Market Structure: Oligopoly

1. Market Structure:Oligopoly

2. Basics • Oligopoly. Industry with only a few firms. • Oligopolist. Producer in industry with only a few firms. • Imperfect competition. When no one firm has a monopoly, but producers can affect market prices.

3. Basics • How can we tell if there’s an oligopoly? • Concentration ratio. Measure of the percentage of industry sales accounted for by the “X” largest firms. • Herfindahl-Hirschman Index (HHI). The square of each firm’s share of market sales summed over the industry, giving a picture of the industry market structure.

4. Basics Using the HHI, you can examine an industry. The higher the number, the stronger the oligopoly.

5. Why do oligopolists have an incentive to cooperate? • Interdependence. When the profit of each firm depends on the actions of the other firms in the market. • This interdependence determines whether oligopoly works, or whether oligopolists eat themselves in a cannibalistic ritual that makes Emeril Lagasse look restrained around crawfish (in other words, price wars!)

6. Oligopolists’ Incentive Assume we have an oligopoly consisting of two firms (duopoly) selling lysine. Lysine is animal feed hormone. If the lysine industry was perfectly competitive, every firm would have an incentive to produce more when P > MC. If we assumeMC = 0, at equilibrium, lysine would be provided for free. Firms would produce until there was a normal profit, P = 0 at 120 million pounds, and $0 total revenue. Clearly, this is stupid. (And a theoretical example for illustration, not reality).

7. Oligopolists’ Incentive But what happens when we have two firms instead of dozens? Well, first off, it would be stupid to just simply let the price of lysine drop to zero. Both would realize that every time they produce one more, the market price lowers. Instead, profits would be higher if both firms limited their production (oh wait, you mean like in monopoly?) (Yes, Dagny.) So how do we do this?

8. Oligopolists’ Incentive Well, assume that both lysine producers agree to maximize their profits. According to the table, where should they set production?

9. Oligopolists’ Incentive Well, assume that both lysine producers agree to maximize their profits. According to the table, the lysine producers should set quantity at 60 million pounds. This would max out their total revenue at $360 million. Once they’ve agreed, then it’s only a matter of how to divide the profits. The problem is even if they agree, there’s still an incentive to cheat and make more.

10. Oligopolists’ Incentive • Collusion. Cooperation between firms to raise profits jointly. • Cartel. Group or producers that agree to restrict output in order to increase prices and joint profits.

11. Collusion and Competition • If the lysine producers split profits down the middle, they’d each produce 30 million pounds of lysine with a profit of $180 million. • But remember, firms act in their own rational self-interest. They want to make money. So naturally, they have a big incentive to cheat.

12. Collusion and Competition Let’s say that Tyler controls one firm and Billy controls the other. Let’s say Tyler honors the agreement, but Billy is a dirty dirty cheater. Billy produces 40 million pounds while Tyler keeps to 30. As total output is now 70 million pounds, the market price drops to $5. Industry revenue would drop from $360 million ($6 x 60 million) to $350 million ($5 x 70 million).

13. Collusion and Competition But Billy gets more revenue. Billy: $5 x 40 million = $200 million Tyler: $5 x 30 million = $150 million It’s a good bet that Tyler’s going to be less than enthused. But let’s face it, Tyler is just as devious as Billy, and he cheats too.

14. Collusion and Competition If both Billy and Tyler cheat, then they’ll end up producing 80 million pounds, which drops market price to $4. Billy: $4 x 40 million = $160 million Tyler: $4 x 40 million = $160 million Awesome. Because both made a decision to cheat, they both lost out and are making $20 million less each than they were if they’d have acted honorably.

15. Collusion and Competition

16. Collusion and Competition • A profit-maximizing monopolist setsMC = MR, but how does that work again? • Quantity effect. With the additional unit sold, TR increases by P at which unit is sold. • Price effect. To sell one more unit, monopolist must cut prices on all units sold. • The negative price effect is the reasonMR < P. • For monopolists, this is not an issue.

17. Collusion and Competition • For oligopolists, it is an issue, because they will each act in their own rational self-interest: to maximize profits. This has negative effects. • In the preceding example, both duopolists suffer a negative price effect if only one firm cheats and drives down price. • But each firm only focuses on the portion of the negative price effect on its production.

18. Collusion and Competition • An individual firm in an oligopoly has a smaller price effect from an additional unit of output than a monopolist. • It would be profitable for any one firm in an oligopoly to increase production, even if that increase reduces profits of the industry as a whole. • Unfortunately, everyone is going to think the same thing. • But if everyone actually cooperates, then they all win, but just less. • Remember, they are all trying to maximize profits.

19. Collusion and Competition • Problem. With a few number of firms, collusion is more likely. Collusion, however, is illegal, whether formal or informal. • We’ll find the solution shortly.

20. Competition: Prices vs. Quantity • We know from monopoly that oligopolists can manipulate prices by quantity output. • However, instead of playing with quantity, why not go after prices? Say instead of selling additional lysine, why not just lower the price? The outcome would be the same.

21. Competition: Prices vs. Quantity • If the oligopolist changes their price, all the other oligopolists will know instantly, and the cheater will be punished much more quickly than manipulating quantity.

22. Competition: Prices vs. Quantity • Joseph Bertrand: price competition. When firms sell an identical product, oligopolists will repeatedly lower price to undercut competition, leading to perfectly competitive outcome where P = MC. • AugustinCournot: quantity competition. When firms sell an identical product, oligopolists will choose to maximize profit, given the output of a rival. There is an equilibrium level of output that allows each firm to earn profits below monopoly, but above normal profits.

23. Prisoners’ Dilemma • The prisoners’ dilemma is a fundamental aspect of game theory, which focuses on the behavior of interdependence and incentives. • Game theory deals with any situation where the reward to one player (payoff) depends not only on his or her own actions, but also on those of other players in the game. • For oligopolists, the payoff is profit.

24. Prisoners’ Dilemma Prisoners’ Dilemma. Game based on two premises: Each player has an incentive to choose an action that benefits itself at the other player’s expense. When both players act in this way, both are worse off than if they had acted cooperatively. This is a payoff matrix based on the example of the lysine producers above. Remember, each acts in their own self-interest.

25. Prisoners’ Dilemma If both Billy and Tyler cooperate, then they can maximize their profits at $180 million, producing 30 million pounds a piece. If one cheats, but the other is honorable, one will benefit from the extra TR at $200 million profit, while the other loses revenue dropping to $150 million. This can create an incentive to cheat for both, which pushes profit to $160 million as market price drops.

26. Prisoners’ Dilemma Looking at it from the point of view of prisoners, here we have Thelma and Louise. They have no ability to contact each other and are isolated in separate interrogation rooms. In theory, if both keep their mouths shut, the max they will get is 5-years. However, they will act in their own rational self-interest.

27. Prisoners’ Dilemma Dominant strategy. A player’s best action regardless of the action taken by the other player. According to the payoff matrix, the dominant strategy for each is to confess, assuming that the other doesn’t. If Thelma confesses, but Louise doesn’t, Thelma gets only 2 years, but Louise gets 20. And vice versa. Since this is the dominant strategy, it’s a good bet they’re both going to confess, which means they’ll both get 15 years. 15 years to argue, make shivs and make prison toilet wine.

28. Prisoners’ Dilemma Nash equilibrium. This is a noncooperative equilibrium. The result when each player in a game chooses the action that maximizes his or her pay off, given the actions of other players. In this case, the Nash equilibrium would be where both Thelma and Louise confess. That’s where both take their dominant strategy. You can have a Nash equilibrium even when there’s no dominant strategy—remember, it’s about taking the action that maximizes pay off, given the actions of other players.

29. Prisoners’ Dilemma After serving their time, both leave jail and want nothing more to do with each other. Louise goes to a bar, and Thelma goes to a movie. Both have achieved Nash equilibrium, because no one will change their behavior given what the other is doing. Key point: In both cases, the pursuit of individual self-interest has the effect of hurting both players.

30. Repeated Interaction andTacit Collusion • Strategic behavior. When firms attempt to influence the future behavior of other firms. • Oligopolists that behave strategically can manage to behave as if they had a formal agreement to collude. • How does this work? Well, remember that we only have a handful of firms to begin with. It’s a good bet that they know each other from interacting in business for years, and knows how they will act. Because of that, the oligopolist looks at both short and long run consequences of their actions.

31. Repeated Interaction andTacit Collusion • Tit for tat. Playing cooperatively at first, then doing whatever the other player did previously. • Knowing that if they act inappropriately, there will be a reaction from the other firm, oligopolists will choose not to do anything which would harm their profits, maximized to where all oligopolists earn money, but don’t lose out. • But if one cheats and benefits, the others will follow suit. This will drive price down.

32. Repeated Interaction andTacit Collusion • Tit for tat is strategic behavior because it is intended to influence the future actions of other players. • Tit for tat strategy offers a reward to the other player for cooperative behavior, and punishment for cheating. • If you behave cooperatively, so will I. • If you cheat, so will I.

33. Repeated Interaction and Tacit Collusion Looking at a payoff matrix for tit for that and cheating, applied to the first example of the lysine producers, we see that where both cooperate (where both do tit for tat), they maximize their profits while matching their production. But when one cheats, and the other behaves, one makes an increase in profit for the first year, but then both earn $160 million profit each in the next year. Why? Because then both cheat, and when they both cheat, they lose out in profit.

34. Repeated Interaction andTacit Collusion • When oligopolists expect to compete with each other over a period of time, each individual firm will conclude that it is in its own best interest to be helpful to other firms in the industry. • Despite the fact that firms have no way of making an enforceable agreement to limit output and raise prices, they act as if they had such an agreement. • Tacit collusion. When firms limit production and raise prices in a way that raises each other’s profits, even though they have not made any formal agreement.

35. Legal Framework • Collusion and cartels are illegal in the United States, primarily because of the Sherman Antitrust Act of 1890. Modern economies make it difficult for monopolies to form and for oligopolies to act like monopolies. • Antitrust policy. Efforts by the government to prevent oligopolistic industries from becoming or behaving like monopolies.

36. Tacit Collusion and Price Wars • Oligopolists may end up tacitly colluding to be productive, with prices above competitive levels (P > ATC). • There are some industry characteristics that make tacit collusion less likely in reality. • Large numbers • Complex products and pricing schemes • Differences in interests • Bargaining power of buyers

37. Tacit Collusion and Price Wars • Large numbers. The more firms in the industry, the less likely tacit collusion will be successful. • If there are many firms, it’s easier to cheat on a tacit agreement without detection. • Easier for firms to enter the industry.

38. Tacit Collusion and Price Wars • Complex products and pricing schemes. It is much easier to tacitly agree to keep a price high if the product is quite simple and if there are very few ways in which price can be set. • Tacit agreements can’t work if there’s a variety of products and related services.

39. Tacit Collusion and Price Wars • Differences in interests. If firms have quite diverse characteristics and interests, it will be more difficult to establish and maintain tacit agreements. • Some firms may not share common interests.

40. Tacit Collusion and Price Wars • Bargaining power of buyers. If the buyers of a product have significant bargaining power, or if they operate in a highly competitive retail environment, tacit agreements by producers to keep the price high are unlikely to succeed. • If Kellogg’s and Quaker were to try to keep cereal prices high, they likely would lose that battle to Wal-Mart, Publix and other groceries stores which buy huge amounts.

41. Product Differentiation • Oligopolies provide a variety of products based on identifiable characteristics (size, features, colors, etc.). They do this to stand out and create a brand loyalty. If consumers follow a product line, then the firm can increase price and consumers will be willing to pay it. • But if all firms agree with this strategy, how will tacit agreement on price develop? • Take me to your leader.

42. Price Leadership • Price leader. Firm that sets a price and the rival firms follow it. By following the leader, tacit agreement is created. • Price leaders have a significant percentage of market power, higher than others. They can increase price, and others will follow, because of the reputation the price leader has established. • If another firm charges less, then their products could be considered inferior.

43. Non-Price Competition • Non-Price Competition. Competing on aspects other than price. • Offering warranties. • Better customer service. • Longer store hours. • Credit cards with rewards. • Personal shoppers. • Amenities in a store (coffee).

44. Reality • Oligopoly is more common than perfect competition and monopoly, but difficult to study because of the varieties of oligopolistic industries. • Oil • Cereal • Cell phone carriers

45. Reality • Economists use the benchmarks of perfect competition and monopoly to judge oligopolistic behavior. • Are firms able to tacitly raise prices? If so, the market will resemble monopoly more than perfect competition.