Wednesday, October 17 Handout: Oligopolies

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1 Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Wednesday, October 17 Handout: Oligopolies Review Perfect Competition: Marginal Revenue and Price Perfect Competition Monopoly Large number of small firms. One large firm. A single firm s production A monopoly produces a quantity decisions cannot significantly and charges a price that lies affect the price. on the market demand curve. MR curve is horizontal: MR curve lies beneath demand curve: MR = Price or Price = MR MR < Price or Price > MR Pareto s Efficiency Question: Are we getting the most from our economy s finite resources? Pareto s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most Is the state of affairs getting the most from the economy s resources? No. from the economy s resources? Yes. State of affairs is inefficient. State of affairs is efficient. Perfect Competition, Monopoly, and Profit Maximization Perfect Competition Profit Maximation Monopoly Price = MR MR = MC Price > MR Price = MR = MC Price = MC Efficient Price > MR = MC Price > MC Inefficient Oligopolies Perfect Competition Oligopoly Monopoly Large number Few moderately One large of small firms. sized firms. firm. Efficient Inefficient Question: Will industries that are oligopolies they act like a monopoly or will they act like a perfectly competitive industry? Why is the answer important? Answer: In general we cannot tell. It depends on how the firms interact with each other.

2 2 Challenge of Oligopoly If an industry is perfectly competitive we can straightforwardly describe the price and quantity that will result. The market demand and supply curve permit us to do this. If an industry is a monopoly, we can straightforwardly describe the price and quantity that will result. The monopoly s marginal revenue and marginal cost curve permit us to do this. If an industry is an oligopoly, the situation is not as straightforward. The resulting price and quantity depend on how the firms interact with each other. Project: Explaining OPEC s Vacillating Behavior September 27, 1993: Wall Street Journal article, Bahree and Tanner report that OPEC was meeting: in an urgent attempt to regain the initiative in its effort to prop up petroleum prices Prices have fallen sharply, by about $3 a barrel this year, largely because OPEC has been producing about one million barrels a day more than its widely ignored ceiling The fall in prices has left the OPEC benchmark about $6 a barrel under the $21 target September 30, 1993: Within a few days, the members of OPEC agreed upon production quotas and oil prices rose. Tanner and Bahree report in the Wall Street Journal: OPEC members agreed on how to divide their new production level and, surprisingly, extended the output arrangement to six months rather than the expected three. The accord sets a ceiling of 24.5 million barrels a day for OPEC. It is intended to reduce actual output by some 200,000 barrels a day and raise world oil prices as a result. [In London,] Brent crude rose 68 cents a barrel [In New York,] crude soared 71 cents a barrel The oil minister hailed the agreement as one of the best ever October 11, 1993: Tanner reported that World oil prices are likely to rise further over the next few weeks if the Organization of Petroleum Exporting Countries stick to its new production quotas. October 12, 1993: The New York Times reported a chink in OPEC s resolve appeared, however. An extra 300,000 or 400,000 barrels of crude oil were being produced every day: The weekly Middle East Economic Survey estimated that production by members of the Organization of Petroleum Exporting Countries rebounded to 24.8 million barrels a day The daily Platt s Oilgram News [estimated] production at nearly 24.9 million barrels a day. [Both estimates exceeded] the output ceiling of 24.5 million barrels October 26, 1993: In of the Wall Street Journal, Tanner reported oil prices quickly responded: petroleum prices [dropped] to the lowest levels since the September meeting of the Organization of Petroleum Exporting Countries. Prices of crude oil fell 50 cents a barrel or more, Summary In late September, the members of OPEC negotiated quotas to restrict the quantity of oil produced. The agreement was applauded by OPEC oil ministers. Oil prices promptly rose. The increase in oil prices proved to be short lived, however. OPEC members violated their agreement within two weeks of consummating it. Within a few weeks, the price of oil fell. Question: How can we explain the behavior of OPEC members?

3 3 Conflicting Interests of an Oligopolies and Cartels: Collective Interests versus Individual Interests It is in the collective interests of the firms in an industry to collude and establish a cartel agreement. It is in their collective interests to collude by reducing production below the competitive level; by establishing a collusive agreement they can restrict production below the competitive level, act like a monopoly, and maximize their joint profits. On the other hand, if a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in the individual interests of a firm to produce more than the agreement allows thereby pushing production back toward the competitive level. Strategy: Begin with a multi-plant monopoly and then convert it to an oligopoly. Multi-Plant Monopoly Suppose that a monopoly firm has two plants, Plant A and Plant B. The marginal cost curves for each plant appear above along with the demand and marginal revenue curves of the monopoly: Plant A Plant B Market MC A MC B MC A MC B D MR q A q B Q ,000 (units per day) (units per day) (units per day) To maximize profits, two conditions must be satisfied when a firm has two plants: Marginal costs of each plant must be equal: MC A = MC B Marginal revenue must equal each plant s marginal cost: MR = MC A = MC B Plant A Plant B Total Production q A = 200 q B = 400 Q = MC A = $ MC B = $ MR = $ Question: What price will the monopoly charge? $. Why?

4 4 Aside: Review of Marginal Revenue for a Monopoly Suppose that a monopoly faces the following demand curve for the good it produces: What is the slope of the demand curve? Slope = Rise Run = = Assume that today the monopoly is current producing 600 units per day. What price is the monopoly charging today? $ Marginal Revenue:. P ($ per unit) Market D To calculate marginal revenue, suppose that the monopoly produces 601 units tomorrow. What price will the monopoly charge tomorrow? $ ,000 Q (units per day) Monopoly s Monopoly s Quantity Price Total Revenue = Price Quantity Tomorrow: ( ) Today: Marginal Revenue: ( ) 600 When an additional unit is sold tomorrow total revenue is affected in two ways: TR tends to rise by $,, as a consequence of the Effect + ( ) 600 TR tends to fall by, $, as a consequence of the Effect What does the monopoly s marginal revenue equal? $ Question: Why is monopoly marginal revenue less than the price?

5 5 Convert the Multi-Plant Monopoly into an Oligopoly The owner of the monopoly firm retires and gives his two plants to his two children, Adam and Beth: Adam receives Plant A and Beth receives Plant B. Now, there are two separate firms, Firm A and Firm B. Initially, Adam and Beth agree to operate the plants just like their father did. By doing so, they will be maximizing their joint profits. They will be acting as though they are simply two different plants of a single monopoly firm. This situation is called a cartel and their agreement is called a cartel agreement. Cartel Agreement: Adam s Firm Beth s Firm Total Production q A = 200 q B = 400 Q = MC A = $ MC B = $ Question: What price will the cartel charge? $. Question: Will cartel agreement persist or will the siblings have an incentive to cheat on the agreement? Claim: The stability of the cartel depends on how an owner would react to the actions of the other owners. We shall consider two cases: Adam does not retaliate if Beth cheats on the cartel agreement. Adam retaliates in kind if Beth cheats on the cartel agreement. We shall now consider each scenario. Scenario 1: Adam does not retaliate if Beth cheats on the cartel agreement. We begin with the cartel profit maximizing agreement in place. Adam s firm produces 200 units and Beth s firm 400 units; total production equals 600 units. Question: What experiment could we conduct tomorrow to calculate Beth s marginal revenue? Answer: Beth could increase her production from 400 to, tomorrow. In this scenario, we assume that Adam does not retaliate: Tomorrow: Adam s Firm Beth s Firm Total Production q A = 200 q B = Q =

6 6 Now, consider the market demand curve: Today the price equals $90.00 and consumers demand 600 units. Hence, to clear the market tomorrow, the price must to increase the quantity demanded by unit. To increase the quantity demanded by this amount, by how much must the price fall? o What does the slope of the market demand curve equal?. o Hence, to increase the quantity demanded by unit, the price must by $, from $90.00 to $. Beth s Beth s Quantity Price Total Revenue = Price Quantity Tomorrow: ( ) Today: Beth s Marginal Revenue: ( ) 400 When Beth sells an additional unit tomorrow total revenue is affected in two ways: TR tends to rise by $,, as a consequence of the Effect + ( ) 400 TR tends to fall by, $, as a consequence of the Effect Beth s marginal revenue: $ Question: Why is Beth s marginal revenue greater than the monopoly s? Question: What does Beth s marginal cost equal? $ Question: What happens to Beth s profits? Beth s Profits = TR TC Does Beth have an incentive to cheat on the collusive agreement if Adam does not retaliate?

7 7 Question: What happens to Adam s profits? What happens to his total revenues? Adam s TR Today: TR A = P q A Adam s TR Tomorrow: TR A = P q A = = $ = = $ What happens to Adam s total revenues? What happens to Adam s total costs? What happens to Adam s profits? Question: What happens to the joint profits of the siblings? by $ Change in Beth s Profit + Change in Adam s Profit = $ = $ Question: What happens to the price?. Question: What happens to consumer surplus?. Summary: Effect of Competition When a producer acts more competitive both producers and consumers are affected: Producers o The more competitive producer s profit by capturing some profit from other producer. o Overall, the joint profits of producers. Consumers are. Question: What might affect Beth s tendency to cheat, to compete? Personal Ties. Threat of Retaliation Government Regulation

8 8 Scenario 2: Adam retaliates in kind if Beth cheats on the cartel agreement. Again, we begin with the cartel profit maximizing agreement in place today. Now, we shall calculate Beth s marginal revenue when Adam responds aggressively. Tomorrow, Beth produces one more unit. But now Adam reacts aggressively by increasing production by 1 unit also: Tomorrow: Adam s Firm Beth s Firm Total Production q A = 201 q B = 401 Q = Again, consider the market demand curve: Today the price equals $90.00 and consumers demand 600 units. Hence, to clear the market tomorrow, the price must to increase the quantity demanded by units. The slope of the demand curve equals.05. To increase the quantity demanded by units, the price must by $ from $90.00 to $. Beth s Beth s Quantity Price Total Revenue = Price Quantity Tomorrow: ( ) Today: Beth s Marginal Revenue: ( ) 400 When Beth sells an additional unit tomorrow total revenue is affected in two ways: TR tends to rise by $,, as a consequence of the Effect + ( ) 400 TR tends to fall by, $, as a consequence of the Effect Beth s marginal revenue: $ Question: What does Beth s marginal cost equal? $ Question: What happens to Beth s profits? Beth s Profits = TR TC Does Beth have an incentive to cheat on the collusive agreement when Adam reacts aggressively?

9 9 Question: How is this relevant to OPEC? OPEC: Cheating and Saudi Arabia (thousands of barrels per day) Date OPEC Prod OPEC Quota Non-Saudi Cheat Saudi Prod Jul-87 20,280 16,220 3,801 4,602 Aug-87 21,346 16,220 4,714 4,755 Sep-87 20,330 16,220 3,800 4,653 Oct-87 20,505 16,220 3,990 4,638 Nov-87 20,021 16,220 3,896 4,248 Dec-87 20,049 16,220 3,560 4,612 Jan-88 19,095 14,680 4,603 4,155 Feb-88 19,107 14,680 4,448 4,322 Mar-88 19,381 14,680 4,712 4,332 Apr-88 19,886 14,680 5,079 4,470 May-88 19,878 14,680 5,057 4,484 Jun-88 20,190 14,680 5,271 4,582 Jul-88 20,280 14,680 5,302 4,641 Aug-88 21,530 14,680 6,016 5,177 Sep-88 22,104 14,680 6,453 5,314 Oct-88 23,366 14,680 6,693 6,336 Nov-88 23,901 14,680 7,032 6,532 Dec-88 24,138 14,680 7,146 6,655 Jan-89 21,336 18,104 2,838 4,918 Feb-89 21,147 18,104 2,894 4,673 Mar-89 21,470 18,104 3,375 4,515 Apr-89 22,096 18,104 3,602 4,914 May-89 22,167 18,104 3,565 5,022 Jun-89 22,770 18,104 4,365 4,825 Jul-89 22,809 19,083 3,572 4,923

10 10 Role of the Government Antitrust legislation: Broadly speaking antitrust legislation is designed to prevent o a firm from becoming a monopoly or o an oligopoly from colluding and acting as a cartel. Regulation Airline Industry: Conflicting Motives of the Firms in an Oligopoly A Stylized History The Civil Aeronautics Board, CAB, was established in the 1930's to promote the interest of the then fledging airline industry. Broadly speaking, the CAB was given two powers: Grant airlines the right to provide service between two cities - grant routes; Set fares for the routes. CAB s Charge: Promoting the interests of the airline industry. Question: What is the best way to promote the interests of the airline industry? Answer: Incentive to Cheat Each airline could increase its profits by cheating, by luring more customers onto its planes assuming of course that the other airlines did not retaliate. But how could an airline retaliate? Non-Price Competition Airlines offered free meals, free drinks, free movies, hotel discounts, etc. In other words, the airlines cheated by using non-price competition. Every time an airline offered an extra perk to lure customers, the CAB tried to control it. For example, when airlines began to offer free drinks, the CAB ruled that it could only provide two free drinks; passengers had to pay for any extras. Airline Deregulation Act: In 1978, Congress passed and President Carter signed the Airline Deregulation Act. This act phased in the deregulation of the industry: CAB lost authority over domestic routes CAB lost authority over airline prices CAB was disbanded Deregulation allowed the airlines to lower prices in an effort to attract new customers. Let us see what happened to airline prices since then: Real Price (Price adjusted for inflation) Year (Cents per passenger mile)