OLIGOPOLY

1. OLIGOPOLY Managerial Economics Lecturer: Jack Wu

2. Samsung Electronics • Oligopoly: Market with a small number of sellers who behave strategically • Samsung • How to adjust pricing and capacity as Korean Won appreciates against U.S. dollar? (c) 1999-2012, I.P.L. Png

3. Outline • Price competition • Limit pricing • Capacity competition • Capacity leadership

4. STRATEGIC VARIABLE FOR OLIGOPOLISTIC SELLERS • In the short run, the strategic variable for oligopolistic sellers is price. • In the long run, the strategic variable for oligopolistic sellers is production capacity.

5. PRICE COMPETITION • The outcome of oligopolistic competition on price depends on whether the product is homogeneous or differentiated.

6. BENCHMARK: MONOPOLY

7. PRICE COMPETITION:HOMOGENEOUS PRODUCT • Simple Case: Duopoly in Wireless Telecommunication • Luna Cellular and Mercury Wireless • Produce at constant marginal cost with unlimited capacity • Compete on price to sell a homogeneous product.

8. BERTRAND MODEL • Under these conditions, the market equilibrium is perfectly competitive. Even though the industry is duopoly, the outcome is the same as with perfect competition. Demand curve is infinitely elastic with respect to a price cut. • Extreme competition – selling undifferentiated commodities • Game in strategic form – competing sellers set prices simultaneously.

9. PRICE COMPETITION: HOMOGENEOUS PRODUCT • Marginal cost = $30 per subscriber per month • Suppose that Luna charges $32. • Mercury has three choices: • Price > $32: no customers • Price = $32: split the market demand in half • Price < $32: gain the whole market – the best strategy. • Nash equilibrium: Both sellers charge price = $30 (marginal cost).

10. PRICE COMPETITION: DIFFERENTIATED PRODUCTS • Case: Luna Cellular and Mercury Wireless • Produce at constant marginal cost with unlimited capacity • Compete on price to sell a product differentiated by distance from consumer. • The price cutter’s demand is not infinitely elastic.

11. HOTELLING MODEL • Suppose that consumers are located uniformly along a street one mile long, with the Luna and Mercury dealers at each end of the street. • Assumption: Differentiation is due to the difference in the consumer’s distances from the two dealers. The competing products are differentiated by location. • Game in strategic form – competing sellers set prices simultaneously

12. PRICE COMPETITION: DIFFERENTIATED PRODUCTS • Residual demand: Demand given the actions of competing sellers. • Given Mercury's price and any price that Luna could set • Consumers relatively closer to Luna would buy from Luna • Consumers relatively closer to Mercury would buy from Mercury • Residual demand curve slopes downward • If Luna raises price, some consumers (located relatively far from Luna) would switch to Mercury

13. Price competition: Differentiated products

14. PRICE COMPETITION: DIFFERENTIATED PRODUCTS • Luna’s profit maximum • Produce at scale where residual marginal revenue = marginal cost • Set price accordingly – as function of Mercury’s price • Best response function: Seller’s best action as a function of the actions of competing sellers.

15. Price competition: Differentiated products

16. PRICE COMPETITION: DIFFERENTIATED PRODUCTS • In fact, Hotelling model applies to differentiation in terms of any attribute on which consumers have differing preferences. • “Transport cost” = consumer’s disutility from consuming any attribute that differs from the ideal or most preferred= strength of consumer preference • Extreme case: : zero transport cost => consumers consider that products are homogeneous => Hotelling model collapses to Bertrand model • Higher transport cost (stronger consumer preference) • Residual demand more inelastic => higher price • Best-response function shifts toward higher prices • Nash Equilibrium: Higher prices

17. PRICE COMPETITION: DIFFERENTIATED PRODUCTS • Higher demand • Higher residual demand • Best-response function shifts toward higher prices • Nash Equilibrium: Higher prices • Higher marginal cost • Best-response function shifts toward higher prices • Nash Equilibrium: Higher prices

18. STRATEGIC COMPLEMENTS • Strategic complements: Adjustment by one party leads other parties to adjust in the same direction • Hotelling model: Prices are strategic complements • Best-response functions slope upward

19. LIMIT PRICING • What if one seller can act before others? • Game in extensive form – competing sellers set prices in sequence

20. LIMIT PRICING • Limit pricing • Entrant must incur fixed cost of production • Set such price so low that potential competitor’s residual demand is so low that potential competitor cannot break even.

21. LIMIT PRICING

22. LIMIT PRICING • Luna’s average cost curve is “U” shaped because of fixed cost • Mercury (incumbent, first-mover) sets its price so that: • Luna’s (entrant) residual demand curve is below its average cost curve

23. LIMIT PRICING • Limit pricing – Necessary conditions • Production requires substantial fixed cost • Leader’s price must be credible • Potential competitors must believe that leader will not change price if potential competitor enters • For leader, must be more profitable to produce at entry-deterring price than to accommodate entry and produce an equal share with competitors.

24. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT • Luna Cellular and Mercury Wireless • Produce at constant marginal cost • Compete on capacity to sell a homogeneous product • Game in strategic form – competing sellers set capacities simultaneously • Cournot Model: The market price equates the demand with the total capacity offered by the two providers.

25. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT • Residual demand: Demand given the actions of competing sellers. • Given Mercury’s capacity, Luna’s residual demand curve slopes downward • Luna’s profit maximum • Produce at scale where residual marginal revenue = marginal cost • Set capacity accordingly – as function of Mercury’s capacity

26. Capacity competition:Homogeneous product

27. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT Best response function: Seller’s best action as a function of the actions of competing sellers.

28. CAPACITY COMPETITION: HOMOGENEOUS PRODUCT • Higher demand • Higher residual demand • Best-response function shifts toward higher capacity • Nash Equilibrium: Higher capacities • Higher marginal cost • Best-response function shifts toward lower capacity • Nash Equilibrium: Lower capacities • Seller with lower cost gains • Directly, from lower cost • (Strategic response) Forces competitor to reduce capacity

29. STRATEGIC SUBSTITUTES • Strategic substitutes: Adjustment by one party leads other parties to adjust in opposite direction • Cournot model: Capacities are strategic substitutes • Best-response functions slope downward

30. STRATEGIC COMPLEMENTS OR SUBSTITUTES? • Generally , there may be either strategic complements or strategic substitutes depending on the relevant demand and cost conditions. • Examples: Advertising & R&D • Increased R&D spending can have a similar effect to increasing capacity. On the other hand, an increase in one seller’s R&D spending may drive competitors to increase R&D as well, particularly when they compete for patents. So, R&D spending might be strategic complements or strategic substitutes depending on circumstances.

31. CAPACITY LEADERSHIP • What if one seller can act before others? • Game in extensive form – competing sellers set capacities in sequence • Stackelberg model: Leader commits to capacity to grab larger share. • Trade-off • Larger market share => higher profit • Larger total capacity (all producers) => Lower profit • Leader does not drive out competitor, simply reduces the follower’s share

32. CAPACITY LEADERSHIP

33. CAPACITY LEADERSHIP • First mover advantage • Necessary conditions -- Leader’s capacity must be credible • Potential competitors must believe that leader will not change capacity if potential competitor enters • For leader, must be more profitable to produce at Stackelberg capacity than to accommodate entry and produce an equal share with competitors.