Chapter 13

1. Chapter 13 Oligopoly and Monopolistic Competition

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

4. 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

5. Monopolistic competition • small or moderate number of firms • free entry •  = 0 • p = AC • usually products differentiated

7. 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

8. 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

9. 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

10. 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

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

12. Airlines Example • American Airlines and United Airlines • compete for customers on flights between Chicago and Los Angeles

13. Notation • Q = total number of passengers flown by both firms; sum of: • qA = passengers on American Airlines • qU = passengers on United Airlines

14. 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

16. Dominant strategy • a strategy that strictly dominates all other strategies regardless of which actions rivals’ chose • in this Table 13.2 game, each firm has a dominant strategy • firm chooses its dominant strategy • where a firm has a dominant strategy, its belief about its rival's behavior is irrelevant

17. Noncooperative game • firms do not cooperate in a single-period game • In Nash equilibrium (qA = qU = 64), each firm earns $4.1 million (< $4.6 million it would make if firms restricted their outputs to qA = qU= 48) • sum of firms' profits is not maximized in this simultaneous choice, one-period game

18. 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

19. 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

20. 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

21. 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

22. Threat • suppose American announces to United that it will use the following two-part strategy: • American produces smaller quantity each period as long as United does the same • if United produces larger quantity in period t, then American will produce larger quantity in period t + 1and all subsequent periods • thus, if firms play same game indefinitely, they should find it easier to collude

23. Know number of periods • suppose firms know that they are going to play game for T periods • period T is like a single-period game, and all firms cheat • hence T-1 period is last interesting period • by same reasoning, they cheat in that period, etc. • cheating is less likely to occur if end period is unknown or there is no end

24. Insurance price wars • from 1984-1995, life insurance companies' prices were high and unchanging • in 1995, prices dropped 25% or more

25. Explanations for price war 1. insurers knew that new “Triple X” regulations were expected to go into effect in 1996 • regulations required insurers to raise reserves on term policies to cover future claims • were expected to boost rates on new policies by as much as 50% • companies cut rates to attract new customers before higher rates took effect 2. formal or informal agreement to keep prices high fell apart as end of original game approached

26. Cooperative oligopoly models 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"

27. 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

28. Historic cartels in late nineteenth century, cartels (trusts) were legal and common in the United States • oil • railroads • sugar • tobacco • steel J.D. Rockefeller

31. Laws against cartels • in response to trusts' high prices, Congress passed • Sherman Antitrust Act in 1890 • Federal Trade Commission Act of 1914 • these laws prohibit firms from explicitly agreeing to take actions that reduce competition, such as jointly setting price • these anti-cartel laws are called • antitrust laws in U.S. • competition policies in most other countries

32. Europe • over the last dozen years, the European Commission has been pursuing competition cases under laws that are similar to U.S. antitrust laws • recently the EC, the DOJ, and the FTC have become increasingly aggressive, prosecuting many more cases • following the U.S., which uses both civil and criminal penalties, the British government introduced legislation in 2002 to criminalize certain cartel-related conduct • EU uses only civil penalties, but its fines have increased dramatically, as have U.S. fines

33. Corporate Leniency Program • in 1993, DOJ introduced a new Corporate Leniency Program that guarantees that participants in cartels who blow the whistle will receive immunity from federal prosecution • as a consequence, DOJ has caught, prosecuted, and fined several gigantic cartels (e.g. Vitamins) • on Valentine’s Day, 2002, EC adopted a similar policy

34. Sotheby’s and Christie’s • Sotheby’s (established in 1744) and Christie’s (1776) are the two largest and most prestigious auction houses in the world • they control 90% of the $4 billion worldwide auction market • for most of the last two and a half centuries, they thrived • starting at least by 1993, when faced with poor business conditions, they started to collude, according to the U.S. Department of Justice (DOJ)

35. Auctions (cont.) • DOJ started investigating in 1997, but gained the necessary evidence in 2000, when Christie’s approached both DOJ and European Commission with proof that it had conspired with Sotheby’s to fix prices • Christie’s applied for leniency under the U.S. antitrust laws, effectively “shopping” its rival

36. Auctions (cont.) • DOJ charged that the pair • held meetings between top-level executives • exchanged confidential lists of super-rich clients • agreed to limit which customers received lower commissions • charged identical commission rates (a sliding scale up to 20%) to other sellers who had little negotiation power • Sotheby’s paid a $45 million fine • the two auction houses agreed to pay more than $512 million to former clients to settle lawsuits

37. Auctions (cont.) • A. Alfred Taubman, Sotheby’s former chairman and who still held a 21% share of stock and controlled 63% of its voting rights, was sentenced for price fixing to a year in prison and fined $7.5 million in 2002 • Christie’s former chairman, Sir Anthony Tennant, lives in England has refused to come to the United States to face trial • however, days before Taubman’s conviction, the European Commission brought charges against both auction houses

38. Why some cartels persist 1. tacit collusion 2. international cartels (OPEC) and cartels within certain countries operate legally 3. illegal cartel believes it can avoid detection or punishment will be small

39. Why cartels form members of cartel believe they can raise their profits by coordinating their actions

40. 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

41. 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

42. Figure 13.1 Competition Versus Cartel (b) Market (a) Firm Price, p , Price, p , $ per unit $ per unit M C S e m p p m m AC e p p c c c MC MC m m Market demand MR q q q * Q Q m c m c Quantity, q , Units Quantity, Q , Units per year per year

43. 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?

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

46. 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

47. Insurance price wars • life insurance companies' prices are normally stable and high • however, in 1995, companies dropped their prices substantially: 25% or more • the previous price war 1981-3, when term insurance rates went from $4 to $1 per thousand dollars of coverage for a 35-year-old for a 10-year plan

48. Cause of price war • theory 1: sparked by new insurance regulations • insurers knew in advance when these new regulations (Triple X) were expected to go into effect • new regulations required insurers raise reserves on term policies to cover future claims; were expected to boost rates by as much as 50% • companies were cutting rates to attract new customers before the higher rates took effect

49. Alternative theory theory 2 (not necessarily incompatible view): a formal or informal agreement to keep prices high fell apart as the end of the original game approached

50. Government created cartels • American, European, and other governments established a cartel in 1944 that fixed prices for international airline flights and prevented competition • baseball teams exempted from some U.S. antitrust laws since 1922 Bud Selig, baseball's commissioner: “[The baseball] antitrust exemption is protection for the fans.” • automobiles