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Understanding Oligopoly: Market Structure & Firm Power

Explore oligopoly market structure, determinants of market power, measuring market power with concentration ratio, and behavior of firms in an oligopoly. Learn about rivalry for market shares and the kinked demand curve in this chapter.

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Understanding Oligopoly: Market Structure & Firm Power

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  1. Oligopoly Chapter 10

  2. Market Structure • Most firms possess some market power.

  3. Degrees of 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.

  4. 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. LO1

  5. Characteristics of Market Structures LO1

  6. Characteristics of Market Structures LO1

  7. Determinants of Market Power • The determinants of market power include: • Number of producers. • Size of each firm. • Barriers to entry. • Availability of substitute goods. LO1

  8. 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. LO1

  9. 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. LO1

  10. Measuring Market Power • The standard measure of market power is the concentration ratio. • The concentration ratio is a measure of market power that relates the size of firms to the size of the market. LO1

  11. Concentration Ratio • Theconcentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). LO1

  12. Firm Size • Market power isn’t necessarily associated with firm size. • A small firm could possess a lot of power in a relatively small market. LO1

  13. Measurement Problems • Many smaller firms acting in unison can achieve market power. • Concentration ratios do not convey the extent to which market power may be concentrated in a local market. LO1

  14. Oligopoly Behavior • Market structure affects market behavior and outcomes. • Assume that the computer market has three oligopolists. LO1

  15. Initial Equilibrium • Initial conditions and market shares of each firms are described in the following slides. • Market share- The percentage of total market output produced by a single firm. LO2

  16. Initial Conditions in Computer Market $1000 Market demand Price (per computer) 0 20,000 Quantity Demanded (computers per month) Industry output LO2

  17. Initial Market Shares of Microcomputer Producers

  18. The Battle for Market Shares • In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms. LO2

  19. Increased Sales at the Prevailing Market Price • Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists. LO2

  20. Increased Sales at Reduced Prices • Lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. • There simply isn’t any way that a firm can do so without causing alarms to go off in the industry. LO2

  21. Retaliation • Oligopolists respond to aggressive marketing by competitors. • Step up marketing efforts. • Cut prices on their product(s). LO2

  22. Retaliation • 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.

  23. Retaliation • An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price. This is why oligopolists avoid price competition and instead pursue nonprice competition. LO3

  24. Rivalry for Market Shares F $1000 G 900 Price (per computer) Market demand 0 20,000 25,000 Quantity Demanded (computers per month) LO3

  25. The Kinked Demand Curve • Close interdependence – and the limitations it imposes on price and output decisions – is a characteristic of oligopoly. LO2

  26. Rivals’ Response to Price Reductions • The degree to which sales increase when the price is reduced depends on the response of rival oligopolists. • We expect oligopolists to match any price reductions by rival oligopolists. LO2

  27. Rivals’ Response to Price Increases • Rival oligopolists may not match price increases in order to gain market share. LO2

  28. The Kinked Demand Curve Confronting an Oligopolist • The shape of the demand curve facing an oligopolist depends on how its rivals responded to a change in the price of its own output. • The demand curve will be kinked if rival oligopolists match price reductions but not price increases. LO2

  29. The Kinked Demand Curve Confronting an Oligopolist 1000 PRICE (per computer) 0 QUANTITY DEMANDED (computers per month) 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 LO2

  30. Game Theory • Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies. • The payoff to an oligopolist’s price cut depends on how its rivals respond. LO3

  31. Game Theory • Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs. LO3

  32. Game Theory • Each oligopolist is uncertain about its rival’s behavior. • The collective interests of the oligopoly are protected if no one cuts the market price. • But an individual oligopolist could lose if it holds the line on price when rivals reduce price. LO3

  33. The Payoff Matrix • A payoff matrix is a table showing the risks and rewards of alternative decision options. • The payoff to an oligopolist’s price cut depends on how its rivals respond. LO3

  34. The Payoff Matrix é ù Probability of Size of loss Expected = X ê ú value rivals matching from price cuts ë û é ù + X Probability of Gain from lone ê ú rivals not matching price cut ë û • The decision to initiate a price cut requires a risk assessment. LO3

  35. Oligopoly Payoff Matrix LO3

  36. Oligopoly vs. Competition • Oligopolists may try to coordinate their behavior in a way that maximizes industry profits. LO3

  37. Price and Output • An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit. • Oligopoly firms must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares. LO3

  38. Maximizing Oligopoly Profits Price or Cost (dollars per unit) 0 Quantity (units per period) 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 LO3

  39. Coordination Problems • There is an inherent conflict in the joint and individual interests of oligopolists. • Each oligopolist wants industry profits to be maximized. • Each oligopolist wants to maximize it’s own market share. LO3

  40. Coordination Problems • To avoid self-destructive behavior, each oligopolist must coordinate production decisions so that: • Industry output and price are maintained at profit-maximizing levels. • Each oligopolistic firm is content with its market share. LO3

  41. Price Fixing • The most explicit form of coordination among oligopolists is called price fixing. • Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold. LO3

  42. Examples of Price Fixing • Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators. • They were charged again in 1972 for continued price fixing. LO3

  43. Examples of Price Fixing • School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states. LO3

  44. Examples of Price Fixing • Vitamin C – The four Chinese suppliers of most of the vitamin C to the U.S. market tripled the price in 2001. Baby Formula – Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula. LO3

  45. Examples of Price Fixing • Perfume – Thirteen companies paid $55 million in 2006 for fixing prices. Art Auction Commissions – In 2000, Southeby’s and Christie’s paid $512 million in fines for fixing commissions throughout the 1990s. LO3

  46. Examples of Price Fixing • Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD. LO3

  47. Examples of Price Fixing • Laser Eye Surgery – The FTC charged VISX and Summit Technology with price-fixing that raised the price of surgery by $500 per eye. LO3

  48. Examples of Price Fixing • Memory chips – In 2005, the world’s largest memory-chip (DRAM) makers (Samsung, Micron, Infineon, and Hynix) admitted they fixed prices and paid $700 million in criminal fines. LO3

  49. Price Leadership • Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry. LO3

  50. Allocation of Market Shares • One way to allocate market share is a cartel agreement. • A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market. LO3

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