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Managerial Economics Applications, Strategies and Tactics, 14e

James R. McGuigan

R. Charles Moyer

Frederick H. deB. Harris

© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

PART IV – PRICING & OUTPUT DECISIONS: STRATEGY AND TACTICS

Chapter 12 –

Price and Output Determination:

Oligopoly

Chapter 12 – Price & Output Determination: Oligopoly Overview (1 of 1)

OLIGOPOLISTIC MARKET STRUCTURES

INTERDEPENDENCIES IN OLIGOPOLISTIC INDUSTRIES

CARTELS AND OTHER FORMS OF COLLUSION

PRICE LEADERSHIP

THE KINKED DEMAND CURVE MODEL

AVOIDING PRICE WARS

Ch 12 – Oligopolistic Market Structures (1 of 1)

An oligopoly is characterized by a relatively small number of firms offering a similar product or service

Oligopoly products may be branded or unbranded

The number of firms is small enough that actions by any one firm on price, output, etc. have a perceptible impact on the sales of the others

Each firm knows that any new price cut or large promotional campaign is likely to evoke a countermove from its rivals

Rival response expectations are the key to firm-level analysis

If rival firms are expected to match price increases and price cuts, a share-of-the market demand curve may illustrate the sales response to the pricing initiatives of the firm (See Figure 12.1)

Figure 12.1 – Rival Response Expectations Determine Firm Demand

Figure 12.2 Browser Market Shares

Ch 12 – Oligopolistic Market Structures Oligopoly in the U.S.: Relative Market Shares (1 of 1)

Much of U.S. industry is best classified as oligopolistic in structure with a wide range of industry configurations, (Table 12.1)

At one extreme are dominant single firms in the markets for razors, beer, etc.

In crackers, handsets, etc. two firms dominate

Sales in tires, U.S. auto & truck markets are dispersed across 6-8 firms

Market shares are more dispersed in telecom equipment and pharmaceuticals

Table 12.1 – Largest U.S. Market Shares in Oligopolistic Industries

Table 12.2 – Market Share Distributions Over Time in Airlines, Cereals, and Wide-Bodied Aircraft

Figure 12.3 – The Relative Sizes of Competitors in the Auto Rental and Gasoline Industries

Ch 12 – Interdependencies in Oligopolistic Industries The Cournot Model (1 of 1)

One standard approach to the interdependency problem among oligopolists is merely to ignore it, for a firm to assume that its competitors will act as if it does not exist

Because of the wide scope of oligopoly industry configurations in Table 12.1, several simplifying models have been used to describe oligopolists’ competitive behavior regarding price, output, etc.

The Cournot oligopoly model asserts that each firm, in determining its profit-maximizing output level assumes that the other firm’s output will not change

Ch 12 – Cartels and Other Forms of Collusion (1 of 1)

Oligopolists sometimes reduce the inherent risk of being so interdependent by either formally or informally agreeing to cooperate or collude in decision-making; such agreements are called cartels

Cartel – A formal or informal agreement among firms in an oligopolistic industry that influences such issues s prices, total industry output, market shares, and the division of profits

In general, collusive agreements are illegal in the U.S. and Europe, but some exceptions exist

Prices and quotas of some agricultural products are set by grower cooperatives

The IATA airlines flying transoceanic routes jointly set uniform prices for these flights

Ocean shipping rates are set by hundreds of collusive conferences on each major route

Illegal collusive arrangements also arise from time to time

Ch 12 – Cartels and Other Forms of Collusion Factors Affecting the Likelihood of Successful Collusion (1 of 2)

Number and Size Distribution of Sellers

Collusion is less difficult as the number of firms involved decreases

Product Heterogeneity

Products that are alike are homogenous, and price is the only distinction that matters; for heterogeneous (differentiated) products, cooperation is more difficult

Cost Structures

The more cost functions differ among competing firms, the more difficult it will be

Size and Frequency of Orders

Effective collusion is more likely when orders are small, frequent, and received regularly, as in the purchase of autos

Ch 12 – Cartels and Other Forms of Collusion Factors Affecting the Likelihood of Successful Collusion (2 of 2)

Threat of Retaliation

An oligopolistic firm will be less tempted to grant secret price concessions to selected customers if it feels that other cartel members would detect those price reductions and then retaliate

Percentage of External Output

Most cartels contain the seeds of their own destruction

rising prices and profits attract the entry of new competitors

any increase in supply from outside the cartel means that larger restrictions on output must be imposed on cartel members in order to sustain price

Ch 12 – Cartels and Other Forms of Collusion Cartel Profit Maximization and the Allocation of Restricted Output (1 of 1)

Under legal cartels & secret collusive agreements, firms attempt to increase prices and profits above the level that would prevail in the absence of collusion

The profit-maximization solution for a two-firm cartel, E and F, is shown graphically in Figure 12.4

If the cartel maximizes its total profits, the market share (quota)for each firm should be set where marginal cost of all firms is identical and the industry (summed) MC = MR

The central problem for cartels is in monitoring these quotas, detecting violations and effectively enforcing punishments

As a result, most cartels are unstable

The longevity of OPEC and the DeBeers diamond cartels is exceptional

Figure 12.4 – Price-Output Determination for a Two-Firm Cartel

Figure 12.5 – How OPEC III Production Quotas Affected Crude Oil Prices

Figure 12.6 – Saudi Arabian Crude Oil Production

Figure 12.7 – Proven Oil Reserves

Figure 12.8 – Components of the Price of Gasoline per Gallon (1990-2009)

Ch 12 – Cartels and Other Forms of Collusion Cartel Analysis: Algebraic Approach (1 of 3)

The profit-maximizing price and output levels for a two-firm cartel can be determined algebraically when the demand and cost functions are given:

Ch 12 – Cartels and Other Forms of Collusion Cartel Analysis: Algebraic Approach (2 of 3)

Ch 12 – Cartels and Other Forms of Collusion Cartel Analysis: Algebraic Approach (3 of 3)

Table 12.3 – Comparisons of Pricing, Output, and Profits for Siemens & Thomson

Ch 12 – Price Leadership (1 of 1)

Price leadership – A pricing strategy followed in many oligopolistic industries. One firm normally announces all new price changes. Either by an explicit or by an implicit agreement, other firms in the industry regularly follow the pricing moves of the industry leader

Barometric Price Leadership

One firm announces a change in price that it hopes will be accepted by others

The leader must, however, be reasonably correct in its interpretation of changing demand and cost conditions

The barometric price leader merely initiates a reaction to changing market conditions that other firms find in their best interests to follow

Ch 12 – Price Leadership Dominant Firm Price Leadership (1 of 1)

One firm establishes itself as the leader because of its larger size, customer loyalty, or lower cost structure in relation to others

The leader may then act as a monopolist in its segment of the market

The incentive for followers to accept the established price may be a fear of cutthroat retaliation from a low-cost dominant firm, or it may be simply a convenience

The price-output solution for the dominant-firm model is shown in Figure 12.9

The dominant firm maximizes its profits by setting price and output where marginal cost equals marginal revenue

Figure 12.9 – Price-Output Determination for the Dominant Firm

Ch 12 – The Kinked Demand Curve Model (1 of 1)

Sometimes when an oligopolist cuts its prices, competitors quickly feel the decline in their sales, and are forced to match the price reduction

Or, if one firm raises its prices, competitors gain customers by maintaining their original prices, and have little motivation to match a price increase

The demand curve facing an individual oligopolist would be far more elastic for price increases than for price decreases (Figure 12.10)

This model explains why stable prices exist in some oligopolistic industries

But the kinked demand model is incomplete in that it offers no reason why the prevailing price level, rather than some other one, is chosen

Figure 12.10 – The Kinked Demand Curve Model

Ch 12 – Avoiding Price Wars (1 of 1)

To sustain profitability, oligopoly firms must avoid discounting tactics in their high-margin business

The ready-to-eat (RTE) Cereal, beer, camera film, DVD industries & more have experienced classic price wars

Growing the Market

One key to avoiding price wars is to attempt to grow the market

Pepsi cannot hope to get rid of Coke

Each rival must anticipate aggressive discounting designed to attract the other firm’s customers

It is better to maintain high prices and focus on opening new markets

Ch 12 – Avoiding Price Wars Customer Segmentation with Revenue Management (1 of 1)

If low-cost new entrants attack a major airline, one effective response involves matching prices to a targeted customer segment and controlling how much capacity is released for sale to that segment

“fencing” restrictions such as 7-day advance-purchase requirements, and Saturday night stayovers prove crucial in segmenting the price-sensitive discretionary traveler from the regular business expense account customer

Incumbent carriers can “meet the competition” in these restricted fare classes while reserving sufficient capacity for those who desire to pay for the reliability, convenience, and change-order responsiveness of business-class and full-coach seats

Established competitors can maintain high prices on segments & routes, etc.

Ch 12 – Avoiding Price Wars Reference Prices and Framing Effects (1 of 1)

Product line extensions can reduce gainshare price discounting by providing reference prices and framing effects that help sell the mid-range product at undiscounted prices

Consumers of unbranded products typically remember the last price they encountered

Branded products, however, trigger much longer reference pricing

Discounting with a major branded item tends to etch in the customer’s mind a new lowball price that can be expected thereafter for months or years’

Therefore, better to introduce a super-premium product offered at price points well above your traditional product; loyal customers will remember

What Went Right? ● What Went Wrong?

Good-Better-Best Product Strategy at Marriott Corp & Kodak

Marriott responded to fierce price competition by introducing upscale, high-quality, mid-range, and down-market product lines to its customers.

Length of stay, proximity to the central business district, and room type effectively segmented Marriott’s customer base

Marriott has no problem getting a substantial price premium for hotel rooms with sitting areas in central business districts & convention hotels

In the late 1990s, Kodak pursued a similar concept with discounted Funtime Film and the Kodak disposable camera

Disposable cameras for everyday use made this film highly accessible

Kodak’s Royal Gold film provided exceptional picture resolution in many lighting conditions, and could memorialize subtleties of expression, at a premium price

Ch 12 – Avoiding Price Wars The Role of Innovation (1 of 1)

Rather than matching price cuts, a higher-priced brand can highlight conspicuous product innovations

Sony’s Mavica was an easy-to-use point-and-shoot digital camera that recorded images onto thumb drives, which popped out of the camera and loaded into any PC for easy editing, storing and printing

While competitor Kodak was improving picture resolution to justify expensive and complicated home printer hardware peripherals using Kodak chemicals and paper, Sony simplified the prices and increased customer value.

Mavica earned a premium price relative to its competitors

Figure 12.11 – Segmented Oligopoly with Extreme Brand Loyalty

Ch 12 – Avoiding Price Wars Matching Price Cuts with Increased Advertising (1 of 1)

Perhaps the best way to avoid a price was is to not start one

If someone else starts a price war, often the best response is simply to match the competition and then accentuate non-price elements of the marketing mix by increasing services or advertising

A final key to avoiding price wars comes through the tactical insights often available from game theory analysis:

Being able to identify a rival’s payoffs using competitor surveillance helps predict the competitor’s response to one’s own price cuts

In other circumstances, cooperative high-price outcomes may arise out of mutual interest

Recognizing the detailed structure of the pricing “game” can be a first step in altering the competitive environment