Oligopoly and Strategic Behavior

1. 13 Oligopoly and Strategic Behavior

2. Oligopoly Policy:Antitrust • Antitrust policy • Government efforts that attempt to prevent oligopolies from behaving like monopolies • Sherman Act of 1890 • “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.”

3. Oligopoly Policy:Antitrust • Clayton Act of 1914 added a few more items that were considered detrimental • Price discrimination that lessens competition • Exclusive dealings that restrict the ability of a buyer to deal with competitors • Tying arrangements (similar to bundling) • Mergers that lessen competition • Prevents a person from serving as a director on more than one board in the same industry

4. Strategic Behavior • Perfect Competition • Only strategy is to reduce costs • Price-taker => output decisions do not affect market price • cross-price elasticity = -1 (perfect substitutes) • Own-price = -∞ • Monopoly • Price-Searcher: output decision determines price • Cross-price = 0 (no substitutes) • Own-price: >= |1| • Oligopoly • Cross-price elasticity near -1 • Own-price elasticity > |1| • Will have to take into account actions of other similar firms when making output/pricing decisions • Much more strategy

5. Oligopoly Behavior • Cooperative Oligopoly • Cartels • Agree to collude; act/price like a single firm monoploist • Price leadership (Stackleberg leader) • Dominant firm establishes the price; other firms react to “leader” • Non-cooperative Oligopolies • Sticky prices (kinked demand curve) • Sticky upward • Nash equilibrium • Characterized by stable prices • Perfect competition • Completely rivalarous

6. Cooperative Oligopolies • Cartels (highly cooperative) • Firms act as single-firm monopolist • Stackelberg Price Leader (passive cooperation) - leader firm moves first and then the follower firms move sequentially • Stackelberg leader is sometimes referred to as the Market Leader.

7. Where We’re Going • How do we tell if a market is an oligopoly? • Market Concentration • CR4: market share for the 4 largest firms • Herfindahl Index (HHI): computed from the squares of the market shares • Strategic behavior (how do they behave in the market place) • Collusive: act together • Non-collusive: act separately and/or strategically

8. How do we tell? • Market concentration • sizeand distribution of firm market shares and the number of firms in the market. • Economists use two measures of industry concentration: • Four-firm Concentration Ratio (CR4) • The Herfindahl-Hirschman Index (HHI)

9. Attempts to Measure Market Concentration • four-firm concentration ratio • market share of the four largest firms in an industry • Herfindahl index, • also known as Herfindahl-Hirschman Index or HHI, • widely applied in competition law and antitrust. • sum of the squares of the market shares of each individual firm. • Decreases in the Herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite.

10. Four-Firm Concentration Ratio • The four-firm concentration ratio (CR4) measures market concentration by adding the market shares of the four largest firms in an industry. • If CR4 > 60, then the market is likely to be oligopolistic.

11. Example

12. Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in 1997

13. The Herfindahl-Hirschman Index • The Herfindahl-Hirschman index (HHI) is found by summing the squares of the market shares of all firms in an industry. • Advantages over the CR4 measure: • Measures how “concentrated” the market is • Large market shares -> squared -> HHI increases exponentially (rather than linearly) • Uses data on all firms

14. Example

15. Example (cont’d) What happens if market shares are evenly distributed?

16. Non-competitive Oligopolies • Non-competitive/collusive behavior (cooperative oligopolies) • Cartels: firms may collude to raise prices and restrict production in the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. • Dominant Firm/Price Leader: • collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development. • does not require formal agreement • although for the act to be illegal there must be a real communication between companies • for example, in some industries, there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership. • Stackleberg price-leader model

17. An Example of a Cartel • Organization of the Petroleum Exporting Countries (OPEC) is an international cartel made up of Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. • Principal aim of the organization, according to its Statute, is the determination of the best means for safeguarding their interests, individually and collectively; devising ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations • OPEC triggered high inflation across both the developing and developed world using oil embargoes in the 1973 oil crisis. • OPEC's ability to control the price of oil has diminished due to the subsequent discovery/development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization. • OPEC nations still account for two-thirds of the world's oil reserves, and, in 2005, 41.7% of the world's oil production,

18. Game Theory Modelsof Oligoploy • Stackelberg's duopoly. In this model the firms move sequentially (see Stackelberg competition). • Cournot's duopoly. In this model the firms simultaneously choose quantities (see Cournot competition). • Bertrand's oligopoly. In this model the firms simultaneously choose prices (see Bertrand competition). • Monopolistic competition. A market structure in which several or many sellers each produce similar, but slightly differentiated products. Each producer can set its price and quantity without affecting the marketplace as a whole.

19. Anti-Competitive Pricing Tactics Predatory Pricing • Predatory pricing • Firms set prices below AVC with the intent of driving rivals from the market • Illegal, but difficult to prosecute • Often difficult to distinguish between predatory pricing and intense market competition • Examples: • Wal-Mart is often assumed to be a predator but is never prosecuted • Microsoft was prosecuted eventually for tying, but not for predatory pricing

20. Predatory Pricing Scheme $ Incumbent Firm’s Price AVC,MC Competitor Enters Competitor Leaves Time

21. Network Externalities • Network externality • Occurs when the number of customers who purchase a good influences the quantity demanded • Often is a factor in whether the resulting market structure is oligopoly • Classic examples include technologies such as cell phones and fax machines • A new technology has to reach “critical mass” before it is effective for consumers • How useful would a fax machine be if only 10 people had the machine?

22. Network Externalities • Positive network externalities • Bandwagon effect • Individual preferences for a good increase as the number of people buying the good increases • Internet, social networks, cell phones, fax machines, MMORPGs, video game consoles, fads, night clubs

23. Network Externalities • Negative network externalities • Snob effect • Individual preferences for a good decrease as the number of people buying the good increases • Exotic pets and sports cars • Hipsters • Services that are prone to “congestion.” Pool, beach, student union gets “too crowded,” and you don’t want to go.

24. Network Externalities • Switching costs • Costs that are incurred by a consumer when he switches suppliers • Another advantage to a firm having a large network • Demand for existing product becomes more inelastic if costs of switching to a new product are higher • Example: cellphone providers • Early termination fees • Free in-network calls • FTC reduced switching costs in 2003 by requiring phone companies to allow a consumer to take their old phone number to a new provider

26. Conclusion • Oligopoly • A market structure in which there are a small number of firms • Firms interact strategically • Can be competitive (results closer to monopolistic competition) • Can be collusive (results closer to monopoly) • Antitrust policies • Restrain excessive market power • Give incentives to compete instead of collude • Each industry examined on a case-by-case basis

27. Summary • Oligopoly: a small number of firms sell a differentiated product in a market with significant barriers to entry. The small number of sellers in oligopoly leads to mutual interdependence. • An oligopolist is like a monopolistic competitor in that it sells differentiated products. • It is also like a monopolist in that it enjoys significant barriers to entry. • Oligopolists have a tendency to collude and to form cartels in hope of achieving monopolylike profits.

28. Summary • Oligopolistic markets are socially inefficient since P > MC. The result under oligopoly will fall somewhere between the competitive and monopoly outcomes. • Game theory helps determine when cooperation among oligopolists is most likely. • In many cases, cooperation fails to materialize because decision-makers have dominant strategies that lead them to be uncooperative. • This causes firms to compete with price, advertising, or R & D when they could potentially earn more profit by curtailing these activities.

29. Summary • A dominant strategy ignores the long run benefits of cooperation and focuses solely on the short run gains • Whenever repeated interaction exists, decision-makers fare better under tit for tat, an approach that maximizes the long run profit • Antitrust laws are complex and cases are hard to prosecute, but they provide firms an incentive to compete rather than collude • The presence of significant positive network externalities causes small firms to be driven out of business or to merge with larger competitors

30. Practice What You Know Which of the following is most likely to become an oligopoly industry? An industry without entry barriers An industry where economies of scale are very small An industry with sizeable network effects An industry with hundreds of competitors

31. Practice What You Know Which of the following is true about oligopoly? Oligopolies are illegal in the United States All oligopoly industries will try to collude Oligopoly industries generally have a high concentration ratio Firms in an oligopoly act independently from other firms in the oligopoly

32. Practice What You Know Why do cartel deals tend not to last? Each firm in the cartel has a dominant strategy to be uncooperative and defect from the cartel agreement Cartel profits are lower than competitive profits Cartels create more competition Firms know that cartels are often illegal so they break the deal to escape

33. Practice What You Know What is an example of a good with a positive network effect? An online multiplayer game A fast-food burger A dry-cleaning service A cable TV subscription

34. Practice What You Know How can a pure strategy Nash equilibrium be accurately described? • It is always the overall best outcome • It’s an outcome in which neither player wants to change strategies • It can only be reached by collusion • One exists in all games