1 Chapter 12 Principles of Economics by Fred M Gottheil Chapter 12 Price and Output Determination Under Oligopoly PowerPoint Slides prepared by Ken Long

1

Principles of Economicsby Fred M Gottheil

Chapter 12Chapter 12

Principles of Economicsby Fred M Gottheil

Chapter 12Chapter 12

Price and Output Price and Output Determination Under Determination Under

OligopolyOligopoly

PowerPoint Slides prepared by Ken Long©©1999 South-Western College Publishing

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What is Oligopoly?What is Oligopoly?

A market structure consisting of only a few firms producing goods that are close substitutes

©©1999 South-Western College Publishing

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What are some examples of Oligopoly?

What are some examples of Oligopoly?

AutomobilesSteelSoup

Cereals©©1999 South-Western College Publishing

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What determines if a market is an Oligopoly?

What determines if a market is an Oligopoly?

The concentration ratio can be used as a guide


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What concentration ratio constitutes an Oligopoly?What concentration ratio constitutes an Oligopoly?

There is no magic number, but if a large percentage of the sales are from the 4 largest firms, it’s an Oligopoly


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What is an example of a high concentration ratio?What is an example of a high concentration ratio?

Out of 151 firms in the aircraft industry the leading 4 constitutes 79% of total sales


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For more information on industry concentration

check out these web pages -

For more information on industry concentration

check out these web pages -

• http://www.census.gov• http://www.census.gov/econ/www/manumenu.html


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What is the Herfindahl-Hirschman Index (HHI)?What is the Herfindahl-

Hirschman Index (HHI)?A measure of industry

concentration, calculated as the sum of the squares of the market shares held by each firm in the industry


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Calculation of the HHICalculation of the HHI

HHI = s12 + s2

2 + …..sn2

where Si = the ith firms market

share, n= number of firms in industry

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Problems: For an industry with only 1

firm, (monopoly), what would be the HHI?

Problems: For an industry with only 1

firm, (monopoly), what would be the HHI?

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Suppose the industry has 10 equal size firms, what

is the HHI?

Suppose the industry has 10 equal size firms, what

is the HHI?What if the industry has

100 equal size firms?

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Answers:Answers:

Monopoly, HHI = 10,00010 equal size firms, HHI = 1,000100 equal size firms, HHI = 100

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How Oligopolistic is the U.S. Economy?

How Oligopolistic is the U.S. Economy?

Oligopoly is very much of a fact of life in the U.S.


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Is the U.S. becoming more Oligopolistic?

Is the U.S. becoming more Oligopolistic?

Answer appears to be NO to this question. While there have been some

periods of time when industries appeared to be getting more

concentrated into fewer firms, there are other periods of history where just

the opposite happened.

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What is Market Power?What is Market Power?A firm’s ability to select

and control market price and output


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What is anUnbalanced Oligopoly?

What is anUnbalanced Oligopoly?An oligopoly in which

the sales of the leading firms are distributed unevenly among them


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What is aBalanced Oligopoly?

What is aBalanced Oligopoly?

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


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In which type is market power most concentrated?In which type is market

power most concentrated?Unbalanced Oligopoly


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Why do Oligopolies exist?Why do Oligopolies exist?MergersEconomies of scaleReputationStrategic barriersGovernment barriers


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What is aHorizontal Merger?

What is aHorizontal Merger?

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


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What is aVertical Merger?

What is aVertical Merger?

A merger between firms that have a supplier - purchaser relationship


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What is aConglomerate Merger?

What is aConglomerate Merger?A merger between firms

in unrelated industries


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For more information on mergers check out these sites:

For more information on mergers check out these sites:

• http://www.stocksmart.com/newsipos.html

• http://www.antitrust.org• http://www.usdoj.gov/atr/index.html

• http://www.usdoj.gov/atr/guidelin.htm• http://www.ftc.gov


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Firms in Oligopoly are said to be Mutually

Interdependent

Firms in Oligopoly are said to be Mutually

InterdependentFirms realize the large impact that other

firms behavior has on their profitsLeads to many models of oligopoly,

depending on how the firms deal with the mutual interdependence issue

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One way to deal with the Mutual Interdependence

problem is…..

One way to deal with the Mutual Interdependence

problem is…..LET’S CHEAT!!!!THE COLLUSION

SOLUTION!!!

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What is Collusion?What is Collusion?The practice of firms to

negotiate price and market decisions that limit competition


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What is a Cartel?What is a Cartel?A group of firms that

collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares


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One model of collusion that can be used is the

cartel model

One model of collusion that can be used is the

cartel model• Internationally, some cartels like

OPEC exist• Domestically, these would be

illegal• If the cartel can collude perfectly,

would tend to charge the monopoly price

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Ingredients for a successful cartelIngredients for a successful cartel

• Control a large share of the market• Inelastic and stable demand for the product• Similar costs among cartel members• Fairly homogenous product• Few number of firms• Ways of preventing cheating on the

agreement

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Check out the Opec CartelCheck out the Opec Cartel

• http://www.opec.org

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What is the relationship between market

concentration and price?

What is the relationship between market

concentration and price?A high concentration ratio in

an industry may translate into noncompetitive prices and behavior


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Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts

but not price increases. Under this assumption, its as if each firm faces a

“kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals

quickly match price cuts.

Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts

but not price increases. Under this assumption, its as if each firm faces a

“kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals

quickly match price cuts.

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Kinked Demand CurveKinked Demand Curve

P1

Starting price

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DMR

MR Gap

Price

QuantityQ1

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Graph explanation: Let P1 and Q1 be the existing price and quantity for

this oligopoly firm: due to the assumptions of this model, the

demand curve has a kink in it at this price and output. Because of the

strange shape of the demand curve, the MR curve is discontinuous, or

has a gap in it.

Graph explanation: Let P1 and Q1 be the existing price and quantity for

this oligopoly firm: due to the assumptions of this model, the

demand curve has a kink in it at this price and output. Because of the

strange shape of the demand curve, the MR curve is discontinuous, or

has a gap in it.

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Kinked demand curve model is an attempt to explain rigid prices in

oligopoly: That is, firms might not change price very often. Why? Firm

is reluctant to raise price if its competitors do not, since it could lose sales to them, and little reason is seen to lower price if competitors quickly

match the price cut, since little will be gained.

Kinked demand curve model is an attempt to explain rigid prices in

oligopoly: That is, firms might not change price very often. Why? Firm

is reluctant to raise price if its competitors do not, since it could lose sales to them, and little reason is seen to lower price if competitors quickly

match the price cut, since little will be gained.

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What does the kinked demand curve illustrate?What does the kinked

demand curve illustrate?There is a great deal of price

stability and nonprice competition is important


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How do firms in an Oligopoly set price?How do firms in an Oligopoly set price?

Most often they practice price leadership


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Price leadership in Oligopoly

Price leadership in Oligopoly

One firm, the dominant firm, sets the price, others follow the leader

Often the dominant firm is the low cost producer in the industry

Is this a form of “tacit” collusion?

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What is an example nonprice competition?What is an example

nonprice competition?Brand multiplication

when there are variations on one good to increase market share


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Game Theory Approach to Oligopoly

Game Theory Approach to Oligopoly

Is Oligopoly best analyzed as a strategic game like chess?

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What is Game Theory?What is Game Theory?A theory of strategy

ascribed to a firm’s behavior in oligopoly


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For more information about Game Theory -

For more information about Game Theory -

• http://www.pitt.edu/~alroth/alroth.html


Prisoner's Dilemma Prisoner's Dilemma

a

Bob’sChoices

Nathan’s Choices

NotConfess

Confess

Confess

Not Confess

Nathan pays $2,000

Bob pays $2,000

Nathan pays $5,000

Bob pays $500

Nathan pays $500

Bob pays $5,000

Nathan pays $3,000

Bob pays $3,000

1 2

3 4

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If the 2 people could collude, would likely choose to not confess, but self interest may drive each to confess, hoping the other does not, end up both confessing, worse off for both—many similar situations perhaps for firms in oligopoly

Two firm gameTwo firm game

a

Firm B’sChoices

Firm A’s Choices

Hold toAgreement

BreakAgreement

BreakAgreement

Hold toAgreement

A earns $50,000 profits

B earns $50,000 profits







1 2

3 4

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What is a dominant strategy?

What is a dominant strategy?

A strategy that is best regardless of what the opposition does. For B, dominant strategy is to break the agreement, and also for A. Both firms avoid the worst case scenario in this manner.

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What is a Nash equilibrium? (named for Mathematician John Nash…did you see the film “A

Beautiful Mind?)

What is a Nash equilibrium? (named for Mathematician John Nash…did you see the film “A

Beautiful Mind?)

A situation where neither firm can improve its payoff, given what the other firm is doing…in this example, breaking the agreement is the Nash equilibrium

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Is there any way to get to box 1 where both firms are better off

short of outright collusion?

Is there any way to get to box 1 where both firms are better off

short of outright collusion?Possibility of a tit-for-tat

strategy….somehow indicate to the other firm that although you want to hold the agreement, you will switch to match what the other firm does.

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For a forum that induces the interactive Prisoner’s

Dilemma check out -

For a forum that induces the interactive Prisoner’s

Dilemma check out -• http://

serendip.brynmawr.edu/~ann/pd.html


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What isPrice Discrimination?

What isPrice Discrimination?

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


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Why would a firm want to price discriminate?

Why would a firm want to price discriminate?

Greater profits possible!!

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Different types of Price Discrimination

Different types of Price Discrimination

“Perfect” price discrimination: Charge each buyer the highest price they are willing to pay

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More usual type of price discrimination

More usual type of price discrimination

• Separate buyers into groups (based perhaps on age, sex, region of country, etc.

• Groups should have different elasticities of demand

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Higher price to more inelastic group, lower to more elastic: must also be able to prevent resale

of product

Higher price to more inelastic group, lower to more elastic: must also be able to prevent resale

of product

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• What is Oligopoly?• What concentration ratio

constitutes an Oligopoly?• What is an Unbalanced Oligopoly?• What is a Balanced Oligopoly?• What is Collusion?• What is a Cartel?

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• What is the distinguishing feature of Oligopoly?

• How do firms in an Oligopoly set price?

• What is Game Theory?• What is the Prisoner’s Dilemma?• What is Price Discrimination?

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ENDENDENDEND


Documents

1 Chapter 12 Principles of Economics by Fred M Gottheil Chapter 12 Price and Output Determination Under Oligopoly PowerPoint Slides prepared by Ken Long