Oligopoly and Monopolistic Competition

1. Oligopoly and Monopolistic Competition

2. Key issues 1. market structure 2. game theory 3. Cournot model of oligopoly 4. Stackelberg model of oligopoly 5. cartels 6. monopolistic competition 7. Bertrand model of oligopoly

3. Market structures markets differ according to • number of firms in market • ease of entry and exit • ability of firms to differentiate their products

5. Oligopoly • small group of firms in a market with substantial barriers to entry • because relatively few firms compete in such a market, • each firm faces a downward-sloping demand curve • each firm can set its price: p > MC • market failure: inefficient (too little) consumption • each affects rival firms • typical oligopolists differentiate their products

6. Strategies and games • oligopolistic or monopolistically competitive firm use a • strategy: • battle plan of actions (such as setting a price or quantity) it will take to compete with other firms • oligopolies engage in a • game: • any competition between players (such as firms) in which strategic behavior plays a major role

7. Game theory • set of tools used by economists, political scientists, military analysts, and others to analyze decision making by players (such as firms) who use strategies • these analytic tools can be used to analyze • oligopolistic games • poker • coin-matching games • tic-tac-toe • elections • nuclear war

8. Firm's objective • obtain largest possible profit (or payoff) at game’s end • typically, one firm's gain comes at expense of other firms • each firm's profit depends on actions taken by all firms

9. Nash equilibrium • set of strategies is a Nash equilibrium if, • holding strategies of all other players (firms) constant, • no player (firm) can obtain a higher payoff (profit) by choosing a different strategy • in a Nash equilibrium, no firm wants to change its strategy because each firm is using its • best response: • strategy that maximizes its profit given its beliefs about its rivals' strategies

10. Duopoly • consider single-period, duopoly, quantity-setting game • duopoly: an oligopoly with two ("duo") firms

11. Firms act simultaneously • each firm selects a strategy that • maximizes its profit • given what it believes other firm will do • firms are playing • a noncooperative game of imperfect information: • each firm must choose an action before observing rivals’ simultaneous actions

12. Dominant strategy • a strategy that strictly dominates all other strategies regardless of which actions rivals’ chose • firm chooses its dominant strategy • where a firm has a dominant strategy, its belief about its rival's behavior is irrelevant

13. Noncooperative game • firms do not cooperate in a single-period game • In Nash equilibrium, each firm earns less than it would make if firms restricted their outputs • sum of firms' profits is not maximized in this simultaneous choice, one-period game

14. Why don't firms cooperate? • don't cooperate due to a lack of trust: • each firm can profitably use low-output strategy only if it trusts other firm! • each firm has a substantial profit incentive to cheat on a collusive agreement

15. Prisoners' dilemma game all players have dominant strategies that lead to a profit (or other payoff) that is inferior to what they could achieve if they cooperated and played alternative strategies

17. Collusion in repeated games • in a single-period prisoners' dilemma game, firms produce more than they would if they colluded • why, then, are cartels frequently observed? • collusion is more likely in a multiperiod game: single-period game played repeatedly • punishment: not possible in a single-period game but possible in a multiperiod game

18. Noncooperative oligopoly • many models of noncooperative oligopoly behavior • firms choose quantities • Cournot model • Stackelberg model • firms set prices: Bertrand model

19. Basic Cournot model • duopoly: 2 firms (no other firms can enter) • firms sell identical products • market that lasts only 1 period (product or service cannot be stored and sold later) • as in prisoners' dilemma game, firms are playing noncooperative game of imperfect information • each firm chooses its output level before knowing what other firm will choose • firms may choose any output level they want

20. Cournot equilibrium • Nash equilibrium where firms choose quantities • set of quantities sold by firms such that, holding quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity

21. American Airlines’ Profit-Maximizing Output: Monopoly

22. American Airlines’ Profit-Maximizing Output: Duopoly

23. American and United’s Best-Response Curves

24. Duopoly Equilibria: Quantities

25. Duopoly Equilibria: Profits

26. Cournot equilibrium varies with number of firms

27. Stackelberg model • Cournot model: both firms make their output decisions simultaneously • Heinrich von Stackelberg's model: firms act sequentially • leader firm sets its output first • then its rival (follower) sets its output

28. Stackelberg Game Tree

29. Stackelberg Equilibrium

30. Credibility and Commitment • When firms move simultaneously, why doesn’t one firm announce it will produce Stackelberg-leader output, to force its rival to produce the Stackelberg-follower’s output level? • Answer: The follower doesn’t view the threat as credible. • not in the leaders best interest to produce large quantity unless it is sure the follower believes the threat. • When one firm moves first, its threat to produce a large quantity is credible because it has already committed to producing large quantity

31. Supergame • if a single-period game is played repeatedly, firms engage in a • supergame: • players’ strategies in this period may depend on rivals' actions in previous periods • in a repeated game, firm can influence its rival's behavior by • signaling • threatening to punish

32. Supergame Outcomes • If firms know the number of periods • “Unravels” from the end, so firms don’t collude • If the timing of the last period is uncertain or the game is played indefinitely • Firms can sustain collusion by threatening to punish each other for cheating

33. Cartels Adam Smith: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices"

34. Factors that Facilitate the Formation of Cartels • The ability to raise the market price • Low expectation of severe punishment • Low organization costs • Enforcing a Cartel Agreement • Detecting cheating • Cartels with little incentive to cheat • Methods of preventing cheating • * most-favored nation clause • * meeting but not beating competition clause • Cartels and Price Wars

35. Structure of Industry:Incentives for Collective Action • Firm Concentration • Demand Elasticity • Barriers to entry • Industry Excess Capacity • Product homogeneity • Facilitating mechanisms

36. Why can cartels raise profits? • if a competitive firm is maximizing its profit, why should joining a cartel increase its profit? • competitive firm is already choosing output to maximize its profit • however, it ignores effect that changing its output level has on other firms' profits • cartel takes into account how changes in one firm's output affect cartel profits

37. Why some cartels persist 1. Tacit collusion 2. International cartels (OPEC) and cartels within certain countries operate legally 3. Difficult to detect 4. Ease of enforcement 5. Government support

38. Diamond Cartel

39. Cartels fail luckily for consumers, cartels often fail because • each firm in a cartel has an incentive to cheat on the cartel agreement by producing extra output • governments forbid them

40. Why cartels fail • cartels fail if noncartel members can supply consumers with large quantities of goods (example: copper) • each member of a cartel has an incentive to cheat on cartel agreement

41. Competition versus Cartel

42. Solved problem • initially, all identical firms in a market collude • if some of these firms leave the cartel and act like price takers, how are consumers affected?

44. Maintaining cartels to maintain a cartel, firms must • detect cheating • punish violators • keep its illegal behavior hidden from governments

45. Detection and enforcement • inspect each other's books (e.g., most-favored nation clauses) • governments report bids on government contracts • divide market by region or by customers mercury cartel (1928-1972) allocated U.S. to Spain and Europe to Italy • use industry organizations to detect cheating • offer "low price" guarantees

46. Entry and cartel success • barriers to entry help cartel: limit competition • cartels with large number of firms rare (except professional associations) • Dept. of Justice price-fixing cases 1963-1972 • 48% involved 6 or fewer firms • average number of firms: 7.25 • only 6.5% involved 50 or more conspirators • cartels often fall apart after entry (mercury)

47. Lysine cartel • 1996: Archer Daniels Midland (ADM) pleaded guilty to price fixing • ADM admitted to price fixing in lysine (used in livestock feed) and citric acid (used in soft drinks and detergents) • Taped oral conversations

48. Lysine buyers • individual U.S. buyers received compensation ≈ their losses • that is, they did not get treble damages • total U.S. corporate settlements: about $85 million

49. Mergers • if antitrust or competition laws prevent firms from colluding, they may try to merge • U.S. laws restrict ability of firms to merge if effect would be anticompetitive • Must determine relevant markets and pricing effects

50. Some mergers raise efficiency • efficiency due to greater scale • sharing trade secrets • closing duplicative retail outlets Chase and Chemical banks merged in 1995: closed or combined 7 branches in Manhattan located within 2 blocks of another branch