Introduction. Learning Objectives. Learning Objectives. Chapter 27. Oligopoly and Strategic Behavior

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1 Chapter 27 Oligopoly and Introduction On a typical day, United Parcel Service will transport over 10 million packages. UPS and its main rival, FedEx Ground, earn more than three-fourths of total revenue earned in the ground delivery of packages. How can an economic model explain the dominance of only two firms in one industry? Slide 27-2 Learning Objectives Learning Objectives Outline the fundamental characteristics of oligopoly Understand how to apply game theory to evaluate the pricing strategies of oligopolistic firms Explain the kinked demand theory of oligopolistic price rigidity Describe theories of how firms may deter market entry by potential rivals Illustrate why network effects and market feedback can explain why some industries are oligopolies Slide 27-3 Slide

2 Chapter Outline Chapter Outline Oligopoly Price Rigidity and the Kinked Demand Curve with Implicit Collusion: A Model of Price Leadership Deterring Entry into an Industry Network Effects Comparing Market Structures Slide 27-5 Slide 27-6 Did You Know That... Oligopoly Intel is the predominant seller of microprocessor chips, with a global market share of 80 percent? Industries such as this, with one predominant seller and several smaller competitors, are not monopolies. They are described by the term oligopoly. Oligopoly A market situation in which there are very few sellers Each seller knows that the other sellers will react to its changes in prices and quantities Slide 27-7 Slide

3 Oligopoly Oligopoly Characteristics of oligopoly Small number of firms Interdependence Strategic dependence Strategic Dependence A situation in which one firm s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry Slide 27-9 Slide Oligopoly Oligopoly Why oligopoly occurs Economies of scale Barriers to entry Mergers Vertical mergers Horizontal mergers Vertical Merger The joining of a firm with another to which it sells an output or from which it buys an input Horizontal Merger The joining of firms that are producing or selling a similar product Slide Slide

4 Oligopoly Computing the Four-Firm Concentration Ratio Measuring industry concentration Concentration Ratio The percentage of all sales contributed by the leading four or leading eight firms in an industry Firm Annual Sales ($ Millions) through Total 450 Total number of firms in Industry = Four-firm concentration ratio = = 88.9% 450 Slide Table 27-1 Slide E-Commerce Example: Concentration in the Search-Engine Industry E-Commerce Example: Concentration in the Search-Engine Industry Internet search-engines collect revenue through advertisements posted on their websites. To measure the concentration ratio in this industry, economists count the number of searches conducted on each site. The four most frequently used searchengines are Google, Yahoo, AOL Time Warner, and MSN. The four-firm concentration ratio in this industry is 91 percent, indicating that it qualifies as an oligopoly. Slide Slide

5 Oligopoly, Inefficiency, and Resource Allocation Oligopolistic firms have some degree of market power, which means each one can affect the market price. This creates some inefficiency in resource allocation. But to the extent that U.S. oligopolies must compete with firms from other countries, their market power is limited. Explaining the pricing and output behavior of oligopoly markets Reaction Function The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry Slide Slide Game Theory A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly Cooperative Game A game in which the players explicitly cooperate to make themselves better off Noncooperative Game A game in which the players neither negotiate nor cooperate in any way Slide Slide

6 Zero-Sum Game A game in which any gains within the group are exactly offset by equal losses by the end of the game Negative-Sum Game A game in which players as a group lose at the end of the game Positive-Sum Game A game in which players as a group are better off at the end of the game Slide Slide Strategies in noncooperative games Strategy Any rule that is used to make a choice Any potential choice that can be made by players in a game Dominant Strategies Strategies that always yield the highest benefit Example: The Prisoner s Dilemma You and your partner rob a bank and get caught. Slide Slide

7 Prisoner s Dilemma Prisoner s Dilemma You are separated and given these options: Both confess and get five years in jail Neither confess and get two years One confess and the other does not Confessor goes free One who does not confess gets ten years What would you do? Remember No cooperation Slide Slide The Prisoners Dilemma Payoff Matrix Applying game theory to pricing strategies Would you choose a high price or a low price? Remember No collusion Figure 27-1 Slide Slide

8 Opportunistic Behavior Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains An example might be writing a check that you know will bounce Figure 27-2 Slide Slide Opportunistic behavior Implies a noncooperative game Not realistic We make repeat transactions Tit-for-Tat In game theory, cooperation that continues so long as the other players continue to cooperate Slide Slide

9 Price Rigidity and the Kinked Demand Curve Price Rigidity and the Kinked Demand Curve d 2 Panel (a) Panel (b) Price and Marginal Revenue per Unit P 0 d 1 A MR 1 MR 2 q 0 d 2 d 1 is relatively elastic if one firm raises its price the others will not and it will lose market share d 1 d 2 is relatively inelastic if one firm lowers its price the others lower their price so gain in sales is small Price and Marginal Revenue per Unit d 1 MR 1 P 0 q 0 A MR 2 d 2 The kinked demand curve indicates the possibility of price rigidity Figure 27-3, Panel (a) Quantity per Time Period Slide Figure 27-3, Panel (b) Quantity per Time Period Slide Price Rigidity and the Kinked Demand Curve with Implicit Collusion: A Model of Price Leadership Price, Marginal Revenue, and Marginal Cost per Unit P 0 d 1 MR 1 MC' MC MC" d 2 Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR Price Leadership A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices Price leadership behavior is apparent in the overnight package delivery industry MR 2 q 0 Quantity per Time Period Figure 27-4 Slide Slide

10 with Implicit Collusion: A Model of Price Leadership Price War A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices with Implicit Collusion: A Model of Price Leadership Markets where price wars are common Cigarettes Long-distance telephone companies Airlines Slide Slide with Implicit Collusion: A Model of Price Leadership Markets where price wars are common Diapers Frozen foods PC hardware and software Example: A Price War in Diapers In 2001, the makers of Huggies disposable diapers reduced the size of its packages by one diaper, but left the package price unchanged. This increased the effective diaper price by 5 percent. Slide Slide

11 Example: A Price War in Diapers Deterring Entry Into an Industry The response from Pampers, the main competitor, was to cut prices by 15 percent. Huggies soon followed with a price reduction, and a price war ensued. As would be expected, there was a benefit to consumers as package prices fell and coupons were made widely available. Entry Deterrence Strategy Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm Slide Slide Deterring Entry Into an Industry Deterring Entry Into an Industry Increasing entry cost Threat of price wars Government regulations Environmental regulation Safety standards Limit-Pricing Strategies A model that hypothesizes that a group of colluding sellers will set the highest common price they believe they can charge, without new firms seeking to enter the industry Slide Slide

12 Deterring Entry Into an Industry Raising switching costs for customers Examples Non-compatible software Non-transferability of college courses Example: QWERTY and High Switching Costs The QWERTY keyboard was designed to solve a mechanical problem of the tendency for typewriter keys to jam. Now that the mechanical problem no longer exists, why does this keyboard layout persist? Slide Slide Network Effects Network Effects A network effect is a situation in which a consumer s inclination to use an item depends on how many others use it. For example, the value of a fax machine increases as there are more fax machines in use. Positive Market Feedback Potential for a network effect to arise when an industry s product catches on Negative Market Feedback The tendency for industry sales to spiral downward rapidly when the product falls out of favor Slide Slide

13 Network Effects and Industry Concentration In an industry selling products subject to network effects, a small number of firms may be able to secure the bulk of the payoffs resulting from positive market feedback. Oligopoly is likely to emerge as the prevailing market structure. Comparing Market Structures Long-Run Number Unrestricted Ability Economic Market of Entry and to Set Profits Product Nonprice Structure Sellers Exit Price Possible Differentiation Competition Examples Perfect Numerous Yes None No None None Agriculture, competition roofing nails Monopolistic Many Yes Some No Considerable Yes Toothpaste competition toilet paper, soap, retail trade Oligopoly Few Partial Some Yes Frequent Yes Recorded music, college textbooks Pure One Not Consider- Yes None Yes Some electric monopoly for entry able (product is companies, unique) some local telephone companies Slide Table 27-3 Slide Issues and Applications: Oligopoly in the Ground-Shipping Business In the industry of shipping packages by ground, the four-firm concentration ratio in the U.S. is 100 percent. The four firms are UPS, FedEx Ground, the U.S. Postal Service, and DHL. Among these four firms, there is strategic dependence regarding both prices and delivery schedules. Issues and Applications: Oligopoly in the Ground-Shipping Business FedEx Ground is willing to deliver on Saturdays. Each of the four delivery services employs computer technology to speed the pace of delivery and to allow customers to track packages in shipment. This industry fits the definition of oligopoly, with four firms competing interdependently. Slide Slide

14 Summary Discussion of Learning Objectives The fundamental characteristics of oligopoly Economies of scale Barriers to entry Strategic dependence Applying game theory to evaluate the pricing strategies of oligopolistic firms Game theory looks at competition for payoffs That depends on the strategies that others employ Slide Summary Discussion of Learning Objectives The kinked demand theory of oligopolistic price rigidity If a firm believes that rivals will follow price cuts but not price increases, it will be reluctant to change price. How firms may deter market entry by potential rivals Raise entry costs Limit pricing Switching policies Slide Summary Discussion of Learning Objectives Why network effects and market feedback encourage oligopoly: Network effects arise when a consumer s demand for a good or service is affected by how many other consumers also use the item Oligopoly can arise because a handful of firms may be able to capture all of the positive market feedback End of Chapter 27 Oligopoly and Slide