chapter 12 price and output determination under oligopoly gottheil — principles of economics, 7e...

Chapter 12Chapter 12

PRICE AND OUTPUT PRICE AND OUTPUT DETERMINATION UNDER DETERMINATION UNDER OLIGOPOLYOLIGOPOLY

Economic PrinciplesEconomic Principles

The concentration ratio and the Herfindahl-Hirschman Index (HHI)

Balanced and unbalanced oligopoly

Horizontal, vertical and conglomerate mergers

Economic PrinciplesEconomic Principles

Cartels

Game theory

Price leadership

Kinked demand

Brand multiplication

Price discrimination

Concentration RatiosConcentration Ratios

For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few—oligopoly.

An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic.

Concentration ratio

• A measure of market power. It is the ratio of total sales of the leading firms in an industry (usually four) to the industry’s total sales.

A criterion for determining whether an industry is an oligopoly:• If the leading four firms in an industry

account for 40 percent or more of total industry sales, then an industry is likely to be an oligopoly.

Herfindahl-Hirschman index

• A measure of industry concentration, calculated as the sum of the squares of the market shares held by each of the firms in the industry.

EXHIBIT 1 CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI

Source: U.S. Bureau of the Census, 2002; Concentration Ratios in Manufacturing, 2004.

Exhibit 1: Concentration Ratios— Exhibit 1: Concentration Ratios— Percentage of Total Industry Sales Percentage of Total Industry Sales

Produced by the Leading FourProduced by the Leading FourFirms, and HHIFirms, and HHI

How many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level?• 13 of the 15 industries

EXHIBIT 2 DISTRIBUTION OF MANUFACTURING INDUSTRIES BY FOUR-FIRM SALES CONCENTRATION

Exhibit 2: Distribution of Exhibit 2: Distribution of Manufacturing Industries by Manufacturing Industries by

Four-Firm Sales ConcentrationFour-Firm Sales Concentration

How many industries had four-firms controlling 40-59 percent of the industry sales in 1982? • 120 out of 448 total industries had four firms

controlling 40-59 percent of the total industry sales.

Oligopoly and Concentration RatiosOligopoly and Concentration Ratios

Contrary to many people’s intuition, there is no convincing evidence that the share of industry sales controlled by the four leading firms in the US manufacturing economy is growing.

EXHIBIT 3 PERCENTAGE OF TOTAL INDUSTRIAL SALES PRODUCED BY INDUSTRIES WITH FOUR-FIRM SALES CONCENTRATION RATIOS OF 50 PERCENT OR MORE: 1895–1982

Exhibit 3: Percentage of Total Industrial Exhibit 3: Percentage of Total Industrial Sales Produced by Industries with Four-Sales Produced by Industries with Four-Firm Sales Concentration Ratios of 50 Firm Sales Concentration Ratios of 50

Percent or More: 1895–1982Percent or More: 1895–1982

What is the trend in the percentage of industrial sales produced by the largest four firms since 1963? • There is a downward trend in the percentage

of industrial sales by the largest four firms from 1963 to 1982.

Market power

• A firm’s ability to select and control market price and output.

Unbalanced oligopoly

• An oligopoly in which the sales of the leading firms are distributed unevenly among them.

Balanced oligopoly

• An oligopoly in which the sales of the leading firms are distributed fairly evenly among them.

EXHIBIT 4 BALANCED AND UNBALANCED OLIGOPOLY

Exhibit 4: Balanced and Exhibit 4: Balanced and Unbalanced OligopolyUnbalanced Oligopoly

1. What percentage of their industry’s total sales do the leading four firms in Industry A and B control?

• The leading four firms in both industry A and B control 80 percent of their industry’s sales.

Exhibit 4: Balanced and Exhibit 4: Balanced and Unbalanced OligopolyUnbalanced Oligopoly

2. Why is industry B considered an unbalanced oligopoly?

• The largest firm in industry B controls 50 percent of the industry’s sales. It’s market share is greater than the other three leading industries combined and more than four times greater than the next largest firm’s sales share.

Oligopoly and Concentration Ratios Oligopoly and Concentration Ratios

• The dominance of oligopolies in industry is not unique to the U.S.

• The concentration ratios for U.S. industries are similar to other modern industrialized economies.

EXHIBIT 5 PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS

Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano Memorial Society, p. 162.

Exhibit 5: Production Concentration Ratios Exhibit 5: Production Concentration Ratios in Japanese Manufacturing Industries by in Japanese Manufacturing Industries by

Leading and Five Leading FirmsLeading and Five Leading Firms

In how many Japanese industries do the five leading firms have greater than a 90 percent production concentration ratio? • Four industries—beer, nylon, glass, and tires and

tubes—are controlled by the five leading firms at a concentration of 90 percent or greater.

Concentrating the ConcentrationConcentrating the Concentration

An oligopoly can build market power in two ways:• Reinvesting its profit and painstakingly

expanding its production capacity.

• Merging with and/or acquiring other firms.

There are three reasons why firms merge:1. To exercise greater market control.

2. To increase control over the supplies of their inputs or the buyers of their goods.

3. To expand and diversify their asset holdings.

There are three types of mergers:

1. Horizontal merger

2. Vertical merger

3. Conglomerate merger

Horizontal merger

• A merger between firms producing the same good in the same industry.

A number of high-profile horizontal mergers occurred in the 1990s.• Boeing and McDonnell Douglas in the aircraft

industry.

• Staples and Office Depot in the office supply industry.

• Union Pacific and Southern Pacific Rail in the railroad industry.

Vertical merger

• A merger between firms that have a supplier-purchaser relationship.

An example of vertical merging is that of Anheuser-Busch.

The firm has acquired malt plants, yeast plants, a corn-processing plant, beer can factories, and a railway that ships freight by rail and truck.

Conglomerate merger

• A merger between firms in unrelated industries.

The conglomerate merger is the most common type of merger.

• One reason for conglomerate mergers is the desire to diversify operations.

• While horizontal and vertical mergers strengthen the firm’s position within the industry, the fate of the firm rests on the health of the industry.

• Acquiring unrelated firms insures the conglomerate against catastrophe if one industry faces severe problems.

Cartel

• A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares.

Collusion

• The practice of firms to negotiate price and market share decision that limit competition in a market.

Cartels are an example of a merger in which firms don’t have to actually buy each other’s assets, yet they enjoy the benefits of having market power.

• While cartels are illegal in the United States, it is difficult to prove collusion.

• Some governments encourage cartels to form in their countries. OPEC is one example.

Many studies support the contention that price and concentration ratios move in the same direction – an increase in one is associated with an increase in the other.

Mergers without MergingMergers without Merging

Firms don’t have to merge or acquire each other to gain the advantages of merging. They can remain independent by creating a joint venture or joining a cartel.

Joint venture

• A business arrangement in which two or more firms undertake a specific economic activity together.

Cartel

• A group of firms that collude to limit competition in a market by negotiating and accepting agreed upon price and market shares.

Collusion

• The practice of firms to negotiate price and market share decisions that limit competition in a market.

Cartel PricingCartel Pricing

• A cartel determines price by acting as if it is a monopoly.

• Price and quantity are determined using the MR = MC rule.

EXHIBIT 6 CARTEL PRICING AND OUTPUT ALLOCATIONS

Exhibit 6: Cartel Pricing and Exhibit 6: Cartel Pricing and Output AllocationsOutput Allocations

Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?• The price and output decisions made by the

cartel are determined by the MR = MC rule.

Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?• The price and quantity assigned to individual

firms within the cartel may not coincide with where the firm would maximize profit using its own MR and MC curves.

Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?

• There is an incentive for the firm to try to secretly increase quantity and thereby increase its own profit.

EXHIBIT 7 RELATIONSHIP BETWEEN THE CONCENTRATION RATIO AND PRICE

Exhibit 7: Relationship Between the Exhibit 7: Relationship Between the Concentration Ratio and PriceConcentration Ratio and Price

Where on the curve in Exhibit 7 does the concentration ratio have the strongest effect on price?

• The effect is the strongest in the middle of the S-shaped curve.

Theories of Oligopoly PricingTheories of Oligopoly Pricing

In monopoly, monopolistic competition and perfect competition, firms react only to the demand and cost structures they face. Prices tend toward equilibrium.

In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change.

Game theory

• A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent.

Nash equilibrium

• A set of pricing strategies adopted by firms in which none can improve its payoff outcome, given the price strategies of the other firm or firms.

Payoff matrix

• A table that matches the sets of gains (or losses) for competing firms when they choose, independently, various pricing options.

EXHIBIT 8 FIRM PROFIT, GENERATED BY HIGH AND LOW PRICING

EXHIBIT 9 PAYOFF MATRIX

Exhibits 8 & 9: Firm Profit Generated Exhibits 8 & 9: Firm Profit Generated by High and Low Pricingby High and Low Pricing

How does total profit change as Dell and Compaq change their prices?• When both firms price high, total profit is 20.

When one firm prices high and the other prices low, total profit is 18. When both firms price low, total profit is 12.

Price leadership

• A firm whose price decisions are tacitly accepted and followed by other firms in the industry. The theory explains pricing in unbalanced oligopolies.

Tit-for-tat

• A pricing strategy in game theory in which a firm chooses a price and will change its price to match whatever price the competing firm chooses.

EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF GODFATHER OLIGOPOLY

Exhibit 10: Price and Output Under Exhibit 10: Price and Output Under Conditions of Godfather OligopolyConditions of Godfather Oligopoly

How is the price of chocolate determined in Exhibit 10?• Hershey is the “godfather” in the chocolate

business. Hershey produces where its MR = MC. That is, 5 tons of chocolate at $5 per pound. The other firms in the chocolate industry accept the $5 per pound price.

EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND CURVE

Exhibit 11: Constructing an Exhibit 11: Constructing an Oligopolist’s Demand CurveOligopolist’s Demand Curve

1. If Lipton were to raise its price above $0.80 per box, what would its competitors do, according to the curve in panel b?• Lipton’s competitors would not follow suit.

Lipton’s demand curve above $0.80 (NK) is relatively elastic.

Exhibit 11: Constructing an Exhibit 11: Constructing an Oligopolist’s Demand CurveOligopolist’s Demand Curve

2. If Lipton were to lower its price below $0.80 per box, then what would its competitors do?• Lipton’s competitors would feel compelled to

follow suit. Lipton’s demand curve below $0.80 (YK) is relatively inelastic.

Kinked demand curve

• The demand curve facing a firm in oligopoly; the curve is more elastic when the firm raises price than when it lowers price.

EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH KINKED DEMAND CURVES

Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked

Demand CurvesDemand Curves

The marginal revenue curve associated with a kinked demand curve is:i. Continuous

ii. Discontinuous

The marginal revenue curve associated with a kinked demand curve is:i. Continuous

ii. Discontinuous

As long as the MC curve crosses the gap created by the discontinuity in the MR curve, price will remain unchanged, as shown in panel b.

If the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c.

Brand MultiplicationBrand Multiplication

Brand multiplication

• Variations on essentially one good that a firm produces in order to increase its market share.

Brand MultiplicationBrand Multiplication

• A firm’s market share =

(Number of brands) × (Brand market share).

• As the number of brands in the industry increases, market share per brand diminishes.

Price DiscriminationPrice Discrimination

Price discrimination

• The practice of offering a specific good or service at different prices to different segments of the market.

• Oligopolists sometimes segment the market in order to charge consumers what they are willing to pay for a good or service.

• Differences in airline ticket prices are a good example.

EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK

Exhibit 13: Demand Schedule Exhibit 13: Demand Schedule for a United Airlines Round-Trip for a United Airlines Round-Trip

Flight Between LA and NYFlight Between LA and NY

If United chose not to segment its market in Exhibit 13, what would be its total revenue?• The maximum total revenue for United

would be achieved at a ticket price of $318 each, for a total of $119,250.

EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK

Exhibit 14: Demand by Market Exhibit 14: Demand by Market Segment for a United Airlines Round-Segment for a United Airlines Round-

Trip Flight Between LA and NYTrip Flight Between LA and NY

What is United’s total revenue when it segments its market into a multiple-fare system?• United’s total revenue is $210,635. This

is an increase of $91,385 over the unsegmented market.

• Price discrimination exists in virtually every market.

• Some differences in price are not clear cases of price discrimination, however.

Why Oligopolists Sometimes Why Oligopolists Sometimes DiscriminateDiscriminate

• For example, many would argue that upper balcony seats are not the same as front row seats at a concert. If the goods are different, then it is not necessarily price discrimination to charge more for the front row seats.

chapter 12 price and output determination under oligopoly gottheil — principles of economics, 7e...

economic principles

industry account

total industries

leading firms

ratio of total sales

industrys total sales

hhi source

measure of market power

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