Chapter 12 Price and Output Determination Under Oligopoly

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Economic Principles The concentration ratio and the Herfindahl-Hirschman Index (HHI) Balanced and unbalanced oligopoly Horizontal, vertical and conglomerate mergers Gottheil - Principles of Economics, 4 e © 2005 Thomson 2

Concentration Ratios For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few—oligopoly. Gottheil - Principles of Economics, 4 e © 2005 Thomson 4

Concentration Ratios An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic. Gottheil - Principles of Economics, 4 e © 2005 Thomson 5

Concentration Ratios Concentration ratio • A measure of market power. It is the ratio of total sales of the leading firms in an industry (usually four) to the industry’s total sales. Gottheil - Principles of Economics, 4 e © 2005 Thomson 6

Concentration Ratios A criterion for determining whether an industry is an oligopoly: • If the leading four firms in an industry account for 40 percent or more of total industry sales, then an industry is likely to be an oligopoly. Gottheil - Principles of Economics, 4 e © 2005 Thomson 7

Concentration Ratios Herfindahl-Hirschman index • A measure of industry concentration, calculated as the sum of the squares of the market shares held by each of the firms in the industry. Gottheil - Principles of Economics, 4 e © 2005 Thomson 8

EXHIBIT 1 CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI Source: U. S. Bureau of the Census, 1997 Concentration Ratios in Manufacturing, 2001. Gottheil - Principles of Economics, 4 e © 2005 Thomson 9

Exhibit 1: Concentration Ratios— Percentage of Total Industry Sales Produced by the Leading Four Firms, and HHI How many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level? • 12 of the 15 industries. Gottheil - Principles of Economics, 4 e © 2005 Thomson 10

EXHIBIT 2 DISTRIBUTION OF MANUFACTURING INDUSTRIES BY FOUR-FIRM SALES CONCENTRATION Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission. Data refer to 1982. Gottheil - Principles of Economics, 4 e © 2005 Thomson 11

Exhibit 2: Distribution of Manufacturing Industries by Four-Firm Sales Concentration How many industries had fourfirms controlling 40 -59 percent of the industry sales in 1982? • 120 out of 448 total industries had four firms controlling 40 -59 percent of the total industry sales. Gottheil - Principles of Economics, 4 e © 2005 Thomson 12

Oligopoly and Concentration Ratios Contrary to many people’s intuition, there is no convincing evidence that the share of industry sales controlled by the four leading firms in the US manufacturing economy is growing. Gottheil - Principles of Economics, 4 e © 2005 Thomson 13

EXHIBIT 3 PERCENTAGE OF TOTAL INDUSTRIAL SALES PRODUCED BY INDUSTRIES WITH FOUR-FIRM SALES CONCENTRATION RATIOS OF 50 PERCENT OR MORE: 1895– 1982 Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission. Gottheil - Principles of Economics, 4 e © 2005 Thomson 14

Exhibit 3: Percentage of Total Industrial Sales Produced by Industries with Four. Firm Sales Concentration Ratios of 50 Percent or More: 1895 -1982 What is the trend in the percentage of industrial sales produced by the largest four firms since 1963? • There is a downward trend in the percentage of industrial sales by the largest four firms from 1963 to 1982. Gottheil - Principles of Economics, 4 e © 2005 Thomson 15

Oligopoly and Concentration Ratios Unbalanced oligopoly • An oligopoly in which the sales of the leading firms are distributed unevenly among them. Gottheil - Principles of Economics, 4 e © 2005 Thomson 17

Oligopoly and Concentration Ratios Balanced oligopoly • An oligopoly in which the sales of the leading firms are distributed fairly evenly among them. Gottheil - Principles of Economics, 4 e © 2005 Thomson 18

Exhibit 4: Balanced and Unbalanced Oligopoly 1. What percentage of their industry’s total sales do the leading four firms in Industry A and B control? • The leading four firms in both industry A and B control 80 percent of their industry’s sales. Gottheil - Principles of Economics, 4 e © 2005 Thomson 20

Exhibit 4: Balanced and Unbalanced Oligopoly 2. Why is industry B considered an unbalanced oligopoly? • The largest firm in industry B controls 50 percent of the industry’s sales. It’s market share is greater than the other three leading industries combined and more than four times greater than the next largest firm’s sales share. Principles of Economics, 4 e 21 Gottheil © 2005 Thomson

Oligopoly and Concentration Ratios • The dominance of oligopolies in industry is not unique to the U. S. • The concentration ratios for U. S. industries are similar to other modern industrialized economies. Gottheil - Principles of Economics, 4 e © 2005 Thomson 22

EXHIBIT 5 PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I. , ed. , The Tsuneta Yano Memorial Society, p. 162. Gottheil - Principles of Economics, 4 e © 2005 Thomson 23

Exhibit 5: Production Concentration Ratios in Japanese Manufacturing Industries by Leading and Five Leading Firms In how many Japanese industries do the five leading firms have greater than a 90 percent production concentration ratio? • Four industries—beer, nylon, glass, and tires and tubes—are controlled by the five leading firms at a concentration of 90 percent or greater. 24 © 2005 Thomson

Concentrating the Concentration An oligopoly can build market power in two ways: • Reinvesting its profit and painstakingly expanding its production capacity. • Merging with and/or acquiring other firms. Gottheil - Principles of Economics, 4 e © 2005 Thomson 25

Concentrating the Concentration There are three reasons why firms merge: 1. To exercise greater market control. 2. To increase control over the supplies of their inputs or the buyers of their goods. 3. To expand diversify their asset holdings. Gottheil - Principles of Economics, 4 e © 2005 Thomson 26

Exhibit 6: A Century of High Merger Activity Complete this sentence: On the whole, the number of mergers per year in the U. S. has ____ between 1890 and 1990. i. Increased ii. Remained the same iii. Decreased Gottheil - Principles of Economics, 4 e © 2005 Thomson 29

Concentrating the Concentration A number of high-profile horizontal mergers occurred in the 1990 s. • Boeing and Mc. Donnell Douglas in the aircraft industry. • Staples and Office Depot in the office supply industry. • Union Pacific and Southern Pacific Rail in the railroad industry. Gottheil - Principles of Economics, 4 e © 2005 Thomson 32

Concentrating the Concentration An example of vertical merging is that of Anheuser-Busch. The firm has acquired malt plants, yeast plants, a cornprocessing plant, beer can factories, and a railway that ships freight by rail and truck. Gottheil - Principles of Economics, 4 e © 2005 Thomson 34

Concentrating the Concentration • One reason for conglomerate mergers is the desire to diversify operations. • While horizontal and vertical mergers strengthen the firm’s position within the industry, the fate of the firm rests on the health of the industry. • Acquiring unrelated firms insures the conglomerate against catastrophe if one industry faces severe problems. Gottheil - Principles of Economics, 4 e © 2005 Thomson 37

Concentrating the Concentration Cartel • A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares. Gottheil - Principles of Economics, 4 e © 2005 Thomson 38

Concentrating the Concentration Collusion • The practice of firms to negotiate price and market share decision that limit competition in a market. Gottheil - Principles of Economics, 4 e © 2005 Thomson 39

Concentrating the Concentration Cartels are an example of a merger in which firms don’t have to actually buy each other’s assets, yet they enjoy the benefits of having market power. Gottheil - Principles of Economics, 4 e © 2005 Thomson 40

Concentrating the Concentration • While cartels are illegal in the United States, it is difficult to prove collusion. • Some cartels are disguised. Agricultural cooperatives in regions of the US behave like cartels. • Some governments encourage cartels to form in their countries. OPEC is one example. Gottheil - Principles of Economics, 4 e © 2005 Thomson 41

Concentrating the Concentration Many studies support the contention that price and concentration ratios move in the same direction – an increase in one is associated with an increase in the other. Gottheil - Principles of Economics, 4 e © 2005 Thomson 42

Exhibit 7: Relationship Between the Concentration Ratio and Price Where on the curve in Exhibit 7 does the concentration ratio have the strongest effect on price? • The effect is the strongest in the middle of the S-shaped curve. Gottheil - Principles of Economics, 4 e © 2005 Thomson 44

Theories of Oligopoly Pricing Game theory • A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent. Gottheil - Principles of Economics, 4 e © 2005 Thomson 45

Theories of Oligopoly Pricing In monopoly, monopolistic competition and perfect competition, firms react only to the demand cost structures they face. Prices tend toward equilibrium. Gottheil - Principles of Economics, 4 e © 2005 Thomson 46

Theories of Oligopoly Pricing In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change. Gottheil - Principles of Economics, 4 e © 2005 Thomson 47

Exhibit 9: Firm Profit, Generated by High and Low Pricing How does total profit change as Dell and Compaq change their prices? • When both firms price high, total profit is 20. When one firm prices high and the other prices low, total profit is 18. When both firms price low, total profit is 12. Gottheil - Principles of Economics, 4 e © 2005 Thomson 50

Theories of Oligopoly Pricing Price leadership • A firm whose price decisions are tacitly accepted and followed by other firms in the industry. The theory explains pricing in unbalanced oligopolies. Gottheil - Principles of Economics, 4 e © 2005 Thomson 51

Exhibit 10: Price and Output Under Conditions of Godfather Oligopoly How is the price of chocolate determined in Exhibit 9? • Hershey is the “godfather” in the chocolate business. Hershey produces where its MR = MC. That is, 5 tons of chocolate at $5 per pound. The other firms in the chocolate industry accept the $5 per pound price. Gottheil - Principles of Economics, 4 e 53 © 2005 Thomson

Theories of Oligopoly Pricing Kinked demand curve • The demand curve facing a firm in oligopoly; the curve is more elastic when the firm raises price than when it lowers price. Gottheil - Principles of Economics, 4 e © 2005 Thomson 54

Exhibit 11: Constructing an Oligopolist’s Demand Curve 1. If Lipton were to raise its price above $0. 80 per box, what would its competitors do, according to the curve in panel b? • Lipton’s competitors would not follow suit. Lipton’s demand curve above $0. 80 (NK) is relatively elastic. Gottheil - Principles of Economics, 4 e © 2005 Thomson 56

Exhibit 11: Constructing an Oligopolist’s Demand Curve 2. If Lipton were to lower its price below $0. 80 per box, then what would its competitors do? • Lipton’s competitors would feel compelled to follow suit. Lipton’s demand curve below $0. 80 (YK) is relatively inelastic. Gottheil - Principles of Economics, 4 e © 2005 Thomson 57

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves The marginal revenue curve associated with a kinked demand curve is: i. Continuous ii. Discontinuous Gottheil - Principles of Economics, 4 e © 2005 Thomson 59

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves As long as the MC curve crosses the gap created by the discontinuity in the MR curve, price will remain unchanged, as shown in panel b. Gottheil - Principles of Economics, 4 e © 2005 Thomson 61

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves If the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c. Gottheil - Principles of Economics, 4 e © 2005 Thomson 62

Brand Multiplication • A firm’s market share = (number of brands) × (brand market share). • As the number of brands in the industry increases, market share per brand diminishes. Gottheil - Principles of Economics, 4 e © 2005 Thomson 64

Price Discrimination Price discrimination • The practice of offering a specific good or service at different prices to different segments of the market. Gottheil - Principles of Economics, 4 e © 2005 Thomson 65

Price Discrimination • Oligopolists sometimes segment the market in order to charge consumers what they are willing to pay for a good or service. • Differences in airline ticket prices are a good example. Gottheil - Principles of Economics, 4 e © 2005 Thomson 66

Exhibit 13: Demand Schedule for a United Airlines Round-Trip Flight Between LA and NY If United chose not to segment its market in Exhibit 12, what would be its total revenue? • The maximum total revenue for United would be achieved at a ticket price of $318 each, for a total of $119, 250. Gottheil - Principles of Economics, 4 e © 2005 Thomson 68

Exhibit 14: Demand by Market Segment for a United Airlines Round-Trip Flight Between LA and NY What is United’s total revenue when it segments its market into a multiple-fare system? • United’s total revenue is $210, 635. This is an increase of $91, 385 over the unsegmented market. Gottheil - Principles of Economics, 4 e © 2005 Thomson 70

Price Discrimination • Price discrimination exists in virtually every market. • Some differences in price are not clear cases of price discrimination, however. Gottheil - Principles of Economics, 4 e © 2005 Thomson 71

Why Oligopolists Sometimes Discriminate • For example, many would argue that upper balcony seats are not the same as front row seats at a concert. If the goods are different, then it is not necessarily price discrimination to charge more for the front row seats. Gottheil - Principles of Economics, 4 e © 2005 Thomson 72

Exhibit 15: Cartel Pricing and Output Allocations Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned? • The price and output decisions made by the cartel are determined by the MR = MC rule. Gottheil - Principles of Economics, 4 e © 2005 Thomson 75

Exhibit 15: Cartel Pricing and Output Allocations Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned? • The price and quantity assigned to individual firms within the cartel may not coincide with where the firm would maximize profit using its own MR and MC curves. Gottheil - Principles of Economics, 4 e 76 © 2005 Thomson

Exhibit 15: Cartel Pricing and Output Allocations Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned? • There is an incentive for the firm to try to secretly increase quantity and thereby increase its own profit. Gottheil - Principles of Economics, 4 e © 2005 Thomson 77