Oligopoly and Strategic Behavior

1. Oligopoly andStrategic Behavior

2. Oligopoly • An oligopoly is a market served by a few firms. • The key feature of an oligopoly is that firms act strategically. • Firms in an oligopoly are interdependent. The actions of one firm affect the profits of the other firms.

3. Oligopoly • Economists use concentration ratios to measure the degree of concentration in a market. • A four-firm concentration ratio is the percentage of the market output produced by the 4 largest firms.

4. Oligopolies in the United States

5. Concentration Ratios in Selected Manufacturing Industries

6. Oligopoly and Barriers to Entry • Economies of scale large enough to generate a natural oligopoly but not a natural monopoly • Government barriers to entry • Substantial investment in an advertising campaign necessary to enter the market Most firms in an oligopoly earn economic profit, yet additional firms do not enter the market, for three reasons:

7. Oligopolistic Firms • A duopoly is a market with two firms. • A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service. • Price fixing is an arrangement in which two firms coordinate their pricing decisions. • The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly.

8. A Cartel Picks the Monopoly Price • In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket. • The firms also split the profit. Each firm earns$7,500 = [(400-300) x 150]/2.

9. Competing DuopolistsPick a Lower Price • When two firms compete against one another, they end up serving 100 passengers each, at a price of $350. • Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm.

10. Duopoly Versus Cartel Pricing • The duopoly produces more output and charges a lower price than the cartel.

11. The Game Tree • A game tree is a graphical representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies.

12. Cartel and DuopolyOutcomes in the Game Tree Two firms coordinating price decisions choose the high price. Two firms acting rationally and interdependently choose the low price.

13. The Outcome of the Price-Fixing Game Jack captures large share of market Jill captures large share of market

14. The Dominant Strategy • Dominant strategy: An action that is the best choice under all circumstances. Irrational for Jack to choose high price • Jack chooses the low price when Jill chooses the high price.

15. The Dominant Strategy • Jack chooses the low price when Jill chooses the low price. Irrational for Jack to choose high price • Dominant Strategy: Jack chooses the low price regardless of Jill’s choice.

16. The Duopolists’ Dilemma Irrational for Jill to be under priced • Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price? • Jill will choose the low price, and the trajectory of the game is X to Z to 4.

17. The Duopolists’ Dilemma • The duopolists’ dilemma is a situation in which both firms in a market would be better off if they chose the high price but each chooses the low price.

18. The Prisoners’ Dilemma • The prisoners’ dilemma is the duopolists’ dilemma. Although both criminals would be better off if they both kept quiet, they implicate each other because the police reward them for doing so.

19. Guaranteed Price Matching • Guaranteed price matching is a scheme under which a firm guarantees that it will match a lower price by a competitor; also known as meet-the-competition policy. • How will Jack respond to Jill’s price-matching policy? • Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits. • Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price.

20. Guaranteed Price Matching • Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel. • Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price!

21. Repeated Pricing andRetaliation for Underpricing • When firms play the price-fixing game repeatedly, price fixing is more likely because firms can punish a firm that cheats on a price-fixing agreement.

22. Retaliation Strategies • Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack. • Grim Trigger: Jill drops her price to the level that will result in zero economic profit. • Tit-for-tat: Jill chooses whatever price Jack chose the preceding month. Schemes to punish Jack if he underprices:

23. Tit-for-Tat Response to Underpricing • After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month. • Jill chooses whatever price Jack chose the preceding month.

24. Price Leadership • Price leadership is an implicit agreement under which firms in a market choose a price leader, observe that firm’s price, and match it.

25. Price Leadership • The problem with an implicit pricing agreement is that price signals sent by the leader may be misinterpreted. • Firms could interpret a price cut in two ways: • A change in market conditions, in which case firms just match the lower price and price fixing continues • Underpricing, in which case a price war may be triggered, destroying the price-fixing agreement

26. The kinked demand model is a model under which firms in an oligopoly match price reductions by other firms but do not match price increases by other firms. The Kinked Demand Curve

27. The Kinked Demand Curve • Increase price: the other firms will not change their prices and quantity will decrease by a large amount (elastic) After the initial price of $6, the firm has two options: • Decrease price: the other firms will decrease their prices, so quantity will increase only by a small amount (inelastic)

28. The Kinked Demand Curve • The demand curve of the typical firm has a kink at the prevailing price. It is relatively flat for higher prices, and relatively steep for lower prices. • There is little evidence, however, that oligopolistic firms really act this way—that firms will not go along with a higher price but only match a lower price.

29. Entry Deterrence byan Insecure Monopolist • An insecure monopoly is a monopoly that is faced with the possibility that a second firm will enter the market.

30. Entry Deterrence byan Insecure Monopolist • An insecure monopolist fears the entry of a second firm, and could react in one of two ways: • A passive strategy: allow the second firm to enter the market • An entry-deterrence strategy: try to prevent the firm from entering • The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit.

31. The Passive Strategy • If Jane adopts a passive strategy, it will allow Dick to enter the market, and each will earn the duopoly profits of $5,000 each.

32. The Entry-Deterrence Strategy • Jane can prevent Dick from entering by incurring a large investment and committing herself to serving a large number of customers at a low price. • If Dick enters anyway, market output will be very large and the firms will lose $1,300 each.

33. The Insecure Monopolist Strategy • If Jane produces a large quantity and Dick stays out, Jane’s profits will be $12,600.

34. Game Tree for the Entry Game • In order to keep Dick from entering, will Jane choose to serve a small or a large quantity of customers?

35. The Outcome of the Entry Game • If Jane is passive and chooses a small quantity, Dick will enter. • If Jane chooses a large quantity, Dick would suffer losses, thus he would stay out.

36. The Outcome of the Entry Game • Jane’s profit is higher if she maintains the insecure monopoly position by choosing a large quantity. • The strategy of picking a price lower than the normal monopoly price to deter entry is know as limit pricing.

37. Entry Deterrenceand Contestable Markets • A contestable market is market in which the costs of entering and leaving are low, so the firms that are already in the market are constantly threatened by the entry of new firms. • In the extreme case of perfect contestability, firms can enter and exit at zero cost, and the market price would be the same as the perfectly competitive price.

38. Characteristics ofDifferent Types of Markets