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ECONOMICS 3200MLecture 6

February 9, 2011

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Oligopoly

Examples of non-cooperation• Overcapacity

• Price wars

• Advertising

– Fixed end-point – financially weak competitor• Lobbying to change bankruptcy laws to make it more difficult to exit

• Aggressive pricing

• Rumors

• Banks unwilling to lend to weak financial institutions

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Oligopoly

Factors facilitating cooperation• Competition law

• No leader

• Low costs for detecting cheating– Small numbers, homogeneous product, transparency in pricing

• Expected benefits

• MAD strategy

• Contracts– Most favored nation clause

– Meet the competition

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Oligopoly

Competition shifts to difficult to detect, time-consuming to respond strategies

• Product innovations/introductions

• Marketing

• Lobbying

• Production technology innovations

• Exclusive contracts – suppliers, distributors

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Oligopoly

• Oligopoly markets generally consist of one to three dominant firms and several smaller firms

• Dominant position may not survive over time

• How does a firm become dominant – see discussion regarding how a monopoly develops

• Why doesn’t dominance not survive?– Consider case of Canadian steel companies (Dofasco, Stelco,

Ipsco, Algoma) and Arcelor Mittal

– Canadian steel companies have been acquired

– Arcelor Mittal has grown form one steel mill in Indonesia 30 years ago to largest and most valuable steel company in world

– Relate to debate on “hollowing out”

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Hollowing Out

• Canadian companies acquired by foreign companies:– Inco; Falconbridge; Dofasco; Ipsco; Stelco; Algoma; Masonite;

ATI; Moore; Four Seasons; Fairmont Hotels; The Bay; Domtar; Alcan; Molson’s; Labatt’s; Vincor; Future Shop

– 2001-2006: 455 Canadian companies acquired for combined price of US$137 billion

• Definition of hollowing out:– As Canadian-owned, Canadian-headquartered companies are

bought up by foreigners, head-office jobs, capital markets listings, corporate tax revenues, and charitable donations are disappearing potentially resulting in the hollowing out of Canada’s economic sovereignty

– Not a Canadian phenomenon alone

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Hollowing Out

• Debate– Causes – government policies or management?

• In a spiky world, firms either globalize or eventually get swallowed up by a globalizing corporation, typically headquartered elsewhere

• Canadian managers that ignore this reality are fooling themselves and selling Canada short (Roger Martin and Gordon Nixon)

– Good or bad for Canada – employment, productivity, standard of living

– Policies: corporate taxation; screening foreign takeovers; regulations; inter-provincial trade barriers; human capital; infrastructure; subsidies

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Hollowing Out

• Michael Porter: explained why entire global industries were often headquartered in a single country if not a single region within a single country

• Set of conditions in local market creates a cluster of competitive companies that pressure each other to innovate and upgrade, teach local customers to be ever-more demanding, draw in and develop human resources, and attract co-location of helpful related and supporting industries

• Result: cluster that keeps getting better and better and, on the basis of that beneficial local competition, helps its members succeed internationally against competitors from elsewhere who don't have the power of a strong local cluster behind them

• Porter's theory predicts a spiky world in which most of the successful competitors in a global industry come from very few places and export to the rest of the world

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Hollowing Out

• Increasing favorable trade conditions and falling transportation and communications costs combine to make globalizing more of a reality as leading national firms find themselves pressured by capital markets to expand globally rather than stay at home

• Research and development-intensive firms find that the only way they can afford to invest in competitive technological solutions is to utilize the scale economies of a global market

• Transformation proceeding in one direction only – to a spikier world in which all the globally competitive firms in all industries are headquartered in a limited number of locations

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Monopolistic Competition

• Product differentiation– Product consists of bundle of characteristics – quality,location, colour,

time of availability, etc.

– Computers, laptops, clothing, air travel, MBA programs

• Firms have some degree of market power

• Standard model

– Free entry may drive profits to 0, at least for marginal firms in market

– Definition of industry/market?

– Critical value for cross-price elasticity of demand?

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Monopolistic Competition

• Location model – example of differentiation

• Different locations represent different varieties of a product– Varieties differentiated by geographic location or other characteristics

• Consumers have preferred location/characteristics for a product– For given price, utility maximized at preferred location

– Utility declines as actual product location differs (moves farther away) from preferred location

• To make problem manageable, focus on one characteristic

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Monopolistic Competition

• Vertical differentiation model – characteristic: quality

• Quality (S): S [0, 1]– Consumers agree over most preferred mix of characteristics and over

preference ordering: S1 > S2 implies that quality S1 exceeds quality S2 and higher quality preferred over lower quality

– Consumers have perfect information regarding quality

– Value (utility – U) to consumer: U = S – P

• Model:– Consumer buys if U > 0 S > P

– Does not buy if U 0 S P

– Distribution of tastes ( ) across all consumers: F(), where F(min) = 0 and F(max) = 1

– F(0): proportion of all consumers with taste parameter [0, 0]

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Monopolistic Competition

Case 1

• 2 products with qualities S1 > S2 and P1 > P2

• Assume:– S1/P1 > S2/P2 S1/P1 > S2/P2

• Consumers will prefer the higher quality product if: S1 – P1 > S2 – P2 and

S1 – P1 > 0

• Since S1/P1 > S2/P2 then:

– [ S1/P1 – 1] > [ S2/P2 – 1]

– P1[ S1 – P1] > P2[ S2 – P2]

– Since P1 > P2 , consumers prefer higher quality product

– Product differentiation, but only high quality variety of product is produced and sold

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Monopolistic Competition

Case 2

• 2 products with qualities S1 > S2 and P1 > P2

• Assume:– S1/P1 < S2/P2 S1/P1 < S2/P2

• Consumers will prefer the higher quality product if: S1 – P1 > S2 – P2 and

S1 – P1 > 0

• Since S1/P1 < S2/P2 then:

– [ S1/P1 – 1] < [ S2/P2 – 1]

– P1[ S1 – P1] < P2[ S2 – P2]

– Since P1 > P2 , consumer preference indeterminate

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Monopolistic Competition

Case 2

• Critical value for separates consumers into two groups: one group prefers S1 { S1 – P1 > S2 – P2} and the other prefers S2 { S1 – P1 < S2 – P2}

• Critical value (*):– Consumers indifferent when: S1 – P1 = S2 – P2

– * = [P2 – P1]/[S1 – S2]

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Monopolistic Competition

Case 2

• When > *, consumer prefers higher quality variety (S1)

– Demand for high quality product: consumers with [(P2 – P1)/(S1 – S2), max]

– Aggregate demand: D(S1, S2, P1, P2) = N[1-F((P2 – P1)/(S1 – S2))]

– D(S1, S2, P1, P2) increases if S1 increases, S2 decreases, P1 decreases and/or P2 increases

• When < *, consumer prefers lower quality variety (S2)

– Demand for low quality product: consumers with [P2/ S2, (P2 – P1)/(S1 – S2)]

– Aggregate demand: D(S2, S1, P1, P2) = N[F((P2 – P1)/(S1 – S2)) – F(P2/ S2)]

– D(S2, S1, P1, P2) increases if S1 decreases, S2 increases, P1 increases and/or P2 decreases

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Monopolistic Competition

• Location model – example of differentiation

• Different locations represent different varieties of a product– Varieties differentiated by geographic location or other characteristics

• Consumers have preferred location/characteristics for a product– For given price, utility maximized at preferred location

– Utility declines as actual product location differs (moves farther away) from preferred location

• To make problem manageable, focus on one characteristic

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Monopolistic Competition

Hotelling model

• Horizontal differentiation – location (nearness in terms of product characteristics other than quality) matters

• Transportation cost – disutility of choice/location different from preferred choice/location: T per unit of “distance”

• Competition drives two firms to locate at same place/location if consumers uniformally distributed (tastes regarding preferred locations) along product/geographic space– No product differentiation

• Identical location result reinforced if consumers normally distributed along product/geographic space– Largest concentration of consumers around mean of distribution

• Identical location – homogeneous products, Bertrand price competition

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Monopolistic Competition

Hotelling model

• Assume two firms locate at end-points (maximize product differentiation) to minimize price competition/maximize market power

• Product differentiation establishes clienteles (market niches) and allows firm to enjoy some market power over clientele

• 2-stage game: firms choose location (anticipating outcome of price competition), then firms simultaneously chooses prices– Optimal location at end-point of 2-dimensional geographic space (straight

line)

– Consumers located at X [0, 1] – total cost to each consumer of two products located at respective end-points

• Product at 0: P0 + TX

• Product at 1: P1 + T(1-X)

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Monopolistic Competition

• 2-stage game

• Each consumer purchases 0 or 1 unit of product

• Consumers have following preferences:– U = V* - total cost of product

– If U(0) > U(1) > 0 or U(0) > 0 > U(1), then buys product at 0

– If U(1) > U(0) > 0 or U(1) > 0 > U(0), then buys product at 1

– If 0 > U, buys neither

• Distribution of consumers by preferred location (X): F(X)– F(0) = 0

– F(1) = 1

– Critical value of X: consumers indifferent between two varieties• V* - [P0 + TX] = V* - [P1 + T(1-X)] > 0

• X^ = [P1 – P2 – T]/2T

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Monopolistic Competition

Case 1

• Overlapping demand P1 – P0 < T

– D(0, P1, P0, T) = N[F(X^)]

– D(1, P1, P0, T) = N[1-F(X^)]

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U

0 1

V* - P0

V* - P1V* - P0 – TX

V* - P1 – T(1-X)

X^

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Monopolistic Competition

Case 2

• Product at 0 has entire demand P1 – P0 > T

– D(0, P1, P0, T) = N for P0 P1 - T

– D(1, P1, P0, T) = 0

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Monopolistic Competition

Case 3

• Separate monopolies at 0 and 1 – demand curves do not overlap

• P0 , P1 [V* - T, V*] P0 + P1 + T > 2V*

– D(0, P1, P0, T) = N[F(X0)] where X0 = (V* - P0)/T

– D(1, P1, P0, T) = N[1-F(X1 )] where X1 = (T - V* - P1)/T > X0

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X0 X1

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Monopolistic Competition

Circular model

• Consumers distributed uniformly along circumference of circle

• No tendency for two firms to locate in same location– Product differentiation

• Consider case where there are no barriers to entry– Assumptions:

• Consumers distributed uniformly along circumference of circle

• Length of perimeter (circumference) = 1

• “Travel” occurs along circumference (not along line between two points)

• Linear transportation costs (T per unit)

• Firms can locate at only point

• Identical unit costs (C)

• Fixed entry cost (Z: sunk cost)

• Location of firms exogenously determined to allow for maximal differentiation

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Monopolistic Competition

Circular model

• Consider case where there are no barriers to entry– Solution:

i = 0 (because of entry)

• N (number of firms, brands) = T/Z

• Pi = C + TZ

• P > C even though = 0

• P increases as Z, T increase

• N increases as Z decreases, T increases (P – C) decreases

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Monopolistic Competition

Circular model

• Alternative outcome: brand proliferation by incumbent – crowd product space to block entry– Entry deterrence greater for brand proliferation if there are economies of

scope, fixed costs