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Chapter 27

Chapter 27. Oligopoly and Strategic Behavior. 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.

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Chapter 27

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  1. Chapter 27 Oligopoly and Strategic Behavior

  2. 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? Introduction

  3. 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

  4. Learning Objectives • 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

  5. Chapter Outline • Oligopoly • Strategic Behavior and Game Theory • Price Rigidity and the Kinked Demand Curve

  6. Chapter Outline • Strategic Behavior with Implicit Collusion: A Model of Price Leadership • Deterring Entry into an Industry • Network Effects • Comparing Market Structures

  7. Did You Know That... • 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.

  8. 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

  9. Oligopoly • Characteristics of oligopoly • Small number of firms • Interdependence • Strategic dependence

  10. Oligopoly • 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

  11. Oligopoly • Why oligopoly occurs • Economies of scale • Barriers to entry • Mergers • Vertical mergers • Horizontal mergers

  12. Oligopoly • 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

  13. Oligopoly • Measuring industry concentration • Concentration Ratio • The percentage of all sales contributed by the leading four or leading eight firms in an industry

  14. 88.9% = 400 Four-firm concentration ratio = 450 Computing the Four-Firm Concentration Ratio Annual Sales Firm ($ Millions) 1 150 2 100 3 80 4 70 5 through 25 50 Total number of firms in Industry = 25 Total 450 Table 27-1

  15. 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.

  16. E-Commerce Example: Concentration in the Search-Engine Industry • The four most frequently used search-engines 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.

  17. 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.

  18. Strategic Behaviorand Game Theory • 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

  19. Strategic Behaviorand Game Theory • 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

  20. Strategic Behaviorand Game Theory • 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

  21. Strategic Behaviorand Game Theory • Zero-Sum Game • A game in which any gains within the group are exactly offset by equal losses by the end of the game

  22. Strategic Behaviorand Game Theory • 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

  23. Strategic Behaviorand Game Theory • 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

  24. Example: The Prisoner’s Dilemma • You and your partner rob a bank and get caught.

  25. 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

  26. Prisoner’s Dilemma • What would you do? • Remember • No cooperation

  27. The Prisoners’ Dilemma Payoff Matrix Figure 27-1

  28. Strategic Behaviorand Game Theory • Applying game theory to pricing strategies • Would you choose a high price or a low price? • Remember • No collusion

  29. Strategic Behaviorand Game Theory Figure 27-2

  30. Strategic Behaviorand Game Theory • 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

  31. Strategic Behaviorand Game Theory • Opportunistic behavior • Implies a noncooperative game • Not realistic • We make repeat transactions

  32. Strategic Behaviorand Game Theory • Tit-for-Tat Strategic Behavior • In game theory, cooperation that continues so long as the other players continue to cooperate

  33. d 2 d 1 A P 0 d 1 MR 1 d 2 MR2 q 0 Price Rigidity and the Kinked Demand Curve Panel (a) d1 is relatively elastic • if one firm raises its price the others will not and it will lose market share Price and Marginal Revenue per Unit d2 is relatively inelastic • if one firm lowers its price the others lower their price so gain in sales is small Quantity per Time Period Figure 27-3, Panel (a)

  34. d 1 MR A 1 P 0 d 2 MR 2 q 0 Price Rigidity and the Kinked Demand Curve Panel (b) The kinked demand curve indicates the possibility of price rigidity Price and Marginal Revenue per Unit Quantity per Time Period Figure 27-3, Panel (b)

  35. d 1 MR 1 P MC ' 0 MC MC" d 2 MR 2 q 0 Price Rigidity and the Kinked Demand Curve Price, Marginal Revenue, and Marginal Cost per Unit Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR Quantity per Time Period Figure 27-4

  36. Strategic Behavior with Implicit Collusion: A Model of Price Leadership • 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

  37. Strategic Behavior 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

  38. Strategic Behavior with Implicit Collusion: A Model of Price Leadership • Markets where price wars are common • Cigarettes • Long-distance telephone companies • Airlines

  39. Strategic Behavior with Implicit Collusion: A Model of Price Leadership • Markets where price wars are common • Diapers • Frozen foods • PC hardware and software

  40. 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.

  41. Example:A Price War in Diapers • 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.

  42. Deterring Entry Into an Industry • 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

  43. Deterring Entry Into an Industry • Increasing entry cost • Threat of price wars • Government regulations • Environmental regulation • Safety standards

  44. Deterring Entry Into an Industry • 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

  45. Deterring Entry Into an Industry • Raising switching costs for customers • Examples • Non-compatible software • Non-transferability of college courses

  46. 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?

  47. 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.

  48. Network Effects • 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

  49. 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.

  50. 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 Table 27-3

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