11 oligopoly & market concentration

Topic

11Oligopolies and Market Power- Sessions 19 / & 16th Sept 2011 -

-Dr Gajavelli V S

Discussion Objectives To introduce the imperfectly competitive markets more particularly oligopolies and market concentration in the hands of few firms. To discuss the firm-concentration measures To introduce the basic models of oligopoly markets: Kinked demand curve model, Price Leadership, Cartels and Game theory& Strategic Behavior of Oligopolists. Efficiency Implications & Concluding Observations Special Article: India threatened by business oligarchies?Slide 2

CASE STUDIES highlight the significance of market structures for firms and its great relevance in decision-making & profitability Case Study 1: Industrial Concentration for Two-wheeler industry in India, Page 356 text-book. Case Study 2: The OPEC Story of Collusion and Cheating. Case Study 3: Something is Rigid in Denmark Kinky! Case Study 4: Firm Architecture & Organizational Competitiveness, page 381 text. Case Study 5: The Top Innovative Companies in the world, page 382 text. Porters Five Force Model - An Application to Soft drink industry: Pepsi, Coke and Bottlers. Special Article: Trend: India threatened by business oligarchies?Slide 3

Pricing and Output Decisions: Strategy & TacticsECONOMIC ANALYSIS AND DECISIONS 1. Demand Analysis and Forecasting 2. Production and Cost Analysis 3. Pricing Analysis 4. Capital Expenditure Analysis.ECONOMIC, POLITICAL, AND SOCIAL ENVIRONMENT 1. Business Conditions (Trends, Cycles, and Seasonal Effects) 2. Factor Market Conditions (Capital, Labor, Land, and Raw Materials) 3. Competitors Responses 4. External, Legal, & Govt.,Regulations 5. Organizational Form

Cash Flows

Risk

Firm Value (Shareholders Wealth)Slide 4

Forces of Competition: Five-force ModelMichael Porter, in his Competitive Advantage, lists 5 forces that determine competitive advantage. Substitutes (threat of substitutes can be offset by brands and special functions served by the product). Potential Entrants (threat of entrants can be reduced by high fixed costs, scale economies, restriction of access to distribution channels, or product differentiation). Buyer Power (threat of concentration of buyers). Supplier Power (threats from concentrated suppliers of key inputs affect profitability). Intensity of Rivalry or Strategic Interaction (market concentration, price competition tactics, exit barriers, amount of fixed costs, and industry growth rates impact profitability).Slide 5

Porters Five Force Model - An Application The profitability of the leading syrup manufacturers Pepsi and Coke and of the bottlers in the cola business is very different. Pepsi and coke enjoy an 81% operating profit as a percentage of sales ; bottlers experience only a 15% operating profit as a percentage of sales. Perform a Porters Five Force Analysis that explain why one type of business is potentially so profitable relevant to the others.

Slide 6

Porters Five Force Model - An Application1. Application solution : Pepsi and Coca-Cola bottlers face enormous supplier power from the syrup manufacturers, sell primarily to concentrated grocery store chains, and are constantly presented with many substitute firms who could provide their role in the value chain. Thus, despite high barriers to entry from high 2. capital requirements, high switching costs, and closed distribution channels, their sustainable profitability is lower than Coca-Cola and Pepsi. The latter face almost no supplier power, few close substitutes as perceived by loyal customers, very high barriers to effective entry, low intensity of rivalry from concentrated markets, non-price tactics, and low costfixity with fast growing demand especially overseas.Slide 7

Oligopoly : Meaning & SignificanceOligopoly is the form of market organisation or industry in which there are few sellers or very large firms of a homogeneous or differentiated product, with mutual dependence recognised.

Slide 8

Price and Output Determination:

Oligopoly Oligopolistic Market Structures: Few Firms Consequently, must consider the reaction of rivals to price, advertising, or product decisions

Interrelated reactions Heterogeneous or Homogeneous Products

Example -- athletic shoe market Nike has 47% of market Reebok has 16% and Adidas has 7%Slide 9

The Sources of Oligopoly Economies of scale may operate over a sufficiently large range of output, as to leave only a few firms supplying the entire market. Huge capital investments and specialized inputs are usually required to enter an oligopolistic industry (say, automobiles, aluminium, steel, mainframe computers, aircraft and similar industries / products or services). A few firms may own a patents for the exclusive right to produce a commodity or to use a particular production process. Established firms may have a loyal following of customers (brand loyalty) based on product quality and service that new firms find very difficult to match A few firms may own or control the entire supply of a raw material required in the production of the product.Slide 10

The Sources of Oligopolycontd., The government may give a franchise to only a few firms to operate in the market. Limit Pricing involves charging of lower than the profit maximising price by a firm in order to discourage the entrance of other firms in to the market.

Slide 11

Market Concentration and Strategic Interaction :Measures of Oligopoly Market Power Concentration Ratios- Four, Eight, Twelve firm Concentration ratios in an industry. Herfindahl Index (H) - H = Sum of the squared values of the market shares of all the firms in an industry. The higher the index, the greater is the degree of concentration in the industry. Warning on Concentration Measures Why Concentration matters? Determinants of concentration.Slide 12

Theory of Contestable Markets If entry is absolutely free and exit is entirely costless then firms will operate as if they are perfectly competitive

Slide 13

What Went Wrong With Amazon.com?- Application Stocks only 1,000 books but displays 2.5 million. Barnes & Noble and Borders are profitable, but Amazon didnt earn a profit & its shares declined in value. Classic example of a business with low barriers to entry and exit. Internet buyers are very price conscience, as they can shop multiple sites with MySimon.com and others.Slide 14

Issue Focus : Low barriers to entry; committed relationship marketing and massive marketing expenditures to maintain brand-equity; and margins are quickly competed away by rival players.

Slide 15

Learning :Internet retailing is a classic examples of a business with low barriers. The net by its very nature is inherently efficient on par with perfectly competitive market conditions and hence hostile to margins or economic profits. Thus the player has to be always conscious of market dynamics in terms of competitors actions, product / service differentiation, possibilities of price-discrimination and enhance its brand equity in internet-based retail business. HOME WORK : Can you use Porters Five Forces Analysis that explains the predicament at Amazon.com ? Will it reflect the basic arguments put forward by the THEORY OF CONTESTABLE MARKETS?Slide 16

Concentration Measured by Value of Sales in Manufacturing Industries, 20074 Largest companiesCigarettes Household Refrigerators Motor Vehicles Aluminum Electric light bulbs Soap Blast furnaces Meat-packing

Next 4 largest companies92% 85% 90% 74% 91% 65% 44% 8% 13% 5% 21% 3% 11% 19% 18%

32%

0%

20%

40%

60%

80%

100 %

120 %Slide 17

Percent of total shipments

How Patterns of Advertising, Research, and Profitability Depend on Level of Concentration?Type of industry (with examples) Four-firm concentrati on ratio, 1982 (%) Advertising spending, 1982 (as % of sales) Research and developm ent, 19801982 (as % of sale) Rate of profit, 1960-1979 (as % of stockholders Equity)

High concentration (motor vehicles, tobacco, non-ferrous metals) Moderate concentration (paper, stone, clay, glass, chemicals) Low concentration (apparel, printing, furniture) Perfectly competitive (corn and wheat farming)

71

2.4

3.2

12.0

14

2.1

3.0

10.7

9 ~ 0.01

1.5 ~0

0.3 ~0

10.5 Not availableSlide 18

Special Characteristics of Oligopoly

Interdependence Importance of Advertising and Selling Costs Group Behavior - Oligopoly is an analysis of group behavior Indeterminateness of Demand Curve facing Oligopolists.

Slide 19

Oligopoly & Strategic BehaviorHoward Putnam, head of Braniff Airlines, and Robert Crandall, head of American Airlines.

Putnam(Braniff) : Do you have a suggestion for me? Crandall (American) : Yes. I have a suggestion for you. Raise your fares 20% and Ill raise mine the next morning. Putnam : Robert, we . Crandall : Youll make more money and I will too.Slide 20

Putnam : We cant talk about pricing !. Crandall : Oh ! Howard. We can talk about any thing we want to talk about. NOTE: It is a tape-recorded conversation between Howard Putnam, head of Braniff Airlines, and Robert Crandall, head of American Airlines by the Federal Bureau of Invetstigation(FBI), United States of America.Slide 21

OLIGOPOLY MODELSA. The kinked Demand Curve Model B. Non-price competition & Game Theory C. Cartel Arrangements Market-sharing Centralized D. Price Leadership A & B Non-Collusive Oligopoly C & D Collusive OligopolySlide 22

Kinked Demand Curve Model Proposed by Paul Sweezy If an oligopolist raises price, other firms will not follow, so demand will be elastic If an oligopolist lowers price, other firms will follow, so demand will be inelastic Implication is that demand curve will be kinked, MR will have a discontinuity, and oligopolists will not change price when marginal cost changesSlide 23

P Oligopolists Kinked Demand Curve $400$350 $300 $250 $200 $150 $100 $50

5 10 15 20 25 30 35 40 45 QSlide 24

Kinked Oligopoly Demand Curve Belief in price rigidity founded on experience of the great depression

Price cuts lead to everyone following highly inelasticP

no one follows a price increase everyone follows price cuts

Price increases, no one follows highly elastic

a kink at the priceSlide 25

P

A Kink Leads to Breaks in the MR Curve Although MC rises, the optimal price remains constant D MC2 Expect to find price rigidity in markets with MC1 kinked demand QUESTION:D

Where would we more likely find KINKS and where NOT?Slide 26

MR

Kinked Demand Curve Model

Slide 27

Empirical Evidence vs. Predictions of the Model Oligopolies with few firms were more rigid in FACT Oligopolies with homogeneous products were MORE rigid in FACT

Slide 28

Price Rigidities Vs. Growth & Jobs Impact Price rigidity will make business downturns worse, by keeping demand at lower levels Employment will be more volatile over the business cycle if there are price rigiditiesif price changes with shifts in demand

A rigid price D BUSTSQ3 Q2 Q1

D BOOMSOUTPUT Slide 29

Cartels Collusion Cooperation among firms to restrict competition in order to increase profits

Market-Sharing Cartel Collusion to divide up markets

Centralized Cartel Formal agreement among member firms to set a monopoly price and restrict output

Incentive to cheatSlide 30

Examples of Cartels GE accused of conspiring with DeBeers --to fix industrial diamond prices. 1950s Electrical Pricing Conspiracy -- GE, Westinghouse, and Allis Chalmers -- to fix prices and divide up the markets for electrical items. OPEC - oil cartel, with Saudi Arabia making up 35% of the groups exports. Today OPECs membership consists of 12 countries that control about 80% of the worlds oil reseves. Siemens and Thompson-CSF to fix prices of airport radar systems International Airline Cartel (IATA / International Air Transport Association) This cartel controls access to airports, fixes airline rates, and promotes mutual objectives for its membersSlide 31

Price Fixing Price Fixing where firm/s fix prices at levels above equilibrium on account of their market power or through selling/distribution arrangements generally termed collusion. e.g., sports replica kits, childrens toys and games, steel, motor vehicles. Cartels Organised price fixing e.g. OPEC (Organisation of Petroleum Exporting Countries) Price fixing is illegal type in price fixing into a search engine to get details of companies and organisations around the world accused of, and convicted of, price fixing!Slide 32

OPEC Meeting in Vienna OPEC influences the supply of oil to fix prices.Source: Getty images available at http://edina.ac.uk/eig/

Centralized Cartel

Slide 33

$40 $35 $30 $25 $20 $15 $10 $5

PPrice & Cost per barrel

Why a Cartel Member Has an Incentive to Cheat ?

MC LRACMR2 MR1

1 2 3 4 5 6 7 8 9Quantity of oil (millions of barrels per day)

QSlide 34

PRICE LEADERSHIPBarometric Price Leader Dominant Firm Price Leader

1. Barometric:

One (or a few firms) sets the price

One firm is unusually aware of changes in cost or demand conditions The barometer firm senses changes first, or is the first to ANNOUNCE changes in its price list Find barometric price leader when the conditions unsuitable to collusion & ensure that firm has good forecasting abilities or good management.Slide 35

Barometric Price Leader Example:Citibank/Corporation Bank & Prime Rate Announcements New York / Mumbai, center of Open Market Operations (OMO)of the Fed Reserve / RBI Citibanks / Corporation Banks announcement represents

CHANGES IN INTEREST RATE CONDITIONS TO OTHER BANKS TOLERABLY WELL.

Slide 36

Price Signaling(rigidity) and Price LeadershipPrice RigidityThe prime rate is the rate that major banks charge large corporate customers for short-term loans. It changes only infrequently because banks are reluctant to undercut one another. When a change does occur, it begins with one bank, and other banks quickly follow suit. The corporate bond rate is the return on long-term corporate bonds. Because these bonds are widely traded, this rate fluctuates with market conditions.Slide 37

Figure 12.8

2. Dominant Firm Price Leadership Implicit Collusion Price Leader (Barometric Firm) Largest, dominant, or lowest cost firm in the industry Demand curve is defined as the market demand curve less supply by the followers

Followers Take market price as given and behave as perfect competitors at the industry given price as set by the leader.Slide 38

Oligopolistic Rivalry & Game Theory John Von Neumann & Oskar Morgenstern- Game Theory used to describe situations where individuals or organizations have conflicting objectives Examples: Pricing of a few firms, Strategic Arms Race, Advertising plans for a few firms, Output decisions of an oligopoly.

Strategy -is a course of action The PAY-OFF is the outcome of the strategy. Listing of PAY-OFFS appear in a pay-off matrix.Slide 39

Strategic Behavior Game Theory Players Strategies Payoff matrix

Nash Equilibrium EACH PLAYER CHOOSES A STRATEGY THAT IS OPTIMAL GIVEN THE STRATEGY OF THE OTHER PLAYER A STRATEGY IS DOMINANT IF IT IS ALWAYS OPTIMAL i.e. BRINGS YOU THE MAXIMUM .Slide 40

Game TheoryAdvertising Example

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Slide 41

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm A



Slide 42

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Firm A


Slide 43

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses not to advertise?

Firm A



Slide 44

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 3. Again, the optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Firm A


Slide 45

Game TheoryRegardless of what Firm B decides to do, the optimal strategy for Firm A is to advertise. The dominant strategy for Firm A is to advertise.

Firm A



Slide 46

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm A



Slide 47

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Firm A


Slide 48

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses not to advertise?

Firm A



Slide 49

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise, the payoff is 5. Otherwise, the payoff is 2. Again, the optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Firm A


Slide 50

Game TheoryRegardless of what Firm A decides to do, the optimal strategy for Firm B is to advertise. The dominant strategy for Firm B is to advertise.

Firm A



Slide 51

Game TheoryThe dominant strategy for Firm A is to advertise and the dominant strategy for Firm B is to advertise. The Nash equilibrium is for both firms to advertise.

Firm A



Slide 52

Game TheoryA Second Advertising Example (HOMEWORK)

Firm A



Slide 53

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm A



Slide 54

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Firm A


Slide 55

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses not to advertise?

Firm A



Slide 56

Game TheoryWhat is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 6. In this case, the optimal strategy is not to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Firm A


Slide 57

Game TheoryThe optimal strategy for Firm A depends on which strategy is chosen by Firms B. Firm A does not have a dominant strategy.

Firm A



Slide 58

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm A



Slide 59

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Firm A


Slide 60

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses not to advertise?

Firm A



Slide 61

Game TheoryWhat is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise, the payoff is 5. Otherwise, the payoff is 2. Again, the optimal strategy is to advertise. Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Firm A


Slide 62

Game TheoryRegardless of what Firm A decides to do, the optimal strategy for Firm B is to advertise. The dominant strategy for Firm B is to advertise.

Firm A



Slide 63

Game TheoryThe dominant strategy for Firm B is to advertise. If Firm B chooses to advertise, then the optimal strategy for Firm A is to advertise. The Nash equilibrium is for both firms to advertise.

Firm A



Slide 64

Prisoners DilemmaTwo suspects are arrested for armed robbery. They are immediately separated. If convicted, they will get a term of 10 years in prison. However, the evidence is not sufficient to convict them of more than the crime of possessing stolen goods, which carries a sentence of only 1 year. The suspects are told the following: If you confess and your accomplice does not, you will go free. If you do not confess and your accomplice does, you will get 10 years in prison. If you both confess, you will both get 5 years in prison.Slide 65

Prisoners DilemmaPayoff Matrix (negative values)

Individual A

Confess Don't Confess

Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

Slide 66

Prisoners DilemmaDominant Strategy Both Individuals Confess (Nash Equilibrium) Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

Individual A

Confess Don't Confess

Slide 67

Prisoners DilemmaApplication: Price Competition

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Slide 68

Prisoners DilemmaApplication: Price Competition Dominant Strategy: Low Price

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Slide 69

Prisoners DilemmaApplication: Non-price Competition

Firm A



Slide 70

Prisoners DilemmaApplication: Nonprice Competition Dominant Strategy: Advertise

Firm A



Slide 71

Prisoners DilemmaApplication: Cartel Cheating

Firm A

Cheat Don't Cheat

Firm B Cheat Don't Cheat (2, 2) (5, 1) (1, 5) (3, 3)

Slide 72

Prisoners DilemmaApplication: Cartel Cheating Dominant Strategy: Cheat

Firm A

Cheat Don't Cheat

Firm B Cheat Don't Cheat (2, 2) (5, 1) (1, 5) (3, 3)

Slide 73

Strategic behavior and International CompetitivenessA Case of Strategic trade and Industrial (competitive)policies of nations - Subsidies and Taxes (The pay-off is in millions of dollars)

Boeing vis--vis Airbus IndustriesAirbus Produce Don't Product (-10, -10) (100, 0) (0, 100) (0, 0)

Boeing

Produce Don't Produce

Slide 74

Harmful Effects of Oligopoly Price is usually greater than long-run average cost (LAC) Quantity produced usually does not correspond to minimum LAC Price is usually greater than long-run marginal cost (LMC) When a differentiated product is produced, too much may be spent on advertising and model changes / new modelsSlide 75

A Continuum of Market Structures Pure competition Monopolistic competition Monopoly OligopolySlide 76

Market structures& Competitive Analysis: OLIGOPOLIES IMPORTANT NOTE: See the handouts on this topic(hard copy) for topic review, key concepts introduced and useful hints from the class coverage. That follows. Closely follow what we covered and ignoreother aspects in this note that include both monopolistic competition and oligopoly.

Slide 77

Perfect vs. Imperfect Competition OLIGOPOLIES Thanks!

Slide 78

11 oligopoly & market concentration

Documents

entire market

large firms

market reebok

new firms

established firms

substitute firms

market power sessions

force analysis