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ECO 2220, Principles of Microeconomics - Section 1C

Class Presentation for

April 5 & 7, 2016

Chapter #27

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Total Revenue $14.792 billion (2013)

Total Assets $15.474 billion (2013)

Total Equity $3.607 billion (2013)

Number of Employees 30,200 (2013)

Will Keith Kellogg

April 7, 1860 – October 6, 1951

Battle Creek, Michigan

Founded February 16, 1906, Battle Creek Michigan

The company was founded as the outgrowth of his work with his brother John Harvey Kellogg at the Battle Creek Sanitarium following practices based on the Seventh-day Adventist Church.

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ECO 2220, Principles of Microeconomics - Section 1C

Looking Forward:

April 5, 2016 – Journal #9 due.
April 7, 2016 – Test #3

Chapters # 24, 25, 26, & 27

April 12, 2016 – Journal #10 due.

April 19, 2016 – Project Paper Due

April 28, 2016 – Test #4

Chapters # 29, 30, & 32

Prepared By Brock Williams

Chapter 27
Oligopoly and Strategic Behavior

In an oligopoly, defined as a market with just a few firms, each firm has an incentive to act strategically, anticipating the possible actions and reactions of its fellow oligopolists.

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Learning Objectives

Explain why a price-fixing cartel is difficult to maintain.

Explain the effects of a low-price guarantee on the price.

Describe the prisoners' dilemma.

Explain the behavior of an insecure monopolist.

Explain two advertisers dilemmas.

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► 3:02 www.youtube.com/watch?v=UoFqV1lxA7Q

Opening Strategy Chess

Originated in India during the Gupta Empire [320 – 550 CE].

Chess

A Game of Strategy

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● oligopoly
A market served by a few firms.

● game theory
The study of decision making in strategic situations.

Oligopoly and Strategic Behavior

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● concentration ratio
The percentage of the market output produced by the largest firms.

An alternative measure of market concentration is the Herfindahl-Hirschman Index (HHI). It is calculated by squaring the market share of each firm in the market and then summing the resulting numbers.

An oligopoly—a market with just a few firms—occurs for three reasons:

1 Government barriers to entry.

2 Economies of scale in production.

3 Advertising campaigns.

WHAT IS AN OLIGOPOLY?

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Generally considered the most complex of the four market structures;

Great deal of mutual interdependence;

Actions of one will affect the others;

Power to fix prices and output.

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WHAT IS AN OLIGOPOLY? (cont.)

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Source: Baleryandsnacks.com

America’s Top 10 Best Selling Brands : 2014

Rank	Brand	$ Sales	Manufacture
1	Honey Nut Cheerios	$ 510,260,672	General Mills
2	Frosted Flakes	$ 434,359,552	Kellogg’s
3	Honey Bunches of Oats	$ 386, 719,872	Post
4	Cheerios	$ 339,127,424	General Mills’
5	Cinnamon Toast Crunch	$ 313,750,720	General Mills’
6	Frosted Mini Wheats	$ 269,797,824	Kellogg’s
7	Lucky Charms	$ 260, 945,312	General Mills’
8	Fruit Loops	$ 251,377,232	Kellogg’s
9	Raisin Bran	$ 184,225,400	Kellogg’s
10	Rice Krispies	$ 146,600,208	Kellogg’s

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TYPES OF COMPETITION

KIND OF COMPETITION	# OF PRODUCERS & DEGREE OF PRODUCT DIFFERTIATION	PART OF ECONOMY WHERE PREVELENT	DEGREE OF CONTROL OVER PRICE	METHODS OF MARKETING
Perfect Competition	Many producers; identical products	A few agricultural industries	None	Market exchange or auction
Imperfect Competition
Many differentiated sellers	Many producers; many real or fancied difference in product	Toothpaste, retail trade; conglomerates
Oligopoly	Few producers: little or no difference in product	Steel, aluminum	- Some	Advertising and quality rivalry; administered prices
Few producers; some differentiation of products	Autos, machinery
Complete monopoly	Single producer; unique product without close substitutes	A few utilities	Considerable	Promotional and ”institutional” public-relations advertising

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Perfect Competition, Monopoly and Monopolistic Competition

Perfect Competition	Monopoly	Monopolistic Competition
There are many sellers.	A single firm sells a product.	Many firms (small economies of scale)
There are many buyers.	There are many buyers.	There are many buyers.
The product is homogeneous.	The product has no close substitutes.	A differentiated products. (offer different performance level or appearance)
There are no barriers to market entry.	There are many barriers to market entry.	No artificial barriers to entry. (no patents or regulations)
Both buyers and sellers are price takers.	The seller has market power to affect price.	Products are close substitutes – (there is intense competition between firms for consumers)

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Econ 2220 November 13 & 18, 2013

Perfect Competition / Monopoly / Monopolistic Competition / Oligopoly

Perfect Competition	Monopoly	Monopolistic Competition	Oligopoly
There are many sellers.	A single firm sells a product.	Many firms (small economies of scale)	Few Firms
There are many buyers.	There are many buyers.	There are many buyers.	There are many buyers.
The product is homogeneous.	The product has no close substitutes.	A differentiated products. (offer different performance level or appearance)	Firms have high degree of concentration in a particular market.
There are no barriers to market entry.	There are many barriers to market entry.	No artificial barriers to entry. (no patents or regulations)	High barriers to entry.

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WHAT IS AN OLIGOPOLY? (cont.)

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● duopoly
A market with two firms.

● cartel
A group of firms that act in unison, coordinating their price and quantity decisions.

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA

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Examples of Duopoly:

Air Bus and Boeing – airlines;

BNSF Railway and Union Pacific Railroad;

Northfolk Southern Railway and CSX Transportation (eastern US)

Apple and Microsoft

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● price-fixing
An arrangement in which firms conspire to fix prices.

 FIGURE 27.1
A Cartel Picks the Monopoly Quantity and Price

The monopoly outcome is shown by point a, where marginal revenue equals marginal cost.

The monopoly quantity is 60 passengers and the price is $400. If the firms form a cartel, the price is $400 and each firm has 30 passengers (half the monopoly quantity).

The profit per passenger is $300 (equal to the $400 price minus the $100 average cost), so the profit per firm is $9,000.

profit = (price − average cost) × quantity per firm

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA (cont.)

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FIGURE 27.2
Competing Duopolists Pick a Lower Price

(A) The typical firm maximizes profit at point a, where marginal revenue equals marginal cost. The firm has 40 passengers.

(B) At the market level, the duopoly outcome is shown by point d, with a price of $300 and 80 passengers. The cartel outcome, shown by point c, has a higher price and a smaller total quantity.

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA (cont.)

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 FIGURE 27.3
Game Tree for the Price-Fixing Game

The equilibrium path of the game is square A to square C to rectangle 4: Each firm picks the low price and earns a profit of $8,000.

The duopolists’ dilemma is that each firm would make more profit if both picked the high price, but both firms pick the low price.

● game tree
A graphical representation of the consequences of different actions in a strategic setting.

Price-Fixing and the Game Tree

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA (cont.)

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Price-Fixing and the Game Tree

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA (cont.)

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Equilibrium of the Price-Fixing Game

● dominant strategy
An action that is the best choice for a player, no matter what the other player does.

● duopolists’ dilemma
A situation in which both firms in a market would be better off if both chose the high price, but each chooses the low price.

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA (cont.)

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Nash Equilibrium

● Nash equilibrium
An outcome of a game in which each player is doing the best he or she can, given the action of the other players.

27.1 CARTEL PRICING AND THE
DUOPOLISTS’ DILEMMA (cont.)

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John Forbes Nash, Jr.

June 13, 1928 - May 23, 2015 (aged 86)

An Americanmathematician with fundamental contributions in game theory, differential geometry, and partial differential equations.

Nash's work has provided insight into the factors that govern chance and decision making inside complex systems in daily life.

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At the beginning of the 19th Century, high overland transportation costs protected salt producers from competition with one another, generating local salt monopolies. Over the course of the 19th Century, decreases in overland transportation costs increased competition between salt producers and decreased prices.

In response to the increased competition, salt producers in a particular state colluded by forming a salt pool, enterprises that set a uniform price and distributed the salt of all participating producers. Some pools established output quotas or paid firms not to produce salt for a year, a practice known as “dead-renting” a salt furnace.

Every pool arrangement broke down, usually within a year or two of its formation. In some cases, individual firms cheated on the cartel by selling salt outside the cartel. In other cases the artificially high price caused new firms to enter the market and underprice the salt pool.

FAILURE OF THE SALT CARTEL

APPLYING THE CONCEPTS #1: Why do cartels sometimes fail to keep price high?

A P P L I C A T I O N

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Low-Price Guarantees

● low-price guarantee
A promise to match a lower price of a competitor.

27.2 OVERCOMING THE
DUOPOLISTS’ DILEMMA

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Low-Price Guarantees

FIGURE 27.4
Low-Price Guarantees Increase Prices

When both firms have a low-price guarantee, it is impossible for one firm to underprice the other. The only possible outcomes are a pair of high prices (rectangle 1) or a pair of low prices (rectangles 2 or 4).

The equilibrium path of the game is square A to square B to rectangle 1. Each firm picks the high price and earns a profit of $9,000.

27.2 OVERCOMING THE
DUOPOLISTS’ DILEMMA (cont.)

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Repeated Pricing Games with Retaliation for Underpricing

● grim-trigger strategy
A strategy where a firm responds to underpricing by choosing a price so low that each firm makes zero economic profit.

● tit-for-tat
A strategy where one firm chooses whatever price the other firm chose in the preceding period.

Repetition makes price-fixing more likely because firms can punish a firm that cheats on a price-fixing agreement, whether it’s formal or informal:

1 A duopoly pricing strategy.

Choosing the lower price for life.

2 A grim-trigger strategy.

3 A tit-for-tat strategy.

27.2 OVERCOMING THE
DUOPOLISTS’ DILEMMA (cont.)

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Repeated Pricing Games with Retaliation for Underpricing

FIGURE 27.5
A Tit-for-Tat Pricing Strategy

Under tit-for-tat retaliation, the first firm (Jill, the square) chooses whatever price the second firm (Jack, the circle) chose the preceding month.

27.2 OVERCOMING THE
DUOPOLISTS’ DILEMMA (cont.)

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Price-Fixing and the Law

Under the Sherman Antitrust Act of 1890 and subsequent legislation, explicit price-fixing is illegal. It is illegal for firms to discuss pricing strategies or methods of punishing a firm that underprices other firms.

27.2 OVERCOMING THE
DUOPOLISTS’ DILEMMA (cont.)

The purpose of the [Sherman] Act is not to protect businesses from the working of the market; it is to protect the public from the failure of the market. The law directs itself not against conduct which is competitive, even severely so, but against conduct which unfairly tends to destroy competition itself.

U.S. Supreme Court in Spectrum Sports, Inc. v. McQuillan 506 U.S. 447 (1993):

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Price Leadership

● price leadership
A system under which one firm in an oligopoly takes the lead in setting prices.

The problem with an implicit pricing agreement is that it relies on indirect signals that are often garbled and misinterpreted. When one firm suddenly drops its price, the other firm could interpret the price cut in one of two ways:

• A change in market conditions.

• Underpricing.

27.2 OVERCOMING THE
DUOPOLISTS’ DILEMMA (cont.)

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In two successive months (November and December), a Florida tire retailer listed prices for 35 types of tires in newspaper advertisements. In November the average price was $45, and in December the average price was $55.

The December advertisement was different in another way: it included a low-price guarantee under which the retailer agreed to match any lower advertised price (and also pay the customer some percentage of the price gap). In fact, for each of the 35 types of tires, the December price was the same or higher than the November price. In this case, a low-price guarantee generated higher prices.

Is the relationship between low-price guarantees and prices apparent or real? A careful study of the retail tire market suggests that prices are generally higher in markets where firms offer low-price guarantees. On average, the presence of a low-price guarantee increases prices by a modest $4 per tire, or about 10 percent of the price.

LOW-PRICE GUARANTEE INCREASES TIRE PRICES

APPLYING THE CONCEPTS #2: Do low price guarantees generate higher or lower prices?

A P P L I C A T I O N

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● payoff matrix
A matrix or table that shows, for each possible outcome of a game, the consequences for each player.

27.3 SIMULTANEOUS DECISION MAKING AND THE PAYOFF MATRIX

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Simultaneous Price-Fixing Game

 FIGURE 27.6
Payoff Matrix for the Price-Fixing Game

Jill’s profit is in red, and Jack’s profit is in blue.

If both firms pick the high price, each firm earns a profit of $9,000. Both firms will pick the low price, and each firm will earn a profit of only $8,000.

27.3 SIMULTANEOUS DECISION MAKING AND THE PAYOFF MATRIX (cont.)

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The Prisoners’ Dilemma

 FIGURE 27.7
Payoff Matrix for the Prisoners’ Dilemma

The prisoners’ dilemma is that each prisoner would be better off if neither confessed, but both people confess.

The Nash equilibrium is shown in the southeast corner of the matrix. Each person gets five years of prison time.

27.3 SIMULTANEOUS DECISION MAKING AND THE PAYOFF MATRIX (cont.)

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An economics professor discovered three students cheating on the final.

Speaking to them individually, he gave each student two options

▪ If the student confessed, he or she would receive a zero on the exam, but suffer no other consequences.

▪ If they did not confess, he or she would go before the Office of Student Judicial Affairs, and any confessions by the other two students would be used as evidence.

Is this a prisoner’s dilemma?

What is the likely outcome?

CHEATING ON THE FINAL EXAM: THE CHEATERS’ DILEMMA

APPLYING THE CONCEPTS #3: When does cooperation break down?

A P P L I C A T I O N

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FIGURE 27.8
Deterring Entry with Limit Pricing

Point c shows a secure monopoly, point d shows a duopoly, and point z shows the zero-profit outcome.

The minimum entry quantity is 20 passengers, so the entry-deterring quantity is 100 (equal to 120 – 20), as shown by point e.

The limit price is $200.

27.4 THE INSECURE MONOPOLIST AND ENTRY DETERRENCE

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Entry Deterrence and Limit Pricing

The quantity required to prevent the entry of the second firm is computed as follows:

deterring quantity = zero profit quantity − minimum entry quantity

27.4 THE INSECURE MONOPOLIST AND ENTRY DETERRENCE (cont.)

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Entry Deterrence and Limit Pricing

 FIGURE 27.9
Game Tree for the Entry-Deterrence Game

The path of the game is square A to square C to rectangle 4. Mona commits to the entry-deterring quantity of 100, so Doug stays out of the market.

Mona’s profit of $10,000 is less than the monopoly profit but more than the duopoly profit of $8,000.

27.4 THE INSECURE MONOPOLIST AND ENTRY DETERRENCE (cont.)

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Entry Deterrence and Limit Pricing

● limit pricing
The strategy of reducing the price to deter entry.

● limit price
The price that is just low enough to deter entry.

27.4 THE INSECURE MONOPOLIST AND ENTRY DETERRENCE (cont.)

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Examples: Aluminum and Campus Bookstores

● contestable market
A market with low entry and exit costs.

Entry Deterrence and Contestable Markets

When Is the Passive Approach Better?

Entry deterrence is not the best strategy for all insecure monopolists.

Sharing a duopoly can be more profitable than increasing output and cutting the price to keep the other firm out.

Alcoa maintained a relatively low price and large quantity between 1893 and 1940 to deter entrance of other firms.

If your campus bookstore suddenly feels insecure about its monopoly position, it could cut its prices to prevent online booksellers from capturing too many of its customers.

27.4 THE INSECURE MONOPOLIST AND ENTRY DETERRENCE (cont.)

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Microsoft has a virtual monopoly in the market for personal-computer operating systems and business software. But there is a constant threat that another firm will launch competing products, so Microsoft engages in limit pricing to deter entry into its key markets. A recent study computes some of the numbers behind the insecure monopoly.

The pure monopoly price for a software bundle of the Windows operating system and the Office Suite of business tools is about $354, but the actual price (the limit price) is about $143. The estimated cost for a second firm to develop, maintain, and market an alternative software bundle is about $38 billion, and Microsoft’s actual price is just low enough to make such an investment unprofitable.

The pure monopoly profit would be about $191 billion, while the profit under Microsoft’s limit pricing is about $153 billion. Although the profit under the entry-deterrence strategy is less than the pure monopoly profit, it is greater than the profit Microsoft would earn if it allowed a second firm to enter the market ($148 billion). In other words, entry deterrence is the best strategy.

MICROSOFT AS AN INSECURE MONOPOLIST

APPLYING THE CONCEPTS #4: How does a monopolist respond to the threat of entry?

A P P L I C A T I O N

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FIGURE 27.10
Game Tree for the Advertisers’ Dilemma

Adeline moves first, choosing to advertise or not. Vern’s best response is to advertise no matter what Adeline does.

Knowing this, Adeline realizes that the only possible outcomes are shown by rectangles 1 and 3.

From Adeline’s perspective, rectangle 1 ($6 million) is better than rectangle 3 ($5 million), so her best response is to advertise. Both Adeline and Vern advertise, and each earns a profit of $6 million.

27.5 THE ADVERTISERS’ DILEMMA

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Milk is advertised by the National Fluid Milk Producers, and industry group. The milk producers pool their resources and fund the campaign with a tax. Why?

The is a standardized good, so advertising by one producer increases demand for all producers.

▪ The Got Milk campaign increases demand about 6 percent.

▪ If a single firm advertised, it would incur all the expense, but only a

fraction of the benefit.

▪ The solution is to share costs and benefits.

GOT MILK?

APPLYING THE CONCEPTS #5: What is the rationale for generic advertising?

A P P L I C A T I O N

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cartel

concentration ratio

contestable market

dominant strategy

duopolists’ dilemma

duopoly

game theory

game tree

grim-trigger strategy

kinked demand curve model

low-price guarantee

limit price

limit pricing

Nash equilibrium

oligopoly

payoff matrix

price-fixing

price leadership

tit-for-tat

K E Y T E R M S

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Econ 2220 November 13 & 18, 2013