OLIGOPOLY Chapter 27

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OLIGOPOLYChapter 27

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

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What does market power really mean?

• Market power is the key to control.
• Monopoly is a type of power that all firms dream
  of, yet pure monopoly is not permitted in our
  economy.
• The next best thing is to PUSH the power base to
  the very edge of government acceptance. Gaining
  market share is a common term we hear from
  businesses and Wall Street.

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MARKET POWER

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

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Defending the LeadWorld-wide PC vender market
share for third quarter. DMN- 10/16/08
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Who is sharing?

• What about the auto industry now. Government
  motors (adv./Ford) Yet Ford 8/2 sees first
  monthly increase in sales in 2 years. Is auto
  industry still oligopoly?
• Oligopoly is no exception Outstanding feature of
  Oligopoly is fewness
• OLI (derivation actually means few.. (do you
  remember your Oligarchy in government?)
• Oligopoly has few sellers- so few that at least
  one firm is large enough to INFLUENCE PRICE
• The vast amount of GDP is accounted for by firms
  in oligopolistic industries.

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Oligopoly

• An important market structure that we have yet to
  discuss involves a situation in which a few large
  firms comprise an entire industry.
• They are not perfectly competitive, nor even
  monopolistically competitive, and because there
  are several of them a pure monopoly doesnt exist.

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Oligopoly (cont'd)

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

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Oligopolist

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

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Characteristics of Oligopoly

• Few firms control the market
• High barriers to entry
• Produce either differentiated or homogeneous
  products
• Lack of available substitutes

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Oligopoly (cont'd)

• Why oligopoly occurs
• Economies of scale
• Barriers to entry
• Mergers
• Vertical mergers
• Horizontal mergers

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Price and Output Under 3 Oligopoly Theories

• Cartel Theory - oligopolistic firms act as if
  there were only one firm in the industry.
• Kinked Demand Curve Theory - assumes that if a
  single firm in the industry cuts prices, other
  firms will do likewise, but if it raises price,
  other firms will not follow suit. The theory
  predicts price stickiness or rigidity.
• Price Leadership Theory - the dominant firm in
  the industry determines price, and all other
  firms take their price as given.

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Characteristics of Market Structures
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More Examples
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Why are certain industries composed of only a few
firms?

• Because cost economies and other barriers to
  entry keep the numbers small (plus mergers keep
  out the smaller guys) (enter the political key on
  who decides if mergers are not eliminating
  competition)
• Where economies of scale are substantial,
  reasonably efficient production will be possible
  only with a small number of producers efficiency
  requires that the productive capacity of each
  firm be large relative to the total market.

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Continued

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

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Examples of Oligopolies

• 1. automobile
• 2. beer
• 3. petroleum
• 4. steel
• 5. tire
• 6. gypsum
• 7. aluminum

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What do we see in the 21St Century?

• Many big corporations seeking more market share
  have been following a simple rule.
• Dont build what you can buy.
• WSJ, February13,2006
• Part of this zeal to purchase is to fill some of
  the empty production space created in the
  building boon of late 90s. This will allow for
  movement to capacity production which is more
  efficient.

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Oligopoly (cont'd)

• Vertical Merger
• The joining of a firm with another to which it
  sells an output or from which it buys an input
• Horizontal Merger
• The joining of firms that are producing or
  selling a similar product

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Oligopoly (cont'd)

• Measuring industry concentration
• Concentration Ratio
• The percentage of all sales contributed by the
  leading four or leading eight firms in an
  industry
• Sometimes called the industry concentration ratio

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Ways to measure degree of Oligopolization

• Concentration Ratio
• This ratio tells the share of output (or combined
  market share) accounted for by the largest firms
  in an industry OR the total percentage share of
  industry sales that each firm possesses.
• Sometimes the market share of one company in
  the oligopoly is so great that it nearly
  resembles a monopoly.

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How do we know?

• Initial Market Shares of Microcomputer Producers

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Table 27-1 Computing the Four-Firm Concentration
Ratio
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E-Commerce Example Market Concentration in the
Personal Computer Industry

• The computer printer industry generated 201.1
  billion in revenues in a recent year, and several
  firms had a high market share.
• Of the four Hewlett-Packard earned 35.0
  billion, Dell 27.9 billion, Lenovo 14.1 billion
  and Acer 13.7 billion.
• These four firms had a concentration ratio for
  the computer printer industry of 45.1

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Are their other ways to get market power?

• Sure several smaller firms can act in unison in
  the amount they supply and price they charge..
• Even in small towns firms can have market power
  (ACE Hardware, Krispy Kreme, or the DunkinDonut
  store in Eastjapip, NJ)

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Key Point

• Concentration ratio is a quantitative measure of
  oligopoly
• The total percentage share of industry SALES of
  the four leading firms is the industry
  concentration ratio. (who has higher of sales
  Ford, GM, or Chrysler?) (the increased foreign
  trade has minimized the impact of the HHI ratio.)
• Obviously, the total aggregate sales are
  compiled. Then the sales for each firm is
  calculated. Come up with 35 of market share
  Then continue on HHI calculation.

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Herfindahl-Hirschman Index HHI

• This is the sum of the square of the market
  shares of each firm in the industry.
• Example.. Monopolist one company controls
  entire industry 100 market share. HHI would be
  100 (squared) 100x100 10,000 (All monopolies
  have 10,000 HHI)
• If firm A has 25 and firms B,C,D also have 25
• Take 25 x 25 625 Add them up (625625625625
  2,500 or the total number of squares for
  industry power is 2,500
• Each firm has 625 squares.

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HHI again

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

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Market Power
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Market Power
Kroger
Albertsons
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Oligopoly (cont'd)

• The more U.S. firms face competition from the
  rest of the world, the less any current oligopoly
  will be able to exercise market power.

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So, where does government enter in this equation?

• The Anti-trust division of the Justice Department
  and the applicable IRC has to decide if a gain of
  X of the market share is destroying competition
  or not when a merger is suggested.
• HP/Compaq (will this destroy the competitive edge
  for Dell?)
• 2. In 1992 the Justice Dept decided to use
  other parameters in determining anti-trust and
  destructive competition---- barrier to entry. If
  low, then highly concentrated industry might be
  compelled to behave more competitively. (hence,
  contestability and structure were now added to
  the merger equation.)

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What happens if one increases sales?

• Increased Sales at the Prevailing Market Price
• Increases in the market share of one oligopolist
  necessarily reduce the shares of the remaining
  oligopolists.

• It is possible that an increase in sales by
  lowering the price may expand total market sales
  and increase the sales of an individual firm
  without affecting the sales of its competitors.
  But it doesnt happen without setting off alarms
  within the industry..(Delta lowers its price)
  (Pepsi lowers price to sell more.. Coke follow?

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Then what happens???

• Retaliation
• Oligopolists respond to aggressive marketing by
  competitors.
• Step up marketing efforts.
• Cut prices on their product(s).
• Rather than cut prices which causes a general
  off the cliff for all concept. (hence kinked
  demand curve) Oligopolists will engage in
  non-price competition. Hint
• their products are differentiated for the most
  part.- American Airlines- more leg room LOL! ?

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So, what happens if Dell does cut prices?
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How does Gateway respond if Dell cuts prices?

• Rivals Response to Price Reductions
• The degree to which sales increase when the price
  is reduced depends on the response of rival
  oligopolists.
• We expect oligopolists to match any price
  reductions by rival oligopolists.
• Rivals Response to Price Increases
• Rival oligopolists may not match price increases
  in order to gain market share.

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DELL WON

• In the actual real world
• Gateway tried to match the competition from Dell
• But Dell sold directly and computers could be
  custom built.
• Gateway kept store presence and still tried to
  lower prices where possible.
• Then Gateway realized it had to close all
  physical stores and try to compete by offering
  ONLINE purchases.
• Dell then lost to HP who did the same thing, then
  Gateway kind of re-entered market.

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The Kinked Demand Curve Confronting an Oligopolist

• The shape of the demand curve facing an
  oligopolist depends on the responses of its
  rivals to a change in the price of its own
  output.
• The demand curve will be kinked if rival
  oligopolists match price reductions but not price
  increases.

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The Kinked Demand Curve Confronting an Oligopolist
Demand curve facing oligopolist if rivals match
price changes
M
B
1100
A
D
900
C
Demand curve facing oligopolist if rivals match
price cuts but not price hikes
Demand curve facing oligopolist if rivals don't
match price changes
8000
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Game Theory

• A mathematical technique used to analyze the
  behavior of decision makers who try to reach an
  optimal position for themselves through game
  playing or the use of strategic behavior, are
  fully aware of the interactive nature of the
  process at hand, and anticipate the moves of
  other decision makers.

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Game Theory

• Each oligopolist has to consider the potential
  responses of rivals when formulating price or
  output strategies.
• The payoff to an oligopolists price cut depends
  on how its rivals respond.
• Game theory is the study of decision making in
  situations where strategic interaction (moves and
  countermoves) between rivals occurs.

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Price and OutputChecking the corporate pie for
profit!

• Price and Output
• Price discounting can destroy oligopoly profits.
• When it occurs, rival oligopolists seek to end it
  as quickly as possible.

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Price and Output

• To maximize industry profit, the firms in an
  oligopoly must agree on a monopoly price and
  agree to maintain it by limiting production and
  allocating market shares.Illegal in U.S.
  OPEC is example of how this works (Cartel)
• .

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The Cooperative Game A Collusive Cartel

• Cartel
• An association of producers in an industry that
  agree to set common prices and output quotas to
  prevent competition.

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

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Price Fixing Examples

• Electric Generators - In 1961, General Electric
  and Westinghouse were convicted of fixing prices
  on electrical generators.
• They were charged again in 1972 for continued
  price fixing.

• School Milk Between 1988 and 1991, the U.S.
  Justice Department filed charges against 50
  companies for fixing the price of milk sold to
  public schools in 16 states.

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So, you think they dont fix prices?

• Gasoline Mobil, Chevron and Shell paid 77
  million in 1993 to settle charges that they
  conspired to fix gasoline prices.
• Music CDs In 2001, the FTC charged AOL-Time
  Warner and Universal Music with fixing prices on
  the Three Tenors CD.
• The airline industry is being investigated as of
  3/8/06 to see if they fixed prices on jet fuel
  purchases.

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WSJ- November 13, 2008

• LCD Makers Plead Guilty to Price Fixing
• Sharp, LG Display, Chunghwa Fined 585 million
  for schemes affecting TV sets, other products.
• Criminal charge
• Consumers paid higher prices for TVs, cellphones,
  and other products using liquid-crystal displays.

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• Whirlpool, rivals face price fixing probe
• Michigan business news in brief Whirlpool,
  rivals face price fixing probeFebruary 19, 2009,
  Detroit Free Press
• Wired PR News Microsoft Corp. has been fined
  for alleged price-fixing. As reported by the
  Associated Press (AP), the companys German
  subsidiary was fined 9 million euros, which is
  the equivalent of 11.8 million, for purportedly
  illegally influencing the retail prices for their
  Microsoft Office 2007 software programs.April
  13, 2009

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How do we know?
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Price Leadership or Fixing?

• Leadership is acceptable.. Fixing is not.
• Sometimes they send up smoke signals to alert
  their rivals about a price increase in hopes the
  rivals will follow.
• Whenever oligopolist successfully raises prices,
  unit sales will decline.
• What happens if AA lowers airline fares?

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Allocation of Market Shares

• One way to distribute output is a cartel
  agreement.
• A cartel is a group of firms with an explicit
  agreement to fix prices and output shares in a
  particular market.
• Cartels are illegal in the United States
• OPEC (Organization of Petroleum Exporting
  Countries) is the most famous now.(11 countries)
• http//www.opec.org/

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Lets Look at Cartels

• Each producer is assigned a they may produce in
  the market. These are explicit production-sharing
  agreements. (most cheat due to high oil prices in
  market)
• Saudi Arabia has increasingly violated the they
  were assigned by OPEC several times to increase
  their market share and to help out the U.S.
• They may be less willing to do this in the future
  (continued war/Iraq)(new terrorism problems)
  (other countries join to ostracize any Arab
  nation that cooperates with U.S.) (supply/demand)
  (U.S. reduces dependency on oil OPEC wont want
  to stray too far.

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Graph for a price-fixing oligopolist

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

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The Benefits of Cheating on the Cartel Agreement I

• The situation for a representative firm of a
  cartel in long-run competitive equilibrium, it
  produces q1 and charges P1, earning zero economic
  profits.
• As a consequence of the cartel agreement, it
  reduces output to qC and charges PC.
• Its profits are the area CPCAB.
• If it cheats on the cartel agreement and others
  do not, the firm will increase output to qCC and
  reap profits of FPCDE.

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The Benefits of Cheatingon the Cartel Agreement
II

• Note, however, that if this firm can cheat on
  the cartel agreement, so can others. Given the
  monetary benefits gained by cheating, it is
  likely that the cartel will exist for only a
  short time.

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Predatory Pricing

• A company decides to lower its prices for a short
  period of time to force a competitor out of
  business. After the competitor leaves, the
  company then raises price again.
• (BroadBand Cable/Internet)
• Utah Pie company (forced out by Mrs. Smiths pies)

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Barriers to entry

• Patents
• Control distribution outlets (ticketmaster)(shelf-
  space for Fritos)
• Mergers and acquisitions
• Government regulation

• Nonprice Competition (big buck advertising)
• Training (technology know-how-training employees
  to use a certain product..changing is difficult
• Network Economies-get there first with the most
  (dont buy a phone if your friends dont have
  one.)

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

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


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Where is the sticky that causes the Kink?

• Sticky Prices
• Like all producers, oligopolists want to maximize
  profits by producing where MC MR.
• The kinked demand curve is really a composite of
  two separate demand curves.

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An Oligipolists Marginal Revenue Curve
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Cost Cushion

• The gap in MR curve creates a cost cushion If
  MC rises or falls within that gap, the
  profit-maximizing rate of output MCMR is
  unchanged.

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• Kinked demand with cushion gap

MR2
D
MR1
Quantity
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Cost Cushion continued

• Gap occurs just below the kink in the demand
  curve.
• If the MC curve passes through the gap in the MR
  curve, modest shifts of the cost curve will have
  no impact on the production decision of an
  oligopolist.

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Reality of this

• Coordination Problems
• There is an inherent conflict in the joint and
  individual interests of oligopolists.
• Each oligopolist wants industry profits to be
  maximized.
• Each oligopolist wants to maximize its own
  market share.
• To avoid self-destructive behavior, each
  oligopolist must coordinate production decisions.

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Reminders

• If an individual firm raises its price and other
  firms continue to sell at the original market-
  that individual firm will LOSE customers, its
  sales will DECLINE sharply.
• If it raises its price unilaterally- demand tends
  to be elastic (the drop in sales is greater
  than the increase in price.)
• When the oligopoly firm attempts a price
  reduction, the demand for its output tends to be
  inelastic ( increase in sales is less than the
  drop in price.)

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QUESTIONS?