renege and produce Q 40,
  determine each firms profits.

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A C T I V E L E A R N I N G 1 Answers
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• If both firms stick to agreement,
• each firms profit 900
• If T-Mobile reneges on agreement and produces Q
  40
• Market quantity 70, P 35
• T-Mobiles profit 40 x (35 10) 1000
• T-Mobiles profits are higher if it reneges.
• Verizon will conclude the same, so both firms
  renege, each produces Q 40
• Market quantity 80, P 30
• Each firms profit 40 x (30 10) 800

P Q
0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
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Collusion vs. Self-Interest
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• Both firms would be better off if both stick to
  the cartel agreement.
• But each firm has incentive to renege on the
  agreement.
• Lesson It is difficult for oligopoly firms to
  form cartels and honor their agreements.
• Self-interest trumps cooperation or group
  interest.

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A C T I V E L E A R N I N G 2 The oligopoly
equilibrium
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P Q
0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50

• If each firm produces Q 40,
• market quantity 80
• P 30
• each firms profit 800
• Is it in T-Mobiles interest to increase its
  output further, to Q 50?
• Is it in Verizons interest to increase its
  output to Q 50?

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A C T I V E L E A R N I N G 2 Answers
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P Q
0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50

• If each firm produces Q 40, then each firms
  profit 800.
• If T-Mobile increases output to Q 50
• Market quantity 90, P 25
• T-Mobiles profit 50 x (25 10) 750
• T-Mobiles profits are higher at Q 40 than at
  Q 50.
• The same is true for Verizon.

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The Equilibrium for an Oligopoly
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• Nash equilibrium a situation in which economic
  participants interacting with one another each
  choose their best strategy given the strategies
  that all the others have chosen
• Our duopoly example has a Nash equilibrium in
  which each firm produces Q 40.
• Given that Verizon produces Q 40, T-Mobiles
  best move is to produce Q 40.
• Given that T-Mobile produces Q 40, Verizons
  best move is to produce Q 40.

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A Comparison of Market Outcomes
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• When firms in an oligopoly individually choose
  production to maximize profit, (MC MR)
• Oligopoly Q is greater than (gt) monopoly Q but
  smaller than (lt) competitive Q.
• Oligopoly P is greater than (gt) competitive P
  but less than (lt) monopoly P.

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The Output Price Effects
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• Increasing output has two effects on a firms
  profits
• output effect If P gt MC, selling more output
  raises profits.
• price effectRaising production increases market
  quantity, which reduces market price and reduces
  profit on all units sold.
• If output effect gt price effect, (Elastic) the
  firm increases production.
• If price effect gt output effect, (Inelastic) the
  firm reduces production.

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The Size of the Oligopoly
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• As the number of firms in the market increases,
• the price effect becomes smaller
• the oligopoly looks more and more like a
  competitive market
• P approaches MC
• the market quantity approaches the socially
  efficient quantity

Another benefit of international trade Trade
increases the number of firms competing,
increases Q, keeps P closer to marginal cost
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Kinked Demand Curve in Oligopoly

• At prices above the kink the demand will tend to
  be elastic. This is because if the firm increase
  their price, other firms may not follow and they
  would lose a lot of demand. Below the kink,
  demand will be inelastic as any price reductions
  are likely to be matched by competitors with
  little gain in demand.

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Kinked Demand Curve in Oligopoly

• The equilibrium of this firm in this situation
  will be where marginal cost equals marginal
  revenue.
• The marginal revenue curve associated with a
  kinked demand curve will be discontinuous and
  have a vertical section. The marginal cost curve
  can shift anywhere along this section and there
  will be no change in the equilibrium price and
  output.

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Kinked Demand Curve in Oligopoly
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Non-price competition

• Non-price competition is a marketing strategy "in
  which one firm tries to distinguish its product
  or service from competing products on the basis
  of attributes like design and workmanship
• The firm can also distinguish its product
  offering through quality of service, extensive
  distribution, customer focus, or any other
  sustainable competitive advantage other than
  price. It can be contrasted with price
  competition, which is where a company tries to
  distinguish its product or service from competing
  products on the basis of low price.
• Non-price competition typically involves
  promotional expenditures, (such as advertising,
  selling staff, the locations convenience, sales
  promotions, coupons, special orders, or free
  gifts), marketing research, new product
  development, and brand management costs.

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Game Theory
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• Game theory the study of how people behave in
  strategic situations
• Dominant strategy a strategy that is best for
  a player in a game regardless of the strategies
  chosen by the other players
• Prisoners dilemma a game between two
  captured criminals that illustrates why
  cooperation is difficult even when it is mutually
  beneficial

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Prisoners Dilemma Example
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• The police have caught Bonnie and Clyde, two
  suspected bank robbers, but only have enough
  evidence to imprison each for 1 year.
• The police question each in separate rooms,
  offer each the following deal
• If you confess and implicate your partner, you
  go free.
• If you do not confess but your partner implicates
  you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.

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Prisoners Dilemma Example
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Confessing is the dominant strategy for both
players.
Nash equilibrium both confess
Bonnies decision
Confess
Remain silent
Bonnie gets 8 years
Bonnie gets 20 years
Confess
Clyde gets 8 years
Clyde goes free
Clydes decision
Bonnie gets 1 year
Bonnie goes free
Remain silent
Clyde gets 1 year
Clyde gets 20 years
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Prisoners Dilemma Example
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• Outcome Bonnie and Clyde both confess, each
  gets 8 years in prison.
• Both would have been better off if both remained
  silent.
• But even if Bonnie and Clyde had agreed before
  being caught to remain silent, the logic of
  self-interest takes over and leads them to
  confess.

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Oligopolies as a Prisoners Dilemma
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• When oligopolies form a cartel in hopes of
  reaching the monopoly outcome, they become
  players in a prisoners dilemma.
• Our earlier example
• T-Mobile and Verizon are duopolists in Smalltown.
• The cartel outcome maximizes profits Each firm
  agrees to serve Q 30 customers.
• Here is the payoff matrix for this example

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T-Mobile Verizon in the Prisoners Dilemma
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Each firms dominant strategy renege on
agreement, produce Q 40.
T-Mobile
Q 30
Q 40
T-Mobiles profit 900
T-Mobiles profit 1000
Q 30
Verizons profit 900
Verizons profit 750
Verizon
T-Mobiles profit 750
T-Mobiles profit 800
Q 40
Verizons profit 800
Verizons profit 1000
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A C T I V E L E A R N I N G 3 The fare
wars game
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• The players American Airlines and United
  Airlines
• The choice cut fares by 50 or leave fares
  alone.
• If both airlines cut fares, each airlines
  profit 400 million
• If neither airline cuts fares, each airlines
  profit 600 million
• If only one airline cuts its fares, its profit
  800 millionthe other airlines profits 200
  million
• Draw the payoff matrix, find the Nash
  equilibrium.

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A C T I V E L E A R N I N G 3 Answers
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• Nash equilibriumboth firms cut fares

American Airlines
Cut fares
Dont cut fares
200 million
400 million
Cut fares
United Airlines
800 million
400 million
600 million
800 million
Dont cut fares
600 million
200 million
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Other Examples of the Prisoners Dilemma
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• Ad WarsTwo firms spend millions on TV ads to
  steal business from each other. Each firms ad
  cancels out the effects of the other, and both
  firms profits fall by the cost of the ads.
• Organization of Petroleum Exporting Countries
  Member countries try to act like a cartel, agree
  to limit oil production to boost prices
  profits. But agreements sometimes break down
  when individual countries renege.

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Other Examples of the Prisoners Dilemma
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• Arms race between military superpowers Each
  country would be better off if both disarm, but
  each has a dominant strategy of arming.
• Common resources All would be better off if
  everyone conserved common resources, but each
  persons dominant strategy is overusing the
  resources.

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Prisoners Dilemma and Societys Welfare
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• The noncooperative oligopoly equilibrium
• bad for oligopoly firms prevents them from
  achieving monopoly profits
• good for society Q is closer to the
  socially efficient output P is closer to MC
• In other prisoners dilemmas, the inability to
  cooperate may reduce social welfare.
• e.g., arms race, overuse of common resources

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Another Example Negative Campaign Ads

• Election with two candidates, R and D.
• If R runs a negative ad attacking D, 3000 fewer
  people will vote for D1000 of these people vote
  for R, the rest abstain.
• If D runs a negative ad attacking R, R loses
  3000 votes, D gains 1000, 2000 abstain.
• R and D agree to refrain from running attack ads.
  Will each one stick to the agreement?

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Another Example Negative Campaign Ads
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Each candidates dominant strategy run attack
ads.
Rs decision
Run attack ads (defect)
Do not run attack ads (cooperate)
no votes lost or gained
R gains 1000 votes
Do not run attack ads (cooperate)
no votes lost or gained
D loses 3000 votes
Ds decision
R loses 3000 votes
R loses 2000 votes
Run attack ads (defect)
D loses 2000 votes
D gains 1000 votes
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Another Example Negative Campaign Ads

• Nash eqm both candidates run attack ads.
• Effects on election outcome NONE. Each sides
  ads cancel out the effects of the other sides
  ads.
• Effects on society NEGATIVE. Lower voter
  turnout, higher apathy about politics, less voter
  scrutiny of elected officials actions.

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Why People Sometimes Cooperate
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• When the game is repeated many times, cooperation
  may be possible.
• Strategies which may lead to cooperation
• If your rival reneges in one round, you renege
  in all subsequent rounds.
• Tit-for-tat Whatever your rival does in one
  round (whether renege or cooperate), you do in
  the following round.

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Price leadership (tacit collusion)

• Tacit collusion occurs when cartels are illegal
  or overt collusion is absent. Put another way,
  two firms agree to play a certain strategy
  without explicitly saying so. Oligopolies usually
  try not to engage in price cutting, excessive
  advertising or other forms of competition. Thus,
  there may be unwritten rules of collusive
  behavior such as price leadership (tacit
  collusion). A price leader will then emerge and
  sets the general industry price, with other firms
  following suit.

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Public Policy Toward Oligopolies
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• Recall one of the Ten Principles from
  Chap.1Governments can sometimes improve market
  outcomes.
• In oligopolies, production is too low and prices
  are too high, relative to the social optimum.
• Role for policymakers promote competition,
  prevent cooperation to move the oligopoly
  outcome closer to the efficient outcome.

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Restraint of Trade and Antitrust Laws
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• Sherman Antitrust Act (1890)forbids collusion
  between competitors
• Clayton Antitrust Act (1914)strengthened rights
  of individuals damaged by anticompetitive
  arrangements between firms

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Controversies Over Antitrust Policy
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• Most people agree that price-fixing agreements
  among competitors should be illegal.
• Some economists are concerned that policymakers
  go too far when using antitrust laws to stifle
  business practices that are not necessarily
  harmful, and may have legitimate objectives.
• We consider three such practices

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1. Resale Price Maintenance (Fair Trade)
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• Occurs when a manufacturer imposes lower limits
  on the prices retailers can charge.
• Is often opposed because it appears to reduce
  competition at the retail level.
• Yet, any market power the manufacturer has is at
  the wholesale level manufacturers do not gain
  from restricting competition at the retail level.
  
• The practice has a legitimate objective
  preventing discount retailers from free-riding
  on the services provided by full-service
  retailers.

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2. Predatory Pricing
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• Occurs when a firm cuts prices to prevent entry
  or drive a competitor out of the market, so
  that it can charge monopoly prices later.
• Illegal under antitrust laws, but hard for the
  courts to determine when a price cut is predatory
  and when it is competitive beneficial to
  consumers.
• Many economists doubt that predatory pricing is a
  rational strategy
• It involves selling at a loss, which is extremely
  costly for the firm.
• It can backfire.

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3. Tying
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• Occurs when a manufacturer bundles two products
  together and sells them for one price (e.g.,
  Microsoft including a browser with its operating
  system)
• Critics argue that tying gives firms more market
  power by connecting weak products to strong ones.
  
• Others counter that tying cannot change market
  power Buyers are not willing to pay more for
  two goods together than for the goods separately.
  
• Firms may use tying for price discrimination,
  which is not illegal, and which sometimes
  increases economic efficiency.

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CONCLUSION
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• Oligopolies can end up looking like monopolies or
  like competitive markets, depending on the number
  of firms and how cooperative they are.
• The prisoners dilemma shows how difficult it is
  for firms to maintain cooperation, even when
  doing so is in their best interest.
• Policymakers use the antitrust laws to regulate
  oligopolists behavior. The proper scope of
  these laws is the subject of ongoing controversy.

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Contestable market

• A contestable market is a market served by a
  small number of firms, but which is nevertheless
  characterized by competitive pricing because of
  the existence of potential short-term entrants.
  Its fundamental feature is low barriers to entry
  and exit a perfectly contestable market would
  have no barriers to entry or exit. Contestable
  markets are characterized by 'hit and run' entry.
  If a firm in a market with no entry or exit
  barriers raises its prices above average cost and
  begins to earn abnormal profits, potential rivals
  will enter the market to take advantage of these
  profits. When the incumbent firms respond by
  returning prices to levels consistent with normal
  profits the new firms will exit. In this manner
  even a single-firm market can show highly
  competitive behavior.

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Contestable market

• Low cost airlines are commonly referred to as an
  example of a contestable market. Entrants have
  the possibility of leasing aircraft and should be
  able to respond to high profits by quickly
  entering and exiting. In practice there may be
  barriers to entry and exit in the market
  associated with terminal leases and availability
  and predatory pricing by incumbents, signaled
  through built-in overcapacity.

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First degree price discrimination

• In first degree price discrimination, price
  varies by customer's willingness or ability to
  pay. This arises from the fact that the value of
  goods is subjective. A customer with low price
  elasticity is less deterred by a higher price
  than a customer with high price elasticity of
  demand. As long as the price elasticity (in
  absolute value) for a customer is less than one,
  it is very advantageous to increase the price
  the seller gets more money for fewer goods. With
  an increase of the price elasticity tends to rise
  above one. This assumes that the consumer
  passively reacts to the price set by the seller,
  and that the seller knows the demand curve of the
  customer. In practice however there is a
  bargaining situation, which is more complex the
  customer may try to influence the price, such as
  by pretending to like the product less than he or
  she really does or by threatening not to buy it.

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Second degree price discrimination

• In second degree price discrimination, price
  varies according to quantity sold. Larger
  quantities are available at a lower unit price.
  This is particularly widespread in sales to
  industrial customers, where bulk buyers enjoy
  higher discounts.
• Additionally to second degree price
  discrimination, sellers are not able to
  differentiate between different types of
  consumers. Thus, the suppliers will provide
  incentives for the consumers to differentiate
  themselves according to preference.

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Third degree price discrimination

• In third degree price discrimination, price
  varies by attributes such as location or by
  customer segment, or in the most extreme case, by
  the individual customer's identity where the
  attribute in question is used as a proxy for
  ability/willingness to pay.
• Additionally to third degree price
  discrimination, the suppliers of a market where
  this type of discrimination is exhibited are
  capable of differentiating between consumer
  classes. Examples of this differentiation are
  student or senior discounts. For example, a
  student or a senior consumer will have a
  different willingness to pay than an average
  consumer, where the reservation price is
  presumably lower because of budget constraints.

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• It is very useful for the price discriminator to
  determine the optimum prices in each market
  segment. This is done in the diagram where each
  segment is considered as a separate market with
  its own demand curve. As usual, the profit
  maximizing output (Q) is determined by the
  intersection of the marginal cost curve (MC) with
  the marginal revenue curve (MR) for the total
  market.

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In the peak market the firm will produce where
MRa MC and charge price Pa, and in the off-peak
market the firm will produce where MRb MC and
charge price Pb. Consumers with an inelastic
demand will pay a higher price (Pa) than those
with an elastic demand who will be charged Pb.
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The key is that third degree discrimination is
linked directly to consumers willingness and
ability to pay for a good or service. It means
that the prices charged may bear little or no
relation to the cost of production.
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CHAPTER SUMMARY
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• Oligopolists can maximize profits if they form a
  cartel and act like a monopolist.
• Yet, self-interest leads each oligopolist to a
  higher quantity and lower price than under the
  monopoly outcome.
• The larger the number of firms, the closer will
  be the quantity and price to the levels that
  would prevail under competition.

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CHAPTER SUMMARY
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• The prisoners dilemma shows that self-interest
  can prevent people from cooperating, even when
  cooperation is in their mutual interest. The
  logic of the prisoners dilemma applies in many
  situations.
• Policymakers use the antitrust laws to prevent
  oligopolies from engaging in anticompetitive
  behavior such as price-fixing. But the
  application of these laws is sometimes
  controversial.