Paul Krugman and Robin Wells. Microeconomics. Third Edition. Chapter 14 Oligopoly. Copyright 2013 by Worth Publishers

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1 Paul Krugman and Robin Wells Microeconomics Third Edition Chapter 14 Oligopoly Copyright 2013 by Worth Publishers

2 What s an oligopoly? (oligos = few, polis = marketplace) A. Key characteristics: Only a few sellers of the product Barriers to entry Product may be identical (steel) or differentiated (automobiles) B. Implications* Any one seller has market power, can affect the market for all sellers Each seller has to anticipate the moves that its rivals might make (and knows that its rivals anticipate its own moves) Powerful incentives to compete Powerful incentives to collude Powerful incentives to cooperate If only a few oligopolists, P and Q will resemble monopoly levels; if many oligopolists, P and Q will be somewhat closer to perfectly-competitive levels *Jean-Paul Sartre (famous French philosopher): In football, everything is complicated by the presence of the other team.

3 It s customary for artists to sell their work through only one dealer. Damien Hirst creator of Shark in Formaldehyde (see below) has two dealers (one in London, the other in NYC). (Any idea why that works to his advantage?)

4 The HHI (Herfindahl-Hirschman Index): = square of each firm s market share, summed over all firms HHI between indicates highly competitive market (e.g., = 100) HHI between indicates somewhat competitive market HHI over 2500 indicates oligopolistic market

5 An example: duopoly (two firms) illustrates conflict between temptation to compete and temptation to collude/cooperate Assume costs = 0, so that Profit = Revenue Costs = Revenue market demand curve is P = 120 Q Q P R = PQ in monopoly: Q* = 60, P* = (since MR = MC = 0 at Q = 60) in duopoly: if the two duopolists collude (form a cartel), they maximize joint profits by setting P = (the monopoly solution!) and producing Q = 30 each: total output = 60; profit (= revenue) = 30 $60 = $ for each duopolist BUT, each duopolist has an incentive to cheat on the cartel agreement: e.g., Firm A makes 10 more units of Q; total Q is now 70, so P falls to 50; Firm A s revenue is now 40 $50 = $2000 (vs. $1800 previously!)

6 Q P R = PQ suppose BOTH duopolists cheat! then each produces 40; total Q = 80; P = so profit for each = $40 40 = $ when both oligopolists produce Q = 40, we have a Nash equilibrium: neither firm can do better for itself, given the behavior of the other firm e.g., suppose each firm produces Q = 40, and now Firm A produces 10 more Q (so its total Q = 50) then P will fall to 30, so revenue for Firm A will fall to $30 50 = $1500 so Firm A would get less profit (the same logic applies to Firm B) So Q = 40 for each firm is a Nash equilibrium. For another example, see next slide

7 another example: ADM and Ajinomoto producing lysine Assume MC = 0: then if they collude, they ll set P = 6 with total (industry) Q = 60 to maximize total revenue and joint profits); each firm sets Q = 30; so each firm s profit will be $180 But now note: each firm has a strong incentive to cheat! e.g., ADM sets Q = 40, so total Q is now = 70, so P falls to 5; so industry R is now 350 but ADM s R is now $5 40 = $200 (vs. $180 previously) But Ajinomoto will have made the same calculation! So industry Q is now 80, industry R is now 320, P = 4, and each firm s R is now only 160. If either firm raised output to Q=50, then industry Q rises to 90, P falls to 3, but that firm s R = 150. So neither firm would move from Q = 40: again, Nash equilibrium.

8 demand curve: Q 1 +Q 2 line Q 1 Q 2 = Q P PQ 1 PQ Market demand curve is given by the middle two columns, for Q and P. Each line shows what happens if the two duopolists produce the indicated amounts (Q 1 or Q 2 ). Again, to simplify, we assume that TC = MC = 0, so that profit is the same as revenue (= PQ). Line 1: Both firms set Q = 30; total Q = 60; P = 60. Industry revenues (and profits) are maximized. Line 2: Firm 2 produces Q = 40. If Firm 2 doesn t react, total Q = = 70, so P falls to 50. Firm 1 s revenue rises; Firm 2 s revenue falls. Line 3: So Firm 2 counterattacks! If Firm 1 doesn t react, it still has Q=40. Firm 2 produces 40, so total Q = 80 and so P = 40. Firm 1 s revenue falls; Firm 2 s revenue rises. Line 4: Check for yourself that neither firm can gain by raising its own Q from 40 to 50 (revenues for each firm would fall). So line 3 is a Nash equilibrium!

9 Corollaries: As the number of firms in an oligopolistic market gets larger, the market outcome gets closer to the competitive outcome with P =MC and higher Q. (Remember Damien Hirst.) Allowing foreign competitors ( free[r] trade ) can help break up a domestic oligopoly. Firms in an oligopolistic market have a perpetual dilemma: compete (and suffer lower profits)? or collude (and run the possible risk of getting caught and prosecuted)?

10 Robert Crandall (president, American Airlines) calling Howard Putnam (president, Braniff Airways): Crandall: I think it s dumb as hell to sit here and pound the out of each other and neither one of us making a dime! Putnam: Do you have a suggestion for me? Crandall: Yes, I have a suggestion for you. Raise your fares 20 percent. I ll raise mine the next morning. Putnam: Robert, we Crandall: You ll make more money, and I will, too. Putnam: We can t talk about pricing! Crandall: Oh #$%&, Howard. We can talk about thing we want to talk about. (Putnam gave a tape of this conversation to the Department of Justice, which sued Crandall. Two years later, Crandall settled with DoJ.)

11 Game theory and the prisoner s dilemma: Models of oligopolistic behavior Dilemma is whether to cooperate/collude, or to compete Prisoners dilemma shows why cooperation is hard to maintain, even when it benefits both parties. (many applications: the arms race, cartel behavior, advertising, etc.) key elements in the prisoners dilemma game : payoff matrix (showing what will happen under different choices dominant strategy (the strategy that is best, regardless of the strategy chosen by the other player(s) in the game) (Note: a particular game may not always have a dominant strategy. But if it does, it is always the way to go!)

12 The prisoners dilemma : compete and you both make less; collude and you both make more. But the dominant strategy is to compete! Suppose you re ADM. If you produce 30m, then (a) if Aji makes 30m, your profit is $180 (b) if Aji makes 40m, your profit is $150. If you produce 40m, then (a) if Aji makes 30m, your profit is $200m (b) if Aji makes 40m, your profit is $160m. So no matter what Aji does, ADM is better off producing 40m instead of 30m. Producing 40m is therefore the dominant strategy for ADM. (And also for Aji!)

13 What does this example show? Even when firms would do better by cooperating/colluding, there can be strong incentives for them to compete: e.g., by colluding, both firms would make $4b; but by competing, both firms make only $3b. (Not surprising: competition would be expected to yield lower profits than collusion.) Cooperation can be good for firms, but bad for society. Competition can be bad for society, cooperation can be good. But society may need a rule-maker (and enforcer) to limit competition. Applications: the arms race (spending more $ on arms doesn t make us safer, it just makes us poorer) need a disarmament agreement the university athletics arms race NCAA to the rescue? some hockey players ( enforcers ) don t wear helmets should the league require players to wear a helmet?

14 Extensions of the simple model A repeated game has both a past ( memory ) and a future so players will think ahead instead of playing on a one-shot basis This may create more incentives to collude/cooperate Tit-for-tat policy: start out by cooperating, then just do whatever the other person does ( measure for measure : a moral principle? I ll do unto you what you did unto me?) problem: can produce endless, destructive cycle of retaliation or, it could lead to tacit collusion/cooperation Generous policy: randomly but periodically forget the opponent s last move don t retaliate; make a fresh start

15 How tit-for-tat can lead to tacit collusion if both play tit-for-tat, then ADM (and Aji) makes $180m profit each year If ADM always cheats and Aji plays tit-for-tat, ADM makes $200m first year but only $160m thereafter If ADM plays tit-for-tat but Aji always cheats, ADM makes $150m in first year and $160m thereafter If ADM always cheats and Aji does too, ADM makes $160m each years So what should ADM do? If it expects to be in the business a long time, AND if it thinks Aji would like to pay tit-for-tat, then ADM should play tit-for-tat too! (Then both make $180m/year.) But if ADM wil be out of the business after one year, it should cheat do unto others before they do unto you!

16 Public policy towards oligopoly Antitrust and restraint-of-trade laws used by both public and private entities to fight oligopoly Predatory pricing: charge low price, drive rivals out of business, then raise prices drastically when no competitors are left standing Resale price maintenance ( fair trade price): manufacturer charges high retail price to ensure good sales/service or is this just anticompetitive? Tied sales (e.g., Microsoft, cable company): bundle products together (possibly a form of price discrimination?)

17 Bundling or tied sales : an example Theatre A: would pay up to $5 for Hamlet, $15 for Superman Theatre B: would pay up to $15 for Hamlet, $5 for Superman With a separate price for each film: charge $15 for each film sell one film to each theatre, make $30 in total With a bundled price for both films: charge $20 for a bundle of the two films sell one bundle to each theatre, make $40 in total

18 Figure 14.4 Crude Oil Prices, (in Constant 2005 Dollars) Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

19 Unnumbered Figure 14.1 Contrasting Approaches To Anti-trust Regulation Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

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