McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Oligopoly Chapter 10.
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Transcript of McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Oligopoly Chapter 10.
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
OligopolyOligopoly
Chapter 10Chapter 10
2
Market Structure
Most firms possess some market power.
3
Degrees of Power
We classify firms into specific market structures based on the number and relative size of firms in an industry.
Market structure – The number and relative size of firms in an industry.
4
Degrees of Power
In imperfect competition, individual firms have some power in a particular product market.
Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service.
LO1
5
Characteristics of Market Structures
Market Structure
Characteristics Perfect
Competition Monopolistic Competition Oligopoly
Number of firms Very large number
Many Few
Barriers to entry None Low High
Market power (control over price
None Some Substantial
Type of product Standardized Differentiated
Standardized or differentiated
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6
Characteristics of Market Structures
Market Structure
CharacteristicsPerfect
Competition Duopoly Monopoly
Number of firms Very largenumber
Two One
Barriers to entry None High High
Market power(control over price
None Substantial Substantial
Type of product Standardized Standardizedordifferentiated
Unique
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7
Determinants of Market Power
The determinants of market power include:
Number of producers.
Size of each firm.
Barriers to entry.
Availability of substitute goods.
LO1
8
Determinants of Market Power
Market power increases:
LO1
The fewer the number of firms in the market.
The larger the relative size of the firms in the market.
The higher the entry barriers.
The fewer the substitutes.
9
Determinants of Market Power
Barriers to entry determine to what extent the market is a contestable market.
Contestable market – An imperfectly competitive industry subject to potential entry if prices or profits increase.
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10
Measuring Market Power
The standard measure of market power is the concentration ratio.
The concentration ratio is a measure of market power that relates the size of firms to the size of the market.
LO1
11
Concentration Ratio
The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).
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12
Firm Size
Market power isn’t necessarily associated with firm size.
A small firm could possess a lot of power in a relatively small market.
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13
Measurement Problems
Many smaller firms acting in unison can achieve market power.
Concentration ratios do not convey the extent to which market power may be concentrated in a local market.
LO1
14
Oligopoly Behavior
Market structure affects market behavior and outcomes.
Assume that the computer market has three oligopolists.
LO1
15
Initial Equilibrium
Initial conditions and market shares of each firms are described in the following slides.
Market share - The percentage of total market output produced by a single firm.
LO2
16
Initial Conditions in Computer Market
20,0000
$1000
Market demand
Quantity Demanded (computers per month)
Pri
ce (
per
com
pute
r)
Industry output
LO2
17
Initial Market Shares of Microcomputer Producers
Producer Output Market Share
Universal Electronics 8,000 40.0%
World Computers 6,500 32.5%
International Semiconductor
5,500 27.5%
Total industry output 20,000 100.0%
18
The Battle for Market Shares
In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms.
LO2
19
Increased Sales at the Prevailing Market Price
Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists.
LO2
20
Increased Sales at Reduced Prices
Lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors.
There simply isn’t any way that a firm can do so without causing alarms to go off in the industry.
LO2
21
Retaliation
Oligopolists respond to aggressive marketing by competitors.
Step up marketing efforts.
Cut prices on their product(s).
LO2
22
Retaliation
One way oligopolists market their products is through product differentiation.
Product differentiation – Features that make one product appear different from competing products in the same market.
23
Retaliation
An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price.
This is why oligopolists avoid price competition and instead pursue nonprice competition.
LO3
24
Rivalry for Market Shares
FG
Marketdemand
$1000900
0 20,000 25,000Quantity Demanded (computers per month)
Pric
e (p
er c
ompu
ter)
LO3
25
The Kinked Demand Curve
Close interdependence – and the limitations it imposes on price and output decisions – is a characteristic of oligopoly.
LO2
26
Rivals’ Response to Price Reductions
The degree to which sales increase when the price is reduced depends on the response of rival oligopolists.
We expect oligopolists to match any price reductions by rival oligopolists.
LO2
27
Rivals’ Response to Price Increases
Rival oligopolists may not match price increases in order to gain market share.
LO2
28
The Kinked Demand Curve Confronting an Oligopolist
The shape of the demand curve facing an oligopolist depends on how its rivals responded 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.
LO2
29
1000
PR
ICE
(pe
r co
mpu
ter)
QUANTITY DEMANDED (computers per month)0
The Kinked Demand Curve Confronting an Oligopolist
Demand curve facing oligopolist if rivals match price changes
Demand curvefacing oligopolist ifrivals don't matchprice changes
Demand curve facing oligopolist if rivals match price cuts but not price hikes
MA
CD
B$1100
900
8000
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30
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.
LO3
31
Game Theory
Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.
LO3
32
Game Theory
Each oligopolist is uncertain about its rival’s behavior.
The collective interests of the oligopoly are protected if no one cuts the market price.
But an individual oligopolist could lose if it holds the line on price when rivals reduce price.
LO3
33
The Payoff Matrix
A payoff matrix is a table showing the risks and rewards of alternative decision options.
The payoff to an oligopolist’s price cut depends on how its rivals respond.
LO3
34
The Payoff Matrix
The decision to initiate a price cut requires a risk assessment.
X=
cutsprice from
loss ofSize
matchingrivals
of Probabilityvalue
Expected
X+
cutprice
lonefrom Gain
matching notrivals
of Probability
LO3
35
Oligopoly Payoff Matrix
Rivals’ Actions
Universal’s Options
Reduce Price Don’t Reduce
Price
Reduce price Small loss for everyone
Huge gain for Universal; rivals lose
Don’t reduce price
Huge loss for Universal; rivals gain
No change
LO3
36
Oligopoly vs. Competition
Oligopolists may try to coordinate their behavior in a way that maximizes industry profits.
LO3
37
Price and Output
An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit.
Oligopoly firms must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.
LO3
38
Pric
e or
Cos
t (d
olla
rs p
er u
nit)
Quantity (units per period)0
Maximizing Oligopoly Profits
Industrymarginal
cost
Industry average
cost
Marketdemand
Industry marginalrevenue
Profits
J
Profit-maximizing
price
Average costat profit-
maximizingoutput
Profit-maximizing output
LO3
39
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.
LO3
40
Coordination Problems
To avoid self-destructive behavior, each oligopolist must coordinate production decisions so that:
Industry output and price are maintained at profit-maximizing levels.
Each oligopolistic firm is content with its market share.
LO3
41
Price Fixing
The most explicit form of coordination among oligopolists is called price fixing.
Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold.
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42
Examples of Price Fixing
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.
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43
Examples of 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.
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44
Examples of Price Fixing
Vitamin C – The four Chinese suppliers of most of the vitamin C to the U.S. market tripled the price in 2001.
LO3
Baby Formula – Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula.
45
Examples of Price Fixing
Perfume – Thirteen companies paid $55 million in 2006 for fixing prices.
LO3
Art Auction Commissions – In 2000, Southeby’s and Christie’s paid $512 million in fines for fixing commissions throughout the 1990s.
46
Examples of Price Fixing
Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD.
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47
Examples of Price Fixing
Laser Eye Surgery – The FTC charged VISX and Summit Technology with price-fixing that raised the price of surgery by $500 per eye.
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48
Examples of Price Fixing
Memory chips – In 2005, the world’s largest memory-chip (DRAM) makers (Samsung, Micron, Infineon, and Hynix) admitted they fixed prices and paid $700 million in criminal fines.
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49
Price Leadership
Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry.
LO3
50
Allocation of Market Shares
One way to allocate market share 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.
LO3
51
Allocation of Market Shares
An oligopolist may resort to predatory pricing when market shares are not being divided in a satisfactory manner.
Predatory pricing - temporary price reductions designed to alter market shares or drive out competition.
LO3
52
Barriers to Entry
Above-normal profits cannot be maintained over the long-run unless barriers to entry exist.
Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market.
53
Patents
Patents prevent potential competitors from setting up shop.
Competitors have to develop an alternative method for producing a product or receive permission from the patent holder to use the patented process.
54
Distribution Control
The control of distribution outlets can be accomplished through selective discounts, long-term supply contracts, or expensive gifts at Christmas.
55
Mergers and Acquisition
A firm can limit competition by acquiring competitors through mergers and acquisition.
56
Government Regulation
Patents are issued by the federal government.
Licensing requirements imposed by government limit competition.
57
Nonprice Competition
Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market.
58
Training
Early market entry can create an important barrier to later competition.
Customers of training-intensive products (such as computer hardware and software) become familiar with a particular system.
59
Network Economies
The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.
60
Antitrust Enforcement
Market power contributes to market failure when it leads to resource misallocations or greater inequity.
Market failure is an imperfection in the market mechanism that prevents optimal outcomes.
61
Industry Behavior
Antitrust is government intervention designed to alter market structure or prevent abuse of market power.
62
Industry Behavior
There are several problems with the behavioral approach to antitrust law:
Limited government resources.
Public apathy.
Difficulty of proving collusion.
63
Industry Structure
Former Supreme Court Chief Justice Earl Warren observed:
“An industry which doesn’t have a competitive structure will not have competitive behavior.”
64
Objections to Antitrust
Some argue that we shouldn’t punish those who achieved monopolies through hard work and innovation.
Noncompetitive behavior, not industry structure, should be the only concern of antitrust.
65
The Herfindahl-Hirshman Index
The Herfindahl-Hirshman index (HHI) is a measure of industry concentration that accounts for number of firms and size of each.
66
The Herfindahl-Hirshman Index
The Herfindahl-Hirshman Index is computed by summing the squares of the market shares of each firm in an industry.
67
The Herfindahl-Hirshman Index
For policy purposes, the Justice Department decided it would draw the line at a value of 1,800.
68
Contestability
Contestability as well as structure now motivates antitrust decisions.
If entry barriers are low enough, even a highly concentrated industry might be compelled to behave more competitively.
69
Behavioral Guidelines: Cost Savings
The FTC now also looks to see if a proposed merger will allow for greater efficiencies and lower costs.
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
OligopolyOligopoly
End of Chapter 10End of Chapter 10