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1
Chapter 11
Oligopoly
2
Define market structures
Number of sellers Product differentiation Barrier to entry
3
Types of Market Structure
4
Oligopoly:
A small number of firms mutually dependent on one another, and each has a substantial market share
5
Characteristics of Oligopoly
mutual dependence
(or interdependence) each firm has a substantial market
share, thus is big enough to affect market price
barriers to entry
6
Barriers to entry:
Entry limiting pricing Capacity barrier Economies of scope New product development
7
Barriers to entry: strategic deterrence
Entry limiting pricing Capacity barrier Economies of scope New product development
8
Entry limiting pricing
if cost situation allows,
set P< min LAC
of the potential entrant
9
Capacity barrier
Keep excess capacity as a threat for larger Q and lower P.
10
Other barriers:
Economies of scope (multi-product cost barrier) new product development
11
Economic Theories
General Equilibrium theory Mechanism Design theory Decision theory
12
General Equilibrium theory
a relatively large number of individual consumers and producers, how the combined individual efforts help define the environment
trade and production (markets) macroeconomic analysis
– monetary or tax policy– stock markets– interest and exchange rates– trade policy and the role of
international trade agreements
13
Mechanism Design theory
the consequences of different types of rules
the design of compensation and wage agreements that effectively spread risk while maintaining incentives, and the design of actions to maximize revenue, or achieve other goals.
14
Decision theory
theory of one person behavior, or a single player against a big environment.
preferences among alternatives, maximization of benefits and minimization of costs
**how best to acquire information before making a decision.
15
Game Theory
Psychologists:
the theory of social situations
focus on how groups of people interact
study of behavior in situations of interdependence
Key characteristic:
Interdependence
16
Interdependencies
In making choices, people must consider the effect of their behavior on others.
In making decisions, firms may consider how rivals will respond to their price changes or new advertising.
17
Basic Elements of a Game
The playersTheir strategiesThe payoffs
18
The Prisoners’ Dilemma
19
Nash Equilibrium
Dominant vs. Dominated Strategy:dominant: a strategy that yields a higher payoff no matter what the other players in a game choosedominated: Any other strategy available
Nash equilibrium occurs when each player has a dominant strategy and follows that strategy
There can be an equilibrium when players do not have a dominant strategy
Prisoner’s dilemma: A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy
20
Raise ad spending Keep same ad spending
Raise adspending
Same spending
$5,500 $5,500 for for American
$5,500 $5,500 for United United
American’s Choices
$2,000 $2,000 for Americanfor American
$8,000 $8,000 for Unitedfor United
$6,$6,000 for Americanfor American
$6,$6,000 for Unitedfor United
$8,000 $8,000 for for American
$2,000 $2,000 for Unitedfor United
Un
ited
’s C
ho
ices
Un
ited
’s C
ho
ices
The Payoff Matrix for an Advertising Game
21
Dominant Strategies
United: increase ad spending American: increase ad spending
22
Equilibrium When One Player Lacks a Dominant Strategy
Raise ad spending Leave ad spending same
Raise adspending
Leave adspendingthe same
$4,000 $4,000 for Americanfor American
$3,000 $3,000 for Unitedfor United
$3,000 $3,000 for Americanfor American
$8,000 $8,000 for Unitedfor United
$2,000 $2,000 for Americanfor American
$5,000 $5,000 for Unitedfor United
$5,000 $5,000 for Americanfor American
$4,000 $4,000 for Unitedfor United
American’s Choices
United’s Choices
23
Strategies:
American: dominant – increase ad spending
United: no dominant strategy:– If American increases ad spending, United
should not increase ad spending– If American does not increase ad spending,
United should increase ad spending Nash Equilibrium: American increases ad
spending (dominant strategy), and United does not increase ad spending
24
Exercise 11.1, P. 287
Does each company have a dominant strategy?
What each company should do?
25
Two main branches of game theory
cooperative: all parties involved cooperate (collude) to achieve best result for all
non-cooperative: how intelligent individuals interact with one another in an effort to achieve their own goals.
26
With Mutual Dependence
uncertainty in D and MR– decisions have to take into account of
reactions from others. Cooperative: follow changes initiated by
rivals Non-cooperative: do not accommodate
price changes of other firms
27
Recall: The Prisoners’ Dilemma
28
Non-Cooperative Oligopoly
Each acts for its own benefit, not for the benefits of all players
29
The desire for non-cooperation:
The Prisoners’ Dilemma
30
Raise ad spending Keep same ad spending
Raise adspending
Leave adspendingthe same
$5,500 $5,500 for for American
$5,500 $5,500 for United United
American’s Choices
$2,000 $2,000 for Americanfor American
$8,000 $8,000 for Unitedfor United
$6,$6,000 for Americanfor American
$6,$6,000 for Unitedfor United
$8,000 $8,000 for for American
$2,000 $2,000 for Unitedfor United
Un
ited
’s C
ho
ices
Un
ited
’s C
ho
ices
The desire for non-cooperation: The Prisoners’ Dilemma
31
The desire for non-cooperation: Advertiser’s Dilemma
Gp = 600
Gc = 600
Gp = 900
Gc = -400
Gp = -400
Gc = 900
Gp = 200
Gc = 200
Low Budget
High Budget
Low
B
ud
get
Hig
h
Bu
dg
et
Pepsi
Cok
e
32
Cooperation
The best result for all players
33
Cooperative:
Openly or secretly enter into contract to act for the best result for all members
Partners of a game Tendency to cheat
34
Cooperative Oligopoly: in general
With homogenous products:
behave as monopoly With differentiated products:
– harder to cooperate; – specific agreement in difference in price or
quality;
35
Cooperative Methods
Price Leadership:
one firm sets a price that the other firms follow
Tacit Collusion:
agreement without explicit communication
cooperation without explicit agreement Cartel: an extreme case
36
Cooperative Oligopoly: Cartel
A group of firms with the objective of limiting competitive forces within a market
A coalition of firms that agrees to restrict output for the purpose of earning an economic profit
A collusive agreement by several producers that increases their combined profits by deciding how much each firm should produce
example: OPEC
37
Cartel: Output Allocation among Members – market sharing
Pre-cartel sales Production capacity Bargaining power Importance Marginal cost
38
Market Sharing based on MC
In order to produce the profit maximizing output, a cartel should allocate production among its members so that MC for all member producers are equal, which is also equal to the common MR. That is, MR=MC1=MC2=MC3...
39
Figure 11.1
Assume• 2 firms (Aquapure &
Mountain Spring)• MC = 0• Cartel is formed & agree
to split output and profits
Impact of Cartel
•Q = 1,000 bottles/day
•P = $1/bottle
•Each firm makes $500/day
The Market Demand for Mineral Water
40
Figure 11.2
Aquapure lowers P
•P = $.90/bottle
•Q = 1,100 bottles/day
Mountains Spring retaliates
•P = $.90/bottle
•Both firms split 1,100 bottles/day @ $.90
•Profit for each firm = $495/day
The Temptation to Violate a Cartel Agreement
41
Charge $1/bottle Charge $0.90/bottle
Charge$1/bottle
Charge$0.90/bottle
Mountain Spring
Aquapure
$990/$990/day for day for Mt. SpringMt. Spring
$0 $0 forforAquapureAquapure$500/$500/day day
for eachfor each
$0 $0 for for Mt. SpringMt. Spring
$990 $990 forforAquapureAquapure $495/$495/day day
for eachfor each
The Payoff Matrix for a Cartel Agreement
42
Cartel:
There is intention to cheat Cooperation between players will
increase the payoff in a prisoner’s dilemma
With time there is a motive to enforce cooperation
Explicit agreement is illegal (antitrust; anti price-fixing)
43
Policy Implication: Cigarette Advertising
Advertise on TV Don’t advertise on TV
Advertise on TV
Don’tAdvertiseon TV
$5 $5 million/yrmillion/yrfor Philip Morrisfor Philip Morris
$10 $10 million/yrmillion/yr for for each
$35 $35 million/yrmillion/yr for RJRfor RJR
Philip Morris
RJR
$$20 million/yrmillion/yr for eachfor each$35 $35 million/yrmillion/yr
for for Philip Morris Morris
$5 $5 million/yr/yr for RJRfor RJR