slide 1 2005 south-western publishing oligopoly chapter 12 oligopolistic market structures »few...
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Slide 12005 South-Western Publishing
Oligopoly Chapter 12
• Oligopolistic Market Structures» Few Firms
• Consequently, each firm must consider the reaction of rivals to price, production, or product decisions
• These reactions are interrelated
» Heterogeneous or Homogeneous Products
• Example -- athletic shoe market» Nike has 47% of market» Reebok has 16% » and Adidas has 7%
Slide 2
Nokia’s Challenge in Cell Phones
• The market shares of oligopolists change. In 1998, the market leader in cell phones was Motorola with 25% market share and Nokia second with 20%
• In 2002, leadership reversed: Nokia held 37% of the market and Motorola 17%
• However, technology in phones is changing, bringing wireless web, photos, and other high-speed G3 technologies
• Entry of other firms and new products, such as Dell, Palm, NEC and Panasonic pose threats to Nokia’s profit margins
• Nokia must decide whether or not to invest heavily in the 3G technology for the future.
• Being a leader in a oligopoly does not mean that you remain the leader for long.
Slide 3
Ignoring Interdependencies:
The Cournot Oligopoly
• Models vary depending on assumptions of actions of rivals to pricing and output decisions.
• Augustin Cournot (1838) created a model that is the basis of Anti-trust Policy in the US.» Relatively simple assumption: ignore the
interdependency with rivals» This makes the math easy
Cournot
Slide 4
A Numerical Example:Competition, Monopoly, and Cournot Oligopoly
• IN COMPETITION» P = MC, so 950 - Q = 50
» PC = $50 and QM = 900
• IN MONOPOLY» MR = MC, so 950 -2Q = 50
» QM = 450 so
» PM = 950 - 450 = $500
• IN DUOPOLY
» Let Q = q1 + q2
D
PM
Pcournot
PC
QM QCournot QC
450 600 900
$500
$350
$50
Let: P = 950 - Q and MC =50
Slide 5
Cournot Solution: Case of 2 Firms (Duopoly)
• Assume each firm maximizes profit
• Assume each firm believes the other will NOT change output as they change output.» The so-called: Cournot Assumption
• Find where each firm sets MR = MC
Slide 6
Let Q Q = q1 + q2
P = 950 - Q = 950 - q1- q2 and MC = 50
TR1 = Pq1= (950- q1-q2)q1 =950q1 - q12 - q1q2
and TR2 = Pq2= (950- q1-q2)q2 =950q2 - q2q1 - q2
2
Set MR1= MC & MR2= MC
950 -2q1 - q2 = 50
950 - q1 - 2q2 = 50
2 equations &2 unknowns
Slide 7
With 2 Equations & 2 Unknowns: Solve for Output
950 -2q1 - q2 = 950 - q1 - 2q2
So, q2 = q1 Then plug this into the demand equation
we find:
950 - 2q1 - q1 = 950 - 3q1 = 50.
Therefore q1 = 300 and Q = 600
The price is: P = 950 - 600 = $350P Q
Competition 50 900Cournot 350 600Monopoly 500 450
Cournot’sanswer is
between theother two.
Slide 8
N-Firm Cournot Model• For 3 firms with linear demand and
cost functions:
» Q = q 1 + q 2 + q 3
» In linear demand and cost models, the solution is higher output and lower price
QCournot = { N / (N+1) }QCompetition
QC
N
N
PC
THEREFORE, Increasing the Number of Firms increases competition. This is the historical basis for Anti-trust Policies
Slide 9
Example: Cournot as N Increases
• If N = 3 Triopoly
• P = 950 - Q & MC=50
• Then, Q = (3/4)(900)• Q = 675• P =$275
• If N = 5• P = 950 - Q and MC
= 50• Then Q = (5/6)(900)• Q = 750• P = $200
N = 3 N = 5
Slide 10
Collusion versus Competition?
• Sometimes collusion succeeds
• Sometimes forces of competition win out over collective action
• When will collusion tend to succeed?» There are six factors that influence
successful collusion as follows:
Slide 11
Factors Affecting Likelihood of Successful Collusion
1. Number and Size Distribution of Sellers. Collusion is more successful with few firms or if there exists a dominant firm.
2. Product Heterogeneity. Collusion is more successful with products that are standardized or homogeneous
3. Cost Structures. Collusion is more successful when the costs are similar for all of the firms in the oligopoly.
4. Size and Frequency of Orders. Collusion is more successful with small, frequent orders.
5. Secrecy and Retaliation. Collusion is more successful when it is difficult to give secret price concessions.
6. Percentage of External Orders. Collusion is more successful when percentage of orders outside of the cartel is small.
Slide 12
Oligopolies & Incentives to Collude
When there are just a few firms, profits are enhanced if all reduce output
But each firm has incentives to “cheat” by selling more
MC MC
P
q
D
QM
incentiveto cut price
MR
Representative firm Industry
Slide 13
Examples of Cartels • Ocean Shipping -- maritime exemption from US Antitrust
Laws• DeBeers -- diamonds• 1950’s Electrical Pricing Conspiracy -- GE,
Westinghouse, and Allis Chalmers• OPEC - oil cartel, with Saudi Arabia making up 33% of
the group’s exports• Siemens and Thompson-CSF -- airport radar systems• NCAA - intercollegiate sports, also Major League
Baseball
Slide 14
PRICE LEADERSHIP
• Barometric: One (or a few firms) sets the price
• One firm is unusually aware of changes in cost or demand conditions
• The barometer firm senses changes first, or is the first to ANNOUNCE changes in its price list
• Find barometric price leader when the conditions unsuitable to collusion & firm has good forecasting abilities or good management
B arom etric P rice L ead er D om in an t F irm P rice L ead er
Slide 15
Barometric Price Leader Example: Citibank & Prime Rate Announcements
• Banking: 6,000 banks and falling, but there are still many banks.
• New York, center of Open Market activities of the Fed Reserve
• Citibank’s announcement represents changes in interest rate conditions to other banks tolerably well.
Slide 16
Dominant Firm Price Leadership
• Dominant Firm: 40% share of market or more.
• No price or quantity collusion
• Dominant Firm (L) expects the other firms (F) to follow its price and produce where
MC F = PL
DT
MC F
DL
Net Demand Curve: DL = DT - MCF
leader’sdemand
Slide 17
• Find leader’s demand curve, DL = (DT - MC F)
• Find where MRL = MCL
DT
MC F
DL
MRL
Graphical Approach to Dominant Firm Price Leadership
Slide 18
• At QL, find the leader’s price, PL
• Followers will supply the remainder of Demand: (QT - QL) = QF
D
MC F
DL
MRL
MCL
PL
QL
Graphical Approach to Dominant Firm Price Leadership
Slide 19
• Followers will supply the remainder of Demand: (QT - QL) = QF
D
MC F
DL
MRL
MCL
PL
QL QT
Graphical Approach to Dominant Firm Price Leadership
Slide 20
Implications of Dominant Firm Price Leadership
• Market Share of the Dominant Firm Declines Over Time» Entry expands MC F, and Shrinks DL and MRL
• Profitability of the Dominant Firm Declines Over Time
• Market Share of the Dominant Firm is PROCYCLICAL» rises in booms, declines in recessions
TIMEprofits
Slide 21
Numerical Example of Dominant Firm Price Leadership
Aerotek is the leader, with 6 other firms, given the following:
1. P = 10,000 – 10 QT is the market demand
2. QT = QL + QF is the sum of leader & followers
3. MCL = 100 + 3 QL and MCF = 50 + 2 QF
What is Aerotek’s price and quantity?» From 2 above, QL = QT – QF and From 1, QT = 1,000 - .1P
» Since followers sell at P=MC, From 3, P = 50 + 2 QF, which rearranged to be QF = .5P - 25
» So, QL = (1,000 - .1P) – (.5P - 25) = 1,025 -.6 P, which can be rearranged to be P = 1,708.3 – 1.67 QL
» MRL = 1,708.3 – 3.34 QL
» And MRL = MCL where: 1,708.3 – 3.34 QL = 100 + 3 QL
» The optimal quantity for Aerotek, the leader is QL 254
» P = 1,708.3 – 1.67 QL = 1,708.3 – 1.67(254) $1,284.
Slide 22
Historical Example:U.S. Steel (USX)
• In early 1901 negotiations among J. P. Morgan, Elbert Gary, Andrew Carnegie, and Charles M. Schwab created United States Steel.» 66% market share in
1901» 46% market share by
1920» 42% share by 1925
profits in adominant firm model
normalprofits
profits when using a lower price
Cokeovens
in. 1912in
Gary, IN
Time
Slide 23
Kinked Oligopoly Demand Curve
• Belief in price rigidity founded on experience of the great depression
• Price cuts lead to everyone following» highly inelastic
• Price increases, no one follows» highly elastic
everyonefollowsprice cuts
no one follows a price increase
a kink at the price
P
Slide 24
A Kink Leads to Breaks in the MR Curve• Although MC rises, the
optimal price remains constant
• Expect to find price rigidity in markets with kinked demand
• QUESTION:» Where would we more
likely find KINKS and where NOT?
P
D
D
MR
MC2
MC1
Slide 25
Which industries are likely to have kinks and which have no kinks?
• The GREATER the number of firms, likely more kinked
• Prices Likely More Rigid
• The more HOMOGENEOUS, likely more kinked
• Prices More Rigid
N = 10
N = 2
homogeneous
heterogeneous
Slide 26
Empirical Evidence vs.
Predictions of the Model
• Oligopolies with few firms were more rigid in FACT
• Oligopolies with homogeneous products were MORE rigid in FACT
22
N
prediction
FACT
heterogeneous homogeneous
prediction
FACT
Slide 27
Are these Empirical Findings Surprising?• A kink is a barrier to profitability• Firms are in business to make profits and avoid
“barriers.”• Simple Alternative Explanations Exist:
» More firms are more competitive» More homogenous products act more competitively
• Collusion leads firms to fix prices. The rigid prices seen in oligopolies are signs of collusion.
Slide 28
Price Rigidities and Employment Impacts
• Price rigidity will make business downturns worse
• Employment will be more volatile over the business cycle if there are price rigidities
D BOOMSD BUSTS
A rigid price
OUTPUT
if price changes with shifts in demand
Q3 Q2 Q1
Slide 29
Oligopolistic Rivalry & Game Theory• John Von Neuman & Oskar Morgenstern--
» Game Theory used to describe situations where individuals or organizations have conflicting objectives
» Examples: Pricing of a few firms, Strategic Arms Race, Advertising plans for a few firms, Output decisions of an oligopoly
• Strategy--is a course of action» The PAYOFF is the outcome of the strategy.
» Listing of PAYOFFS appear in a payoff matrix.
• A Strategy Game – involves decisions with consciously interdependent behavior of two or more participants.
Slide 30
Two Person GameTable 12. 4 page 537
• Each player knows his and opponent’s alternatives
• Preferences of all players are known• Single period game• Each player can invade the territory
of the other (Maraude) or Guard his own territory
• Kahn’s payoff is given first, Randle’s payoff is second.
• Randle ranks Guard above Maraude.• Randle has a Dominant Strategy: a
decision that maximizes welfare independent of the other player’s strategy choice
• Knowing what Randle will do, Kahn decides to Guard as well.
• An Equilibrium--none of the participants can improve their payoff
ASSUMPTIONSRandle
Kahn
Guard
Maraude
Guard Maraude
Better, 1st Worst, 4th
Worse, 2nd Best, 3rd
We will get to {Guard, Guard}which is an Equilibrium
Slide 31
Six or Seven Territories?Table 12.5 on page 538
• Sharp and Xerox compete in copiers. Payoffs for Xerox are in the lower triangle
• The payoffs depend on the number of territories in which they compete
• Sharp has a dominant strategy of 6 territories.
• What should Xerox do?• We see we get to {6, 6}
as the iterated dominate strategy.
Sharp
Xerox
6 territories 7 territories6 territories 7 territories
$40 $70 $35 $55
$30 $60 $45 $45
Slide 32
Other Strategic Games
• These are viewed as single period, but businesses tend to be on-going, or multi-period games
• These are two-person games, but oligopolies often represent N-person games, where N is greater than 2
• Some games are zero-sum games in that what one player wins, the other player loses, like a game of poker
• Other games are non-zero sum games where the whole payoffs depend on strategy choices by all players.
Slide 33
The Prisoner’s Dilemma• Often the payoffs vary
depending on the strategy choices
• The Prisoner’s Dilemma» Two suspects are
caught & held separately
• Their strategies are either to Confess (C) or Not Confess (NC)
» a one period game» Suspect 1 in lower triangle
(Bold Red)
• Noncooperative Solution» both confess: {C, C}
• Cooperative Solution» both do not confess {NC,NC}
• Off-diagonal represent a Double Cross
suspect 2
suspect 1
NC
C
NC C1 yr 0 yrs
15 yrs 6 yrs
1 yr 15 yrs
0 yrs 6 yrs
Slide 34
Paradox?• The Prisoner’s Dilemma highlights the
situation where both parties would be best off it the cooperated
• But the logic of their situation ends up with a non-cooperative solution
• The solution to cooperation appears to be transforming a one-period game into a multi-period game.
• The actions you take now will then have consequences in future periods.