Chapter 11

1. Chapter 11 Oligopoly

2. Define market structures • Number of sellers • Product differentiation • Barrier to entry

3. Types of Market Structure

4. Oligopoly: • A small number of firms mutually dependent on one another, and each has a substantial market share

5. Characteristics of Oligopoly • mutual dependence (or interdependence) • each firm has a substantial market share, thus is big enough to affect market price • barriers to entry

6. Barriers to entry: • Entry limiting pricing • Capacity barrier • Economies of scope • New product development

7. Barriers to entry: strategic deterrence • Entry limiting pricing • Capacity barrier • Economies of scope • New product development

8. Entry limiting pricing if cost situation allows, set P< min LAC of the potential entrant

9. Capacity barrier • Keep excess capacity as a threat for larger Q and lower P.

10. Other barriers: • Economies of scope • (multi-product cost barrier) • new product development

11. Economic Theories • General Equilibrium theory • Mechanism Design theory • Decision theory

12. General Equilibrium theory • a relatively large number of individual consumers and producers, how the combined individual efforts help define the environment • trade and production (markets) • macroeconomic analysis • monetary or tax policy • stock markets • interest and exchange rates • trade policy and the role of international trade agreements

13. Mechanism Design theory • the consequences of different types of rules • the design of compensation and wage agreements that effectively spread risk while maintaining incentives, and the design of actions to maximize revenue, or achieve other goals.

14. Decision theory • theory of one person behavior, or a single player against a big environment. • preferences among alternatives, maximization of benefits and minimization of costs • **how best to acquire information before making a decision.

15. Game Theory Psychologists: • the theory of social situations • focus on how groups of people interact • study of behavior in situations of interdependence Key characteristic: Interdependence

16. Interdependencies • In making choices, people must consider the effect of their behavior on others. • In making decisions, firms may consider how rivals will respond to their price changes or new advertising.

17. Basic Elements of a Game • The players • Their strategies • The payoffs

18. The Prisoners’ Dilemma

19. Nash Equilibrium • Dominant vs. Dominated Strategy: dominant: a strategy that yields a higher payoff no matter what the other players in a game choose dominated: Any other strategy available • Nash equilibrium occurs when each player has a dominant strategy and follows that strategy • There can be an equilibrium when players do not have a dominant strategy • Prisoner’s dilemma: A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

20. The Payoff Matrix for an Advertising Game American’s Choices Raise ad spending Keep same ad spending United’s Choices $5,500 for United $8,000 for United Raise ad spending $5,500 for American $2,000 for American $2,000 for United $6,000for United Same spending $8,000 for American $6,000for American

21. Dominant Strategies • United: increase ad spending • American: increase ad spending

22. $3,000 for United $8,000 for United $4,000 for American $3,000 for American $4,000 for United $5,000 for United $5,000 for American $2,000 for American Equilibrium When One Player Lacks a Dominant Strategy American’s Choices Leave ad spending same Raise ad spending Raise ad spending United’s Choices Leave ad spending the same

23. Strategies: • American: dominant – increase ad spending • United: no dominant strategy: • If American increases ad spending, United should not increase ad spending • If American does not increase ad spending, United should increase ad spending • Nash Equilibrium: American increases ad spending (dominant strategy), and United does not increase ad spending

24. Exercise 11.1, P. 287 • Does each company have a dominant strategy? • What each company should do?

25. Two main branches of game theory • cooperative: all parties involved cooperate (collude) to achieve best result for all • non-cooperative: how intelligent individuals interact with one another in an effort to achieve their own goals.

26. With Mutual Dependence • uncertainty in D and MR • decisions have to take into account of reactions from others. • Cooperative: follow changes initiated by rivals • Non-cooperative: do not accommodate price changes of other firms

27. Recall: The Prisoners’ Dilemma

28. Non-Cooperative Oligopoly • Each acts for its own benefit, not for the benefits of all players

29. The desire for non-cooperation: The Prisoners’ Dilemma

30. The desire for non-cooperation: The Prisoners’ Dilemma American’s Choices Raise ad spending Keep same ad spending United’s Choices $5,500 for United $8,000 for United Raise ad spending $5,500 for American $2,000 for American $2,000 for United $6,000for United Leave ad spending the same $8,000 for American $6,000for American

31. The desire for non-cooperation: Advertiser’s Dilemma Pepsi Low Budget High Budget Low Budget Coke High Budget

32. Cooperation • The best result for all players

33. Cooperative: • Openly or secretly enter into contract to act for the best result for all members • Partners of a game • Tendency to cheat

34. Cooperative Oligopoly: in general • With homogenous products: behave as monopoly • With differentiated products: • harder to cooperate; • specific agreement in difference in price or quality;

35. Cooperative Methods • Price Leadership: one firm sets a price that the other firms follow • Tacit Collusion: agreement without explicit communication cooperation without explicit agreement • Cartel: an extreme case

36. Cooperative Oligopoly: Cartel • A group of firms with the objective of limiting competitive forces within a market • A coalition of firms that agrees to restrict output for the purpose of earning an economic profit • A collusive agreement by several producers that increases their combined profits by deciding how much each firm should produce example: OPEC

37. Cartel: Output Allocation among Members – market sharing • Pre-cartel sales • Production capacity • Bargaining power • Importance • Marginal cost

38. Market Sharing based on MC • In order to produce the profit maximizing output, a cartel should allocate production among its members so that MC for all member producers are equal, which is also equal to the common MR. That is, MR=MC1=MC2=MC3...

39. The Market Demand for Mineral Water Figure 11.1 • Assume • 2 firms (Aquapure & Mountain Spring) • MC = 0 • Cartel is formed & agree to split output and profits • Impact of Cartel • Q = 1,000 bottles/day • P = $1/bottle • Each firm makes $500/day

40. The Temptation to Violate a Cartel Agreement Figure 11.2 • Aquapure lowers P • P = $.90/bottle • Q = 1,100 bottles/day • Mountains Spring retaliates • P = $.90/bottle • Both firms split 1,100 bottles/day @ $.90 • Profit for each firm = $495/day

41. The Payoff Matrix for a Cartel Agreement Mountain Spring Charge $1/bottle Charge $0.90/bottle $0 for Aquapure $500/day for each Charge $1/bottle $990/day for Mt. Spring Aquapure $990 for Aquapure Charge $0.90/bottle $495/day for each $0 for Mt. Spring

42. Cartel: • There is intention to cheat • Cooperation between players will increase the payoff in a prisoner’s dilemma • With time there is a motive to enforce cooperation • Explicit agreement is illegal (antitrust; anti price-fixing)

43. Policy Implication: Cigarette Advertising Philip Morris Advertise on TV Don’t advertise on TV $35 million/yr for RJR $10 million/yr for each Advertise on TV $5 million/yr for Philip Morris RJR $5 million/yr for RJR Don’t Advertise on TV $20million/yr for each $35 million/yr for Philip Morris