Market Structures:Oligopoly

Imperfect Competition
The spectrum of competition: Perfect Comp. ------------- Monopoly Monop. Comp.-- Oligopoly Assumptions underlying oligopoly
Few Sellers
Interdependence each seller must be aware that their actions will provoke actions by rival firms

Differentiated versus non-differentiated products (cars or oil

Differentiated products leads to non-price competition through activities such as advertising, style changes, quality

Oligopoly
Price competition vs. non-price competition
Interdependence in pricing means that price wars may develop and reduce profits Product differentiation avoids price competition Advertising is used to increase market share
Informative Persuasive (self-cancelling)

Modeling oligopoly is difficult because interdependence can lead to different behaviors

Duopoly Example
Assumptions
Two producers: Jack and Jill Zero marginal costs (for simplicity revenue=profits

Outcomes
Competition: Maximum production, zero price(remember there are no costs) , and no profits Monopoly: Reduced Output, highest price, positive profits Oligopoly: Let the games begin!

Table 1 The Demand Schedule for Water

-Jack and Jill collude with 30 gals each Profit max = $3,600 split two ways $1,800 -Jack assumes Jill will stay at 30 gals, increases production to 40 gals. price falls to $50, Jacks profit rises to $2,000, but Jill may do the same and price falls to $40, both make $1,600 -If Jack tries to increase to 50 gals, price falls to $30 and his profits go to $1,500
Copyright 2004 South-Western

Table 1 The Demand Schedule for Water

-At 40 gals. Neither Jack nor Jill have an incentive to change production. -Nash Equilibrium : choose the best strategy given the strategies that the other economic agents have chosen. -Note: when firms in a duopoly act to max. profit they chose a level of output less than a competitive firm but more than a monopolist would produce.
Copyright 2004 South-Western

 Duopoly (cont.)
Collusion form a cartel and act like a monopolist highest economic profit, in most cases in the US, this is illegal. Pursuing own self-interest actions depend on what you think the other will do: not react or react
The incentive to cheat:
If you produce more (or charge a lower price and sell more), assuming MR>MC, your profits will rise, that is, if the other firm does not do the same thing.

The incentive to cooperate

If you produce more (or charge a lower price and sell more), the other firm will do the same, and your profits will fall

Oligopolists Supply Decision

Raising (or lowering) output produces two effects:
Output effect: because P>MC, the additional output will raise profits Price effect: additional output will lower the price and reduce profits on all those units that would have been sold at the old price

Rules for action:

Raise output if OE>PE Dont raise output if OE<PE

As the number of firms increases, the PE falls, so output is increased, many firms produce the competitive or efficient solution.
Freer trade has resulted in increasing number of firms in the automobile market, the camera market, and the electronics markets.

Cartels
Explicit agreements among firms to fix output and prices Examples are OPEC, Electrical Conspiracy (Econ USA), Shipping Cartel Incentive to cooperate earn monopoly profits Incentive to cheat increase individual profits if cheating is not detected or punished. Sources of instability in cartels:
Number of Sellers Cost differences Potential competition Recessions Cheating

Links
http://www.sunship.com/mideast/oil.html http://www.eia.doe.gov/emeu/cabs/chron.ht ml
http://www.naseo.org/energy_sectors/fossil/oil/Supply_Graphs.htm#Prices,%201973-97

Game Theory
Game theory is an attempt to model and understand behavior given the presence of interdependence Games have the following characteristics:
Rules Strategies Payoffs Outcome

The Prisoners Dilemma

Two criminals, Bill and Paul, are caught redhanded stealing a car, and will receive 2 year sentences; however, they become suspects in a previous bank robbery. The DAs job is to see if he can solve the bank robbery.
Rules:
Each player is held in separate rooms and cannot communicate. Each is told that he is suspected of the larger crime and
if both confess to the bank robbery, they get 5 year sentences if one rats on the other and the other does not confess to the bank robbery, he gets off, and the other gets a 10 year sentence

 Strategies: Each player has two possible actions

Confess to the bank robbery Do not confess to the bank robbery

Payoffs: Two players with two outcomes four possible outcomes with the following payoffs
Both confess each get 5 year sentences Both deny each get 2 year sentence Bill confesses and Paul denies Bill gets off and Paul gets 10 years Paul confesses and Bill denies Paul gets off and Bill gets 10 years.

Bill BILL Confess Deny

5 years
P Confess 5 years A U Paul L Deny

10 years
Off

Off 2 years

2 years

10 years

Paul if Bill confesses I should too (5 vs 10), if Bill denies, I should still confess (off vs 2) Bill if Paul confesses I should too (5 vs 10); if Paul doesnt. I should still confess (off vs 2)

 Nash Equilibrium the player does what is best for himself after he takes into account the other players actions. Dominant solution the outcome that is better than all the rest. Dominant solution for Paul is to confess and the same is true for Bill. The best solution for both is to cooperate, but the dilemma is that they cant so they end up with a second best solution.

Kinked Demand Curve Model

Show a situation where the best situation for players is to maintain current prices and that prices remain stable in spite of firms with different cost structures. Asymmetry in price movements:
If firm raises price, no one follows, therefore quantity demanded is elastic If firm lowers price, all follow suit so the quantity demanded is quite inelastic

Marginal revenue curve is discontinuous and allows for various marginal cost curves.

Kinked Demand Curve

If the firm raises its price above P, it faces an elastic demand curve, payoff low If the firm lowers its price below P, it faces an inelastic demand curve, payoff low

Kinked Demand Curve

Different firms can have different MCs. As long as they fall with in the discontinuous MR, P will remain stable. Output Effect < Price Effect for price movements with the discontinuous MR curve. If MC increases enough, all firms raise their prices and the kink vanishes.

Dominant Firm Price Leadership

A large dominant firm with lower costs that it competitors becomes the price maker. A competitive fringe with many firms that are price takers or followers. The dominant firms demand curve is the total market demand minus the supply of the competitive fringe. The dominant firm sets price and its quantity based upon residual demand and this determines the price for competitive firms and their supply. (Examples OPEC).

Dominant Firm
The large firm can set the price and receives a marginal revenue that is less than price along the curve MR. Dominant Firms Demand Curve

Residual Demand

Dominant Firm
As long as the dominant firm has lower costs, it can act like a monopolist over the residual demand.

Other Price Leadership Models

Barometric price leadership - firms come to tacit agreement to allow one firm to set the price according to cost considerations. If cost move is justified, others will follow and validate the price . If not, or if some firm decides to defect, the price change will not be validated. Rotating price leadership firms come to tacit agreement to allow the price leading firm to rotate among key players in the industry.

Cartels and Government

Monopoly power is often granted by government via regulation. Example Ma Bell (Econ USA). Other examples are shipping and the airline industry (pre-deregulation). Justifications for government regulation include infant industry and natural monopoly. Criticisms include decreased competition, increased costs due to x-inefficiency and lobbying, and regulation outlives its usefulness.

Measuring Market Power : Market Concentration

One presumption is that as the number of sellers decreases, market power increases. Concentration Ratios percentage of market share controlled by x number of firms, most commonly a four-firm concentration ratio Four-firm concentration ratio = (Sales by four largest firms in an industry/Sales by all firms in the industry) x 100

Concentration Ratios
Primary Copper Cigarettes Beer Breakfast Cereals Motor Vehicles Greeting Cards Small-arms munitions Household Refrigerators and Freezers 98,95 93,99 90,90 85,83 84,83 84 84,89 82,82

Problems with Concentration Ratios

Do not take into account foreign competition Fail to account for potential competition.
Contestable markets firms are able to enter and exit at low cost. Potential entry acts as a limit to market power.

US Auto Industry 2001

GM Ford Daimler-Chrysler Toyota Honda Nissan Mitsubishi Mazda Subaru Suzuki 27 24 16 10 7 4 2 2 1 .3
4 US firms Control 67%

Japanese Firms Control 26%

WSJ 4/4/2001 and Carbaugh page 201

Mergers Increasing Concentration

Vertical Merger merging with a firm that supplies inputs Horizontal Merger merging with a competitor Conglomerate Merger merging with firms that are not related Successful mergers Boeing and McDonnellDouglas Unsuccessful Mergers AOL Time Warner