OLIGOPOLYChapter 27

What determines how much market power a firm has?

How do firms in an oligopoly set prices and output?

What problems does an oligopoly have in maintaining price and profit?

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Maximizing Oligopoly Profits

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What does market power really mean?

Market power is the key to control. Monopoly is a type of power that all firms

dream of, yet pure monopoly is not permitted in our economy.

The next best thing is to PUSH the power base to the very edge of government acceptance. Gaining market share is a common term we hear from businesses and Wall Street.

MARKET POWER

Tom Thumb wants to gain market share from Albertsons.

Wal-Mart wants market share from Kmart… boy did they get it!

Central Market wants market share from Whole Foods

Google wants market share from Facebook.

“Defending the Lead”World-wide PC vender market share for third quarter. DMN- 10/16/08

HP 18.4% Dell 13.6% Acer 12.5 Lenova 7.3 Toshiba 4.6 Others 43.7%

Top 5 Worldwide PC Vendors, Market Share 4Q12 (unit shipment) World-wide quarterly report – 1/2013

http://www.icharts.net/chartchannel/top-5-worldwide-pc-vendors-market-share-4q12-unit-shipment_m37bzspdc

Share of market- pizza and Iphones

Market Share-North Texas July 2013

Grocery Store % of market share

Walmart 27.8

Kroger 14.5

Tom Thumb 10.1

Albertsons 6.9

Target ,super 6.7

Sam’s 5.2

Costco 5.2

HEB Central Market 2.5

Whole Foods 1.2

Market Street 1.0

Who is sharing?

Oligopoly is no exception… Outstanding feature of Oligopoly is “fewness”

OLI (derivation actually means few.. (do you remember your Oligarchy in government?)

Oligopoly has few sellers- so few that at least one firm is large enough to INFLUENCE PRICE

The vast amount of GDP is accounted for by firms in oligopolistic industries.

Oligopoly (cont'd)

Oligopoly

A market situation in which there are very few sellers.

Each seller knows that the other sellers will react to its changes in prices and quantities.

Oligopoly (cont'd)

Strategic Interdependence

A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry

Such dependence can exist only when there are a limited number of firms in an industry.

Oligopolist

The oligopolist is a price searcher. It produces the quantity of output at which

MR = MC.

Characteristics of Oligopoly

1. Few firms control the market

2. High barriers to entry

3. Produce either differentiated or homogeneous products

4. Lack of available substitutes

5. Name some examples!

Barriers to entry

Patents Control distribution

outlets (ticketmaster)(shelf-space for Fritos)

Mergers and acquisitions

Government regulation

Nonprice Competition (big buck advertising)

Training (technology know-how-training employees to use a certain product..changing is difficult

Network Economies-get there first with the most (don’t buy a phone if your friends don’t have one.)

Industries that are oligopolies

Steel industry Aluminum Film Television Cell phone Gasoline Airline

Companies - oligopolies Four music companies control 80% of the market -

Universal Music Group, Sony Music Entertainment, Warner Music Group and EMI Group

Six major book publishers - Random House, Pearson, Hachette, HarperCollins, Simon & Schuster and Holtzbrinck

Four breakfast cereal manufacturers - Kellogg, General Mills, Post and Quaker

Two major producers in the beer industry - Anheuser-Busch and Miller/Coors (reason why it is not FTC watched)

Two major providers in the healthcare insurance market - Anthem and Kaiser Permanente

Small transportation – UPS, Fed X

Oligopoly (cont'd)

Why oligopoly occurs

Economies of scale

Barriers to entry

Mergers Vertical mergers

Horizontal mergers

Price and Output Under 3 Oligopoly Theories

Cartel Theory - oligopolistic firms act as if there were only one firm in the industry.

Kinked Demand Curve Theory - assumes that if a single firm in the industry cuts prices, other firms will do likewise, but if it raises price, other firms will not follow suit. The theory predicts price stickiness or rigidity.

Price Leadership Theory - the dominant firm in the industry determines price, and all other firms take their price as given.

Why are certain industries composed of only a few firms?

cost economies and other barriers to entry keep the numbers small

mergers keep out the smaller guys) (enter the political key on who decides if mergers are not eliminating competition)

if economies of scale are substantial, reasonably efficient production will be possible only with a small number of producers… efficiency requires that the productive capacity of each firm be large relative to the total market. (large market share)

Continued

Technological progress has made more and more economies of scale attainable over time.

Other barriers such as: patents, control of strategic raw materials, in some cases prodigious advertising

(Budweiser) outlays which add a financial barrier to entry for other firms.

What does prodigious mean?

http://www.youtube.com/watch?v=o-r4Z1K_LDc

What do we see in the 21St Century?

Many big corporations seeking more market share have been following a simple rule.“Don’t build what you can buy.”

WSJ, February13,2006

Part of this zeal to purchase is to fill some of the empty production space created in the building boon of late 90’s…. This will allow for movement to capacity production which is more efficient. (translated- full employment.)

Oligopoly (cont'd)

Vertical Merger The joining of a firm with another to which it sells

an output or from which it buys an input

Horizontal Merger The joining of firms that are producing or selling a

similar product

Oligopoly (cont'd)

Measuring industry concentration

Concentration Ratio The percentage of all sales contributed by the leading

four or leading eight firms in an industry

Sometimes called the industry concentration ratio

Ways to measure degree of Oligopolization

Concentration Ratio: This ratio tells the share of output (or combined

market share) accounted for by the largest firms in an industry OR… the total percentage share of industry sales that each firm possesses.

Sometimes the market share of one company in the oligopoly is so great that it nearly resembles a monopoly. (remember the cell phone chart?)

Computing the Four-Firm Concentration RatioReferred as HHI Index

Are their other ways to get market power?

Sure… several smaller firms can act in unison in the amount they supply and price they charge..

Even in small towns firms can have market power… (ACE Hardware, Krispy Kreme, or the Dunkin’Donut store in Eastjapip, NJ)

Key Point

Concentration ratio is a quantitative measure of oligopoly

The total percentage share of industry SALES of the four leading firms is the industry concentration ratio. (who has higher % of sales Ford, GM, or Chrysler?) (the increased foreign trade has minimized the impact of the HHI ratio.)

Obviously, the total aggregate sales are compiled = $ Then the sales for each firm is calculated. Come up with certain% of market share…

Herfindahl-Hirschman Index HHI

This is the sum of the square of the market shares of each firm in the industry.

Example.. Monopolist – one company controls entire industry = 100% market share. HHI would be 100 (squared) 100x100 = 10,000 (All monopolies have 10,000 HHI)

If firm A has 25% and firms B,C,D also have 25 %Take 25 x 25= 625 Add them up

(625+625+625+625 =2,500 or the total number of squares for industry power is 2,500

Each firm has 625 squares.

Market Power

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Oligopoly (cont'd)

The more U.S. firms face competition from the rest of the world, the less any current oligopoly will be able to exercise market power.

Any ideas that come to mind on this concept?

So, where does government enter in this equation?

1. The Anti-trust division of the Justice Department and the applicable IRC has to decide if a gain of X% of the market share is destroying competition or not when a merger is suggested.

HP/Compaq (will this destroy the competitive edge for Dell?)

AMR/U.S. Air ????2. In 1992 the Justice Dept decided to use other parameters

in determining anti-trust and destructive competition---- barrier to entry. If low, then highly concentrated industry might be compelled to behave more competitively. (hence, contestability and structure were now added to the merger equation.)a) does it look like a monopoly?b) does it behave like a monopoly?

What happens if one increases sales?

Increased Sales at the Prevailing Market Price Increases in the market share of one oligopolist

necessarily reduce the shares of the remaining oligopolists.

• It is possible that an increase in sales by lowering the price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. But it doesn’t happen without setting off alarms within the industry..(Delta lowers its price- Southwest follows) (Pepsi lowers price to sell more.. Coke follow? Kinked Demand Curve concept

What is the objective here?

Then what happens???

Retaliation Oligopolists respond to aggressive marketing by

competitors. Step up marketing efforts. Cut prices on their product(s).

Rather than cut prices which causes a general “off the cliff for all concept.” (hence kinked demand curve) Oligopolists will engage in “non-price competition.” Hint:

their products are differentiated for the most part.- American Airlines- more leg room… LOL!

The Kinked Demand Curve Confronting an Oligopolist

The shape of the demand curve facing an oligopolist depends on the responses of its rivals to a change in the price of its own output.

The demand curve will be kinked if rival oligopolists match price reductions but not price increases.

Game Theory

A mathematical technique used to analyze the behavior of decision makers who try to reach an optimal position for themselves through game playing or the use of strategic behavior, are fully aware of the interactive nature of the process at hand, and anticipate the moves of other decision makers.

Game Theory

Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies.

The payoff to an oligopolist’s price cut depends on how its rivals respond.

Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.

Game Theory

Game theory: the study of how people behave in strategic situations

Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players

Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial

Prisoners’ Dilemma Example

The police have caught Bonnie and Clyde, two suspected bank robbers, but only have enough evidence to imprison each for 1 year.

The police question each in separate rooms, offer each the following deal: If you confess and implicate your partner,

you go free. If you do not confess but your partner implicates

you, you get 20 years in prison. If you both confess, each gets 8 years in prison.

Prisoners’ Dilemma Example

Confess Remain silent

Confess

Remain silent

Bonnie’s decision

Clyde’s decision

Bonnie gets

8 yearsClyde gets 8 years

Bonnie gets

20 years

Bonnie gets

1 year

Bonnie goes free

Clyde goes free

Clyde gets 1 year

Clyde gets 20 years

Confessing is the dominant strategy for both players.

Nash equilibrium: both confess

Prisoners’ Dilemma Example

Outcome: Bonnie and Clyde both confess, each gets 8 years in prison.

Both would have been better off if both remained silent.

But even if Bonnie and Clyde had agreed before being caught to remain silent, the logic of self-interest takes over and leads them to confess.

Moves in the economy

Pepsi meets to decide how to gain market share

If they reduce Pepsi cost in Plano, and have increased promotion, what will Coke respond with? Are they looking over their shoulder?

Will any of that strategy be applied throughout the U.S. or is it effective only regionally.

Dr. Pepper… what would strategy be in NE?

Price and OutputChecking the corporate pie for profit!

Price and Output Price discounting can

destroy oligopoly profits.

When it occurs, rival oligopolists seek to end it as quickly as possible.

Price and Output

To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.===Illegal in U.S. – OPEC is example of how this works (Cartel)

Drug Cartel in Mexico.

Allocation of Market Shares

One way to distribute output is a cartel agreement.

A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market.

Cartels are illegal in the United States…OPEC (Organization of Petroleum Exporting

Countries) is the most famous now.(11 countries)

http://www.opec.org

Let’s Look at Cartels

Each producer is assigned a % they may produce in the market. These are explicit production-sharing agreements. (most cheat due to high oil prices in market)

Saudi Arabia has increasingly violated the % they were assigned by OPEC several times to: increase their market share and to help out the U.S.

They may be less willing to do this in the future (continued war/Iraq)(new terrorism problems) (other countries join to ostracize any Arab nation that cooperates with U.S.) (supply/demand) (U.S. reduces dependency on oil… OPEC won’t want to stray too far.

The Cooperative Game: A Collusive Cartel

Cartel An association of producers in an industry that

agree to set common prices and output quotas to prevent competition.

PRICE FIXING IS ILLEGAL Price Fixing Examples

Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators.

They were charged again in 1972 for continued price fixing.

School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states.

So, you think they don’t fix prices? Gasoline – Mobil, Chevron and Shell paid $77

million in 1993 to settle charges that they conspired to fix gasoline prices.

Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD.

The airline industry is being investigated as of 3/8/06 to see if they fixed prices on jet fuel purchases.

WSJ- November 13, 2008

“LCD Makers Plead Guilty to Price Fixing” Sharp, LG Display, Chunghwa Fined $585

million for schemes affecting TV sets, other products.

Criminal charge Consumers paid higher prices for TVs,

cellphones, and other products using liquid-crystal displays.

Whirlpool, rivals face price fixing probe Michigan business news in brief: Whirlpool, rivals

face price fixing probeFebruary 19, 2009, Detroit Free Press

Wired PR News – Microsoft Corp. has been fined for alleged price-fixing. As reported by the Associated Press (AP), the company’s German subsidiary was fined 9 million euros, which is the equivalent of $11.8 million, for purportedly illegally influencing the retail prices for their Microsoft Office 2007 software programs.April 13, 2009

TX Doctors agree to settle price-fixing (2006)

The FTC’s complaint alleges that Health Care Alliance of Laredo, LC (HAL), a multi-specialty IPA with about 80 physician members, restrained competition among the members in violation of Section 5 of the FTC Act. HAL claimed it employed a “messenger model” process to negotiate contracts. If properly orchestrated, a messenger model process does not restrain competition. HAL engaged in collective bargaining, however, and did nothing that might justify its challenged conduct.

2009

FTC Settles Price-Fixing Charges Against San Francisco Bay Area Doctors’ Group

For Release: 02/28/2013 Eight Puerto Rico Kidney Doctors Settle

FTC Price-Fixing Charges

Nephrologists Will No Longer Boycott Insurers and Patients to Obtain Higher Prices

April 11, 2012

Justice Department sues Apple, publishers over e-book prices

The Justice Department on Wednesday accused five of the nation’s largest publishing houses and Apple of fixing prices on e-books, forcing consumers to pay tens of millions of dollars more for their favorite titles.

How do we know?

Price Leadership or Fixing?

Leadership is acceptable.. Fixing is not.

Sometimes they send up smoke signals to alert their rivals about a price increase in hopes the rivals will follow.

Whenever oligopolist successfully raises prices, unit sales will decline. (old theory)

This has become theory since Delta began charging for baggage. Now carry-on’s are being charged by Spirit

What happens if AA lowers airline fares?

Graph for a price-fixing oligopolist

The graph for a price-fixing oligopolist will look exactly like the monopolist.

The Benefits of Cheating on the Cartel Agreement I The situation for a

representative firm of a cartel: in long-run competitive equilibrium, it produces q1 and charges P1, earning zero economic profits.

As a consequence of the cartel agreement, it reduces output to qC and charges PC.

Its profits are the area CPCAB. If it cheats on the cartel

agreement and others do not, the firm will increase output to qCC and reap profits of FPCDE.

The Benefits of Cheatingon the Cartel Agreement II

Note, however, that if this firm can cheat on the cartel agreement, so can others. Given the monetary benefits gained by cheating, it is likely that the cartel will exist for only a short time.

Predatory Pricing - illegal

A company decides to lower its prices for a short period of time to force a competitor out of business. After the competitor leaves, the company then raises price again.

(BroadBand Cable/Internet)

Utah Pie company (forced out by Mrs. Smith’s pies)

http://www.youtube.com/watch?v=nGx4E8w5VHg&NR=1

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Maximizing Oligopoly Profits

Industrymarginal

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Industry average

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Marketdemand

Industry marginalrevenue

Profits

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Profit-maximizing output

Reality of this

Coordination Problems There is an inherent conflict in the joint

and individual interests of oligopolists. Each oligopolist wants industry profits to be

maximized. Each oligopolist wants to maximize it’s own

market share. To avoid self-destructive behavior, each

oligopolist must coordinate production decisions.

Table 27-3 Comparing Market Structures

QUESTIONS?