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6POligopoly.pptxOligopoly
Look for:
Determination of the profit maximizing price and quantity.
Implications for efficiency
Issues of Oligopoly
Game theory and collusion
3 oligopoly models
Profit maximization
Efficiency
Please listen to the audio as you work through the slides.
Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC
Learning objectives
Students should be able to thoroughly and completely explain:
The characteristics of oligopoly
The conditions under which the Oligopolist firm achieves profit maximization and loss minimization.
Oligopoly Behavior, including collusion and game theory.
Some Oligopoly examples
In the US, 90% of the music produced and sold comes from one of 4 studios: Universal, Sony, Warner, or EMI. Limited price competition. Talent search and marketing are critical to gain advantage.
The $1 billion stent market is dominated by 3 firms: Boston Scientific, Johnson & Johnson, and Medtronic. Limited price competition. R&D is the competitive advantage tool.
Two companies control US grain trading: Cargil – Continental, and Archer, Daniels, Midland (ADM).
3 Companies control 44% of the global proprietary seed market: Monsanto, DuPont, and Syngenta.
Some Oligopoly examples
4 Companies control over 80% of the US beef market: Tyson, Cargil, Swift, and National Beef Packing Company
Airlines – fierce price competition among a small number of firms. Industry consolidation.
4 firms dominate the market for tennis balls – Wilson, Penn, Dunlop, Spalding
Oligopolies compete on:
price, new product development, marketing, advertising, and development of complements.
The market structures – compare the characteristics
Type of products
Control over price
Exit and entry
Non price competition
Price output determination
Efficiency
Market Structure Continuum
Pure
Competition
Pure
Monopoly
Monopolistic
Competition
Oligopoly
Four Market Models
Oligopoly: characteristics
A Few Large Producers with large market share: – “big 3”, “big 6”
Homogeneous (standardized) or Differentiated Products
Steel, lead, aluminum, cement – industrial products
Automobiles, tires, electronic equipment, breakfast cereals, cigarettes (non-price competition / advertising) – consumer products
Market Structure Continuum
Pure
Competition
Pure
Monopoly
Monopolistic
Competition
Oligopoly
Four Market Models
Oligopoly: characteristics
Control Over Price – price makers,
Mutual Interdependence – profits depend on strategies of others
Strategic Behavior – self interested behavior that takes into account the reactions of others.
Entry Barriers –
Economies of scale – they have it and exploit it
Large capital expenditures – refineries, auto assemblers, commercial aircraft, large scale mfg. facilities.
Ownership of raw materials – mining, food production
Patents – big pharma, electronics, seeds
Preemptive and retaliatory pricing and ad strategies
Evolution of Oligopolies
Growth of dominant firms – they just get big
Mergers – auto industry, banking, food manufacturers, airlines, Beer, Pharmacies
They attempt to achieve monopoly power – without attracting the attention of the anti-trust division of the Justice Dept.
Where do Oligopolies come from?
Oligopoly Behavior
Game theory – a subfield of economics that analyzes the choices made by rival firms, people, and even governments as they try to maximize their own well-being while anticipating and reacting to the actions of others in their environment.
A key tool during the Cold War period.
Oligopoly Behavior
Game Theory
Mutual Interdependence
Collusive Tendencies
Collusion – cooperation with rivals
Independent behavior of firms leads to lower prices – a benefit to consumers
Collusive behavior of firms leads to higher prices - a benefit to business
Incentive to Cheat
Introduction to Game Theory…
Oligopoly Behavior – 2 firms, 2 strategies
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
Oligopoly Behavior
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
Greatest
Combined
Profit
Oligopoly Behavior
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
Independent
Actions
Stimulate
Response
Oligopoly Behavior
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
Independent
Actions
Stimulate
Response
Gravitating
to the
Worst Case
Oligopoly Behavior
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
Collusion
Invites a
Different
Solution.
Oligopoly Behavior
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
Collusion
Invites a
Different
Solution.
Oligopoly Behavior
A Game-Theory Overview
High
Low
High
Low
Uptown’s Price Strategy
RareAir’s Price Strategy
B
A
D
C
$12
$15
$12
$6
$6
$8
$8
$15
But, the
incentive
to cheat
is very real.
Collusion
Invites a
Different
Solution.
Diversity of Oligopolies
Tight oligopolies – 2 to 3 firms dominate industry
Loose oligopolies – 6 to 7 firms share 70% or more of the market (the smaller firms share the rest)
Both sell differentiated or standard products
Complications of Interdependence
Firms cannot (or have great difficulty) estimate their demand or MR data, and are challenged to determine their profit maximizing price and output
Can’t predict the reaction of rivals with certainty.
Three Oligopoly Models
No Standard Model due to the diversity of oligopoly
Three Oligopoly Models
Alternative models -
Two interrelated characteristics:
If the macro economy is stable then prices are typically inflexible
When prices do change, firms are likely to change their prices together
The 3 Models
1 – Kinked Demand Curve model*
2 – Cartels and Collusion model
3 – Price Leadership model
Kinked Demand Curve Theory
Assumptions:
3 firms
Independent pricing, no collusive behavior
Differentiated products
What does a firms’ demand curve look like?
Location and shape depends on how rivals react to a price change
Two plausible assumptions about behavior of rivals.
The 2 rivals match price changes of firm #1
Firm 1 cuts price - firm #1 would achieve small sales increase because rivals also cut price to match.
Firm 1 raises price – firm #1 has small sales loss because rivals also raise prices to match.
The 2 rivals ignore price changes of firm #1
Firm 1 lowers price and rivals don’t. Firm 1 gains sales.
Firm 1 raises price and rivals don’t. Firm 1 looses sales.
Conclusion about strategy
Rival behavior will depend on the direction of firm 1’s price change!!
Key point!
There exists a price:
below which they will match price decreases and
above which they will ignore price increases.
Given a price change by firm 1,
Case 1:
Rivals will ignore price increases above that price and gain customers.
Case 2:
Rivals will match price decreases below that price to avoid losing customers
D1
MR1
Quantity
Case 1.
Firm 1’s demand and marginal revenue curves assuming a price decrease by firm 1 and the 2 rivals match the change. Firm 1 receives only a small increase in sales.
Kinked Demand Theory:
Noncollusive Oligopoly
Price
MR2
D1
D2
MR1
Quantity
Case 2.
Firm 1’s Demand and marginal revenue curves assuming a price increase by firm 1 and the 2 rivals ignore the price increase. Firm 1 has only a small sales loss.
Kinked Demand Theory:
Noncollusive Oligopoly
Price
MR2
D1
D2
MR1
Quantity
Kinked Demand Theory:
Noncollusive Oligopoly
Price
Rivals tend to
follow a price cut
MR2
D1
D2
MR1
Quantity
Kinked Demand Theory:
Noncollusive Oligopoly
Price
Rivals tend to
follow a price cut
or ignore a
price increase
MR2
D1
D2
MR1
Quantity
Effectively creating
a kinked demand curve
For firm #1
Kinked Demand Theory:
Noncollusive Oligopoly
Price
D
Quantity
Effectively creating
a kinked demand curve
For firm #1
Kinked Demand Theory:
Noncollusive Oligopoly
Price
D
MR1
Quantity
Effectively creating
a kinked demand curve
For firm #1
Note: the MR curves
Kinked Demand Theory:
Noncollusive Oligopoly
Price
MR2
D
Quantity
Profit maximization or
loss minimization for firm #1
occurs at the kink where
MR = MC
Kinked Demand Theory:
Noncollusive Oligopoly
Price
MC2
MC1
MR2
MR1
If a few firms face identical or highly similar demand and costs...
Oligopoly is conducive to collusion.
they will tend to seek joint profit maximization.
Cartels and Other Collusion
Graphically…
3 similar Colluding Oligopolists Will Split the Monopoly Profits by limiting output and setting a single common price.
D
MC
ATC
MR
Economic
Profit
MR = MC
Price and costs
Q0
P0
A0
Cartels and Other Collusion
Overt Collusion
Cartels with defined – written agreements
The OPEC Cartel
Covert Collusion
U.S. – It is Illegal
Tacit Understandings – gentlemen's agreements
1993 Borden, Pet, Dean Foods bid rigging on milk products
1996 ADM and 3 Japanese and South Korean firms price fixing on livestock feed additives.
1960’s - manufacturers of heavy electrical equipment including General Electric
Cartels and Other Collusion
Obstacles to Collusion
Demand and Cost Differences
Number of Firms: more firms = less collusion
Cheating
Recession – pressure to lower prices.
Potential Entry – successful collusion requires blocking entry in some way.
Antitrust Law
Cartels and Other Collusion
Price Leadership Model
Leadership Tactics -
Requires implicit understanding among the players such that they can coordinate prices without engaging in outright collusion based on formal agreements and secret meetings. (General Mill, Post Foods, Kellogs)
Infrequent Price Changes
Communications – press conferences
Limit Pricing
They want to keep price below the short run profit maximizing level to discourage new competitors from entering.
Breakdowns in Price Leadership - Price Wars
Oligopoly and Advertising
Product development and advertising are less easily duplicated by rivals
Oligopolists typically financially strong – Cash flow, economic profit
Positive Effects of Advertising
Providing information to consumers
Diminishes monopoly power – Toyota and Honda vs the Big 3 of the USA (check out the 1989 pre-launch commercial)
Enhance efficiency
Greater competition, more technological progress, higher output, lower LR ATC, better able to achieve economies of scale.
Potential Negative Effects of Advertising
Disinformation to consumers
Barrier to entry
Brand Development
Oligopoly and efficiency
Many oligopolists sustain economic profit
Production often occurs where price > MC and price > minimum ATC.
Production is below the output at which ATC is minimized
Neither productive efficiency nor allocative efficiency is achieved.
Pure Competition conditions:
Productive Efficiency: P = Minimum ATC and
Allocative Efficiency: P = MC
Oligopoly Situation relative to efficiency:
P > Minimum ATC
P > MC
Output is below the output at which ATC is minimized
Oligopoly and efficiency
price leadership
KEY TERMS
