oligopoly characteristics of oligopoly –small number of firms –interdependence strategic...

Oligopoly

• Characteristics of oligopoly– Small number of firms– Interdependence

• Strategic dependence

• Whatever you do, I shall do –the zero percent financing

Oligopoly

• Strategic Dependence– A situation in which one firm’s actions

with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry

– LIKE PLAYING CHESS

Oligopoly

• Why oligopoly occurs– Economies of scale– Barriers to entry– Mergers

• Vertical mergers• Horizontal mergers

Oligopoly

• Vertical Merger– The joining of a firm with another to which it

sells an output or from which it buys an input

• Horizontal Merger– The joining of firms that are producing

or selling a similar product

Oligopoly

• Measuring industry concentration– Concentration Ratio

• The percentage of all sales contributed by the leading four or leading eight firms in an industry

Computing the Four-Firm Concentration Ratio

Annual SalesFirm ($ Millions)

1 1502 1003 804 705 through 25 50

Total 450

Total numberof firms inIndustry = 25

Four-firm concentration ratio =450

40088.9%

Computing the Four-Firm Concentration Ratio

Percentage of Value of TotalDomestic Shipments Accounted

Industry For By the Top Four Firms %

Domestic motor vehicles 84

Breakfast cereals 85

Soft drinks 69

Tobacco products 93

Primary aluminum 59

Household vacuum cleaners 59

Electronic computers 45

Printing and publishing 23

Source: U.S. Bureau of the Census

Models of Oligopoly

• Game Theory– A way of describing the various possible

outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly

Game Theory

• Cooperative Game– A game in which the players explicitly cooperate to make

themselves better off• Noncooperative Game

– A game in which the players neither negotiate nor cooperate in any way

• Zero-Sum Game– A game in which any gains

within the group are exactly offset by equal losses by the end of the game

• Negative-Sum Game– A game in which players as a group

lose at the end of the game

Strategic Behaviorand Game Theory

• Positive-Sum Game– A game in which players as a group

are better off at the end of the game

Strategic Behaviorand Game Theory

• Strategies in noncooperative games– Strategy

• Any rule that is used to make a choice• Any potential choice that can be made

by players in a game

– Dominant Strategies• Strategies that always yield the highest benefit

Prisoner’s Dilemma

• You and your partner rob a bank and get caught.

Prisoner’s Dilemma

• You are separated and given these options:– Both confess and get 5 years in jail– Neither confess and get 2 years– One confess and the other does not

• Confessor goes free• One who does not confess get 10 years

The Prisoners’ Dilemma Payoff Matrix

Figure 25-3

Strategic Behaviorand Game Theory

• Applying game theory to pricing strategies– Would you choose a high price

or a low price?• Remember

– No collusion

Strategic Behaviorand Game Theory

Figure 25-4

Strategic Behaviorand Game Theory

• Opportunistic Behavior– Actions that ignore the possible long-run

benefits of cooperation and focus solely on short-run gains

Strategic Behaviorand Game Theory

• Opportunistic behavior– Implies a noncooperative game– Not realistic

• We make repeat transactions

Strategic Behaviorand Game Theory

• Tit-for-Tat Strategic Behavior– In game theory, cooperation that continues

so long as the other players continue to cooperate

• Pakistan agreed to certain conditions for an IMF loan– In 1999, the IMF discovered that Pakistan

had spent much of this loan on the development of nuclear weapons

– Soon, Pakistan had to default on its debt

• Why would Pakistan engage in this behavior with the IMF?

International Example:Strategically Relating Subsidies to Nuclear

Weapons

d1 is relatively elastic• if one firm raises itsprice the others will notand it will lose marketshare

d2 is relatively inelastic• if one firm lowers itsprice the others lowertheir price so gain in salesis small

Price Rigidity and the Kinked Demand Curve

Figure 25-5, Panel (a)

The kinked demand curve indicates the possibility of price rigidity

Price Rigidity and the Kinked Demand Curve

Figure 25-5, Panel (b)

Price Rigidity and theKinked Demand Curve

Figure 25-6

Changes in cost donot impact outputand prices as long as MC remains in thevertical portion of MR

d1

d2

MR2

P0

q0

Criticisms of theKinked Demand Curve

Quantity per Time Period

Pri

ce a

nd

Mar

gin

al R

even

ue

per

Un

it

MR1

• Cannot determine P0

• Empirical evidence does not confirm the kinked demand theory

Strategic Behavior

• Do pet products have nine lives?– H.J. Heinz’s Pet Products Company

• Dropped its price of 9-Lives cat food by 22% to meet increased competition from Nestle, Quaker, Grand Metropolitan, and Mars

• Heinz then decided to raise prices• Its competition did not and Heinz’s market share

dropped from 23 to 15 percent

• Price Leadership– A practice in many oligopolistic industries in

which the largest firm publishes its price list ahead of its competitors, who then match those announced prices

Strategic Behavior with Implicit Collusion: A Model of Price Leadership

• Price War– A pricing campaign designed to drive

competing firms out of a market by repeatedly cutting prices

Strategic Behavior with Implicit Collusion: A Model of Price Leadership

• Markets where price wars are common– Cigarettes– Long-distance telephone companies– Airlines

Strategic Behavior with Implicit Collusion: A Model of Price Leadership

• Markets where price wars are common– Diapers– Frozen foods– PC hardware and software

Strategic Behavior with Implicit Collusion: A Model of Price Leadership

• Cigarette price wars– Philip Morris cut Marlboro

by 40 cents a pack– RJR Nabisco matched the cut for Camel– Marlboro’s market share rose

from 22.1% to 27.3%– Profits and stock prices fell

Strategic Behavior with Implicit Collusion: A Model of Price Leadership

• Cigarette price wars– Phillip Morris reduced prices by 18%

and sales went up by only 12.5% • Profits fell by 25%

Strategic Behavior with Implicit Collusion: A Model of Price Leadership

• Entry Deterrence Strategy– Any strategy undertaken by firms in an

industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm

Deterring Entry Into an Industry

• Increasing entry cost– Threat of price wars– Government regulations

• Environmental regulation• Safety standards

Deterring Entry Into an Industry

• Limit-Pricing Strategies– A model that hypothesizes that a group

of colluding sellers will set the highest common price that they believe they can charge without new firms seeking to enter that industry in search of relatively high profits

Deterring Entry Into an Industry

• Raising customer’s switching cost– Examples

• Non-compatible software• Non-transferability of college courses

Deterring Entry Into an Industry