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Section A: Strategic decision making in imperfectly competitive markets

Section A: Strategic decision making in imperfectly competitive markets. Outline of sessions Monopoly, oligopoly and collusion Sustaining profitability: Rivalry and monopoly profits Market failures due to monopoly power and oligopoly collusion Strategic decision making - Game theory

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Section A: Strategic decision making in imperfectly competitive markets

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  1. Section A: Strategic decision making in imperfectly competitive markets • Outline of sessions • Monopoly, oligopoly and collusion • Sustaining profitability: Rivalry and monopoly profits • Market failures due to monopoly power and oligopoly collusion • Strategic decision making - Game theory • Prisoners’ dilemma and collusion – more game theory • Prisoners’ dilemma and trade • Entry barriers and entry deterrence • Credibility– more game theory • Case studies: • Exception to the rule: competitive balance and collusion in sports leagues • Industry case studies

  2. Suggested reading • For the theory and some business applications: • Allen et al. 2009. Managerial Economics. Norton. Chapters 7, 10-11, 16 • Kreps, D. M. 2004. Microeconomics for Managers. Norton. Chapters 20-23 • Frank, R. H. 2008. Microeconomics and behaviour. McGraw Hill. Chapters 12-13 • Wall,S., Minocha, S. and Rees, B. 2010. International Business, Pearson. Chapter 7 • Dixit, A., Reiley, D. H. and Skeath, S. 2009. Games of Strategy, 3rd Edition , Norton • Rasmusen, E. 2007. Games and Information, Blackwell. Chapters 1-2, 4-5 • Carmichael, F. 2004. A Guide to Game Theory, Pearson. Chapters 1-4, 7-8 • And for the sports application: • Grimes, P, Register, C. and Sharp, A. 2009. Economics of Social Issues, McGraw Hill. Chapter 9 • Plus sports economics texts of which there are many e.g: Sandy, Sloane and Rosentraub, The Economics of Sports, Palgrave. Chapters 1-6

  3. Objectives: by the end of this section you should be able to: • Collusion, cooperation and the prisoners’ dilemma: • Use game theory and/or one detailed example to explain why economists predict that collusion between oligopolists is likely to be fragile unless particular conditions are satisfied e.g. some possibility of repetition in the longer term, and/or the specific characteristics of the market are conducive to cooperation. • Use the concept of the prisoners’ dilemma to make predictions about trade wars • Entry barriers and entry deterrence: • Use one detailed example and/or sequential game theory to explain what is meant by the idea of a credible threat e.g. the threat to fight the entry of a new firm into an industry or the threat to strike/lock-out. • Use sequential game theory to show how an incumbent monopolist (or oligopolistic cartel) might be able to deter entry even though fighting entry is costly .

  4. Monopoly, oligopoly and collusion: Sustaining profitability • Key to determination of profits of firms in an oligopoly and how they can continue to improve profits • Porter’s 5 forces (1980) – profitability depends on: • Extent of rivalry among existing firms (competition) • Number of potential entrants (and barriers to entry) • Number of substitutes (and complements) • The bargaining power of customers • The bargaining power of suppliers • Question: when is a firm more profitable in terms of the 5 forces?

  5. Entry deterrence and entry barriers - Porter’s Five Forces • a firm is more profitable: • The less intense the rivalry among existing firms (monopoly or if oligopoly -collusion vs. strategic competition) • The less the danger of potential entrants and the higher barriers to entry • The fewer substitutes for the firm’s products (the more firms that sell complements) • The weaker the bargaining power of customers • The weaker the bargaining power of suppliers

  6. Porter’s first force: Extent of rivalry; Monopoly and collusion in oligopolies Monopoly: a market dominated by one large firm Oligopoly: a market dominated by a small number of large firms that have an incentive to collude in order to make monopoly profits (i.e. aim to minimise competition and if compete, compete strategically on aspects other than price – kinked demand curve)

  7. Revision: Monopoly (zero rivalry) MC = S AC D = AR What is the profit maximising level of output under monopoly and what are the monopolists supernormal profits?

  8. Revision: Monopoly MC = S PMONOP AC D = AR QMONOP = supernormal profits

  9. Implications • Monopolists make supernormal profits by restricting output in order to charge a higher price • Oligopolists therefore have an incentive to collude by restricting output to the profit maximising level under monopoly – implying limited competition on price • Porter’s 5 forces: Rivalry - a firm is more profitable the less intense the rivalry among existing firms (monopoly or if oligopoly -collusion vs. competition) • Collusion implies restrained rivalry • But monopoly and collusion are not in the interests of consumers

  10. Revision: Monopoly vs. competition MC = S PMONOP AC D = AR QMONOP What would price and output be if the market were competitive (in the short-run)? i.e. PCOMP, QCOMP

  11. Revision: Monopoly vs. competition MC = S PMONOP PCOMP AC D = AR QMONOP QCOMP if the market is competitive: Price = PCOMP and output = QCOMP Only normal profits

  12. Revision: Monopoly as a market failure MC = S PMONOP PCOMP D = AR QMONOP QCOMP What is the DEADWEIGHT LOSS to society under monopoly?

  13. Revision: Monopoly as a market failure MC = S PMONOP PCOMP D = AR QMONOP QCOMP The total DEADWEIGHT LOSS to society under monopoly is the total blue shaded area.

  14. Implications • Restricted rivalry under monopoly and oligopoly collusion, is inefficient from the perspective of society as a whole but large firms have an incentive to collude and at the very least not compete on price • Rationale for competition policy in the UK, anti-trust policy in the USA; see www.competition-commission.org.uk • But oligopolists are likely to participation in non-price competition: competition among the few - strategic competition • But what is strategic competition and does it (1) weaken the sustainability of oligopoly collusion and (2) sustain profits by deterring entry?

  15. Strategic competition among the few • Oligopolists are interdependent agents (players) involved in strategic decision making - taking into account each others moves and responses • when they make moves in secret they can be analysed as if moving simultaneously • To predict the outcome need to use game theory • Simultaneous move games and the concept of a Nash equilibrium - collusion • Sequential/dynamic games – entry deterrence

  16. Exercise on monopoly 1. Explain (i) how the economic analysis of monopoly shows that firms can gain from a monopoly position and (ii) how a comparative analysis of monopoly and perfect competition shows that consumers are likely to be worse off if competition in a market is reduced? As well as using diagrammatic analysis, illustrate aspects of your analysis with reference to (a) the FT letter from David McConnell on BT (British Telecom) and (b) the UK Competition Commission News Release 28 November 2007 on the Tesco sell-off. Hints: You need to use diagrammatic analysis to contrast monopoly and perfect competition and consider the role of government policy.

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