Oligopoly

1. Oligopoly Chapter 10

2. In This Chapter… 10.1. Revisit Market Structure and Market Power • What determines how much market power a firm has? 10.2. Profit Maximization Under Oligopoly (Kinked Demand Curve and Sticky Prices) • How do firms set prices and outputs? 10.3. Coordination, Problems and the Government • What problems oligopolists have in maintaining price and output levels?

3. 10.1. Revisiting Market Structure and Market Power

4. Market Structure and Market 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. • Most firms possess some market power.

5. Degrees of Power • In imperfect competition, individual firms have some power in a particular product market. • Oligopolyis a market in which a few firms produce all or most of the market supply of a particular good or service.

6. Degrees of Power • Oligopolyis a market in which a few firms produce all or most of the market supply of a particular good or service. • Examples: • Sports Shoes • Cereals Producer • Auto Manufacturers

7. Characteristics of Market Structures

8. Characteristics of Market Structures One Unique

9. Determinants of Market Power • Market power of a firm is a function of: • The Number of producers • The Size of each firm • The Barriers to entry • The Availability of substitute goods

10. Determinants of Market Power Market power increases: • 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.

11. 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.

12. Measuring Market Power • The standard measure of market power is the concentration ratio. • It relates the size of firms to the size of the market. • What proportion of the market supply is concentrated in the hands a few firms?

13. Concentration Ratio • Concentration Ratio: • is the proportion of total industry output produced by the largest firms (usually the four largest). • Market power isn’t necessarily associated with firm size. • ….because a small firm could possess a lot of power in a relatively small market.

14. The Herfindahl-Hirshman Index • The Herfindahl-Hirshman Index (HHI): is a measure of the concentration of market only on some of the firms in the market. equals the sum of the squares of the market shares of each firm in an industry.

15. The Herfindahl-Hirshman Index • HHI:

16. Measurement Problems • HHI doesn’t tell it all • Concentration ratios do not convey the extent to which market power may be concentrated in a local market. • That is, many smaller firms acting in unison can achieve market power.

17. Summary Note • Oligopoly is a market in which a few firms supply significant amount of the market supply • …and thus can have market power ( the ability to alter prices/outputs) to maximize profits

18. 10.2: Profit Maximization Under Oligopoly (Price and Output Decisions under Oligopoly) • Kinked Demand Curve and • Sticky Prices

19. Oligopoly Behavior Like all other markets, under Oligopoly as well, the Profit Maximizing Output is the level of output at which MR=MC

20. Price or Cost (dollars per unit) 0 Quantity (units per period) Maximizing Oligopoly Profits MC ATC Profit- Max. price Market demand Profits ATC at profit- Max. Q J Marginal Revenue Profit-max Q

21. Oligopoly Behavior • However, market structure affects market behavior (strategic actions) and outcomes (Profit and Utility Max). • As there are only a few firms in the market, Oligopolies Might • Cut/raise prices even if it is not warranted by Costs of production • Not respond to changes in Costs of Production

22. Oligopoly Behavior • Assume that the computer market has three oligopolists: • Universal Electronics • World Computers • International Semiconductor

23. $1000 Market demand Price (per computer) 0 20,000 Quantity Demanded (computers per month) Initial Conditions in Computer Market Industry output

24. Initial Equilibrium • Market share - The percentage of total market output produced by a single firm. • Consider that the data in the following table describes each firms market share

25. Initial Market Shares of Microcomputer Producers

26. Price or Cost (dollars per unit) 0 Quantity (units per period) Maximizing Oligopoly Profits Industry marginal cost Industry average cost Profit- maximizing price Market demand Profits Average cost at profit- maximizing output J Industry marginal revenue Profit-maximizing output

27. Battle for Market Shares • Given the above graph: • Will the profit be equally shared among the three markets? • If so, which producer will have higher share of the profit? • What would those with the lower profit share do? • How?

28. Increased Sales at Reduced Prices • It is possible that lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. • There is no way that a firm can do so without causing alarms to go off in the industry. • There are few firms in the market, and they closely follow each other’s action

29. Increased Sales at Reduced Prices • In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms. • …because increase in the market share of one oligopolist necessarily reduces the shares of the remaining oligopolists

30. Retaliation • Oligopolists respond to aggressive marketing by competitors by either of the following methods. 1. Non-Price Competition • Step up marketing efforts 2. Price Competition • Cut prices on their product(s).

31. Retaliation—Non-Price • 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. • This Could be Virtual (Artificial) or Real

32. Retaliation-Prices • Price War • However, an attempt by one oligopolist to increase its market share by cutting prices may lead to a general reduction in the market price…. • ! • This is why oligopolists always want to avoid price competition and thus pursue nonprice competition.

33. Rivals’ Response to Price Reductions/Increases • A typical characteristic of oligopoly is thus the presence of close interdependence in the activities and decisions of firms in the market. • The presence of such close interdependence imposes limitations on price and output decisions of Oligopoly firms

34. Rivals’ Response to Price Reductions/Increases • The degree to which sales increase when the price is reduced by one Oligopolist thus depend on the response of the rival oligopolists. • We expect Oligopolists to match any price reductions by the rival oligopolist. • However, rival Oligopolists may not match a price increase ….why? • …..in order to gain market share.

35. The Kinked Demand Curve Confronting an Oligopolist • The shape of the demand curve facing an oligopolist thus depends on how its rivals responded to a change in the price of its own output. • The demand curve will be kinkedif rival oligopolists match price reductions but not price increases.

36. Price or Cost (dollars per unit) 0 Quantity (units per period) Recall:The Starting Point Industry marginal cost Industry average cost Profit- maximizing price Market demand Profits Average cost at profit- maximizing output J Industry marginal revenue Profit-maximizing output

37. 1000 PRICE (per computer) 0 QUANTITY DEMANDED (computers per month) The Demand Curve Confronting an Oligopolist…. Demand curve facing oligopolist if rivals match price changes M B $1100 A D 900 C Demand curve facing oligopolist if rivals match price cuts but not price hikes Demand curve facing oligopolist if rivals don't match price changes 8000

38. 1000 PRICE (per computer) 0 QUANTITY DEMANDED (computers per month) The Kinked Demand Curve Confronting an Oligopolist B Kinked Demand Curve 8000

39. Game Theory • Oligopoly Price and Output Decisions are thus strategic! • Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs. • Each oligopolist considers the potential responses of rivals when formulating price or output strategies. • The payoff to an oligopolist’s price cut/increase depends on how its rivals respond.

40. é ù Probability of Size of loss Expected = ´ ê ú value rivals matching from price cuts ë û é ù + ´ Probability of Gain from lone ê ú rivals not matching price cut ë û The Payoff Matrix • The decision to initiate a price cut requires a risk assessment.

41. Oligopoly Payoff Matrix

42. Oligopoly vs. Competition • Thus oligopolists would want to coordinate their behavior in a way that maximizes industry profits. • There is a Motive for Coordination • An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit

43. Price and Output • To maximize industry profit, the firms in an oligopoly must agree: 1. on a monopoly price and maintain it, • by limiting production and allocating market shares. • Cartel: • is a group of firms with an explicit agreement to fix prices and output shares in a particular market. • Example: OPEC

44. Sticky Prices • Prices in oligopoly industries tend to be stable. • Like all producers, oligopolists want to maximize profits by producing where MR = MC.

45. Sticky Prices • The kinked demand curve is really a composite of two separate demand curves. • Creates a gap in an oligopolist’s marginal revenue (MR) curve. • Marginal revenue – The change in total revenue that results from a one-unit increase in the quantity sold.

46. Sticky Prices • As a result, modest shifts of the cost curve will have no impact on the production decision of an oligopolists.

47. S A Price (dollars per computer) F d1 G mr2 mr1 d2 0 H 8000 Quantity Demanded (computers per month) An Oligopolist’s Marginal Revenue Curve The kink in the demand curve The MR gap

48. Marginal revenue MC2 MC1 MC3 Price or Cost (dollars per unit) 0 Quantity (units per period) The Cost Cushion

49. 10.3. Coordination, Problems and the Government • What problems oligopolists have in maintaining price and output levels?

50. Some Problems • There is an inherent conflict in the joint and individual interests of oligopolists. • Each oligopolist wants the industry profits to be maximized. • Each oligopolist also wants to maximize it’s own market share.