Chapter 27 Oligopoly and Strategic Behavior Introduction

Chapter 27 Oligopoly and Strategic Behavior

Introduction The number of languages decreased by 40% during the past 10, 000 years, even as the global population exploded. This example, although based on language, helps us understand scarcity, positive market feedback, and network effects that exist in markets. These concepts, in turn, help us understand oligopoly and strategic behavior. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 2

Learning Objectives • Outline the fundamental characteristics of oligopoly • Understand how to apply game theory to evaluate the pricing strategies of oligopolistic firms • Explain the kinked demand theory of oligopolistic price rigidity • Describe theories of how firms may deter market entry by potential rivals • Illustrate why network effects and market feedback can explain why some industries are oligopolies Copyright © 2008 Pearson Addison Wesley. All rights reserved. 3

Chapter Outline • Oligopoly • Strategic Behavior and Game Theory • Price Rigidity and the Kinked Demand Curve • Strategic Behavior with Implicit Collusion: A Model of Price Leadership • Deterring Entry into an Industry • Network Effects • Comparing Market Structures Copyright © 2008 Pearson Addison Wesley. All rights reserved. 4

Did You Know That. . . • Only two private companies, Accu. Weather and the Weather Channel, provide weather forecasts on a nationwide basis? • In the microprocessor and defense industries, the top five firms account for about 80% of all sales? • Similarly, the top three publishers of college textbooks generate well over 70% of all of the textbook sales? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 5

Oligopoly • An important market structure that we have yet to discuss involves a situation in which a few large firms comprise an entire industry. • They are not perfectly competitive, nor even monopolistically competitive, and because there are several of them a pure monopoly doesn’t exist. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 6

Oligopoly (cont'd) • Oligopoly § A market situation in which there are very few sellers § Each seller knows that the other sellers will react to its changes in prices and quantities. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7

Oligopoly (cont'd) • Characteristics of oligopoly § Small number of firms § Interdependence Ø

Oligopoly (cont'd) • Strategic Dependence § A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry § Such dependence can exist only when there a limited number of firms in an industry. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 9

Oligopoly (cont'd) • Why oligopoly occurs § Economies of scale § Barriers to entry

Oligopoly (cont'd) • Vertical Merger § The joining of a firm with another to which it sells an output or from which it buys an input • Horizontal Merger § The joining of firms that are producing or selling a similar product Copyright © 2008 Pearson Addison Wesley. All rights reserved. 11

Oligopoly (cont'd) • Measuring industry concentration § Concentration Ratio Ø The percentage of all sales contributed by the leading four or leading eight firms in an industry Ø Sometimes called the industry concentration ratio Copyright © 2008 Pearson Addison Wesley. All rights reserved. 12

Table 27 -1 Computing the Four-Firm Concentration Ratio Copyright © 2008 Pearson Addison Wesley.

Table 27 -2 Four-Firm Domestic Concentration Ratios for Selected U. S. Industries Copyright ©

E-Commerce Example: Market Concentration in the Computer Printer Industry • The computer printer industry generated $50 billion in revenues in a recent year, and four firms had a high market share. • Of the four: Hewlett-Packard earned $24 billion, Lexmark $9. 7 billion, Dell $6. 9 billion and Epson $5. 2 billion. • These figures imply a concentration ratio of 91. 6%. Thus, the printer industry is very concentrated. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15

Oligopoly, Inefficiency, and Resource Allocation • To the extent oligopolists have market power—the ability to individually affect the market price for the industry’s output—they lead to resource misallocations, just as monopolies do. • But if oligopolies occur because of economies of scale, consumers might actually end up paying lower prices. • All in all, there is no definite evidence of serious resource misallocation in the United States because of oligopolies. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16

Oligopoly, Inefficiency, and Resource Allocation (cont'd) • The more U. S. firms face competition from the rest of the world, the less any current oligopoly will be able to exercise market power. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 17

Strategic Behavior and Game Theory • Explaining the pricing and output behavior of oligopoly markets § Reaction Function Ø The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry Copyright © 2008 Pearson Addison Wesley. All rights reserved. 18

Strategic Behavior and Game Theory (cont'd) • Game Theory § A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly § The plans made by these individuals are known as game strategies. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 19

Strategic Behavior and Game Theory (cont'd) • Cooperative Game § A game in which the players explicitly cooperate to make themselves better off Ø Firms collude for higher than competitive rates of return • Noncooperative Game § A game in which the players neither negotiate nor cooperate in any way Ø Relatively few firms with some ability to change price Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20

Strategic Behavior and Game Theory (cont'd) • Zero-Sum Game § A game in which any gains within the group are exactly offset by equal losses by the end of the game Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21

Strategic Behavior and Game Theory (cont'd) • Negative-Sum Game § A game in which players as a group lose at the end of the game • Positive-Sum Game § A game in which players as a group are better off at the end of the game Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22

Strategic Behavior and Game Theory (cont'd) • Strategies in noncooperative games § Strategy Ø Any rule that is used to make a choice such as “always pick heads” § Dominant Strategies Ø Strategies that always yield the highest benefit Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23

Example: The Prisoners’ Dilemma • Two people involved in a bank robbery are caught. • What should they do when questioned by police? • The result has been called the prisoners’ dilemma. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24

Example: The Prisoners’ Dilemma (cont'd) • The two are interrogated separately and their interrogator indicates the following: 1. If both confess, they each get five years in jail for the crime. 2. If neither confesses, they each get two years based on a lesser charge. 3. If only one confesses, that person will go free, but the other receives ten years. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 25

Example: The Prisoners’ Dilemma (cont'd) • Question § What would you do in this situation, keeping in mind no cooperation is involved between Sam and Carol? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26

Example: The Prisoners’ Dilemma (cont'd) • The prisoners’ alternatives are shown in a payoff matrix. There are four possibilities: 1. Both confess. 2. Neither confesses. 3. Sam confesses; Carol doesn’t. 4. Carol confesses; Sam doesn’t. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27

Figure 27 -1 The Prisoners’ Dilemma Payoff Matrix Copyright © 2008 Pearson Addison Wesley.

The Prisoners’ Dilemma Payoff Matrix • Regardless of what the other prisoner does, each person is better off if she or he confesses. • So confessing is the dominant strategy, and each ends up behind bars for five years. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 29

Strategic Behavior and Game Theory (cont'd) • Applying game theory to pricing strategies § Would you choose a high price or a low price? Ø Remember q No collusion Copyright © 2008 Pearson Addison Wesley. All rights reserved. 30

Figure 27 -2 Game Theory and Pricing Strategies Copyright © 2008 Pearson Addison Wesley.

Strategic Behavior and Game Theory (cont'd) • Opportunistic Behavior § Actions that, because long-run benefits of cooperation are perceived to be smaller, focus on short-run gains § An example might be writing a check that you know will bounce. § Implies a noncooperative game which is not realistic—we make repeat transactions Copyright © 2008 Pearson Addison Wesley. All rights reserved. 32

Strategic Behavior and Game Theory (cont'd) • Tit-for-Tat Strategic Behavior § In game theory, cooperation that continues so long as the other players continue to cooperate Copyright © 2008 Pearson Addison Wesley. All rights reserved. 33

Price Rigidity and the Kinked Demand Curve • Let’s hypothesize decision makers in an oligopolistic firm assume rivals will react in the following way: § They will match price decreases (in order not to be undersold) § But not price increases (because they want to capture more business) Copyright © 2008 Pearson Addison Wesley. All rights reserved. 34

Figure 27 -3 The Kinked Demand Curve, Panel (a) • d 1 is relatively elastic • If one firm raises its price, the others will not and it will lose market share • d 2 is relatively inelastic • If one firm lowers its price, the others lower their price so gain in sales is small Copyright © 2008 Pearson Addison Wesley. All rights reserved. 35

Figure 27 -3 The Kinked Demand Curve, Panel (b) The kinked demand curve indicates

Figure 27 -4 Changes in Cost May Not Alter the Profit-Maximizing Price and Output Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR Copyright © 2008 Pearson Addison Wesley. All rights reserved. 37

Price Rigidity and the Kinked Demand Curve (cont'd) • Criticisms of the kinked demand curve § Oligopoly prices do not appear to be as rigid, particularly in an upward direction, as the kinked demand curve implies. § During the 1970 s and 1980 s, when prices were rising overall, oligopolistic producers increased prices frequently. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 38

Strategic Behavior with Implicit Collusion: A Model of Price Leadership • Price Leadership § A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices § Also called parallel pricing Copyright © 2008 Pearson Addison Wesley. All rights reserved. 39

Strategic Behavior with Implicit Collusion: A Model of Price Leadership (cont'd) • Price War § A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices Copyright © 2008 Pearson Addison Wesley. All rights reserved. 40

Strategic Behavior with Implicit Collusion: A Model of Price Leadership (cont'd) • Markets where price wars are common § Cigarettes § Long-distance telephone companies § Airlines Copyright © 2008 Pearson Addison Wesley. All rights reserved. 41

Strategic Behavior with Implicit Collusion: A Model of Price Leadership (cont'd) • Markets where price wars are common § Diapers § Frozen foods § PC hardware and software Copyright © 2008 Pearson Addison Wesley. All rights reserved. 42

Deterring Entry Into an Industry • Entry Deterrence Strategy § Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm Copyright © 2008 Pearson Addison Wesley. All rights reserved. 43

Deterring Entry Into an Industry (cont'd) • Increasing entry cost § Threat of price wars § Government regulations Ø Environmental Ø Safety regulation standards Copyright © 2008 Pearson Addison Wesley. All rights reserved. 44

Deterring Entry Into an Industry (cont'd) • Limit-Pricing Model § A model that hypothesizes that a group of colluding sellers will set the highest common price they believe they can charge, without new firms seeking to enter the industry in search of relatively high profits Copyright © 2008 Pearson Addison Wesley. All rights reserved. 45

Example: Switching Costs Keep the HDTV Market on a Dim Setting • Consumers are not the only ones who face switching costs in the market for HDTVs. • Indeed, the complications that consumers face arise in part from the fact producers have also been struggling with switching costs of their own. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 46

Example: Switching Costs Keep the HDTV Market on a Dim Setting (cont'd) • The substantial switching costs have slowed sales in the market for HDTVs. • At present, sales of HDTVs account for only slightly more than 10% of total television sales. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 47

Network Effects • Network Effect § A situation in which a consumer’s willingness to purchase a good or service is influenced by how many others also buy or have bought the item Copyright © 2008 Pearson Addison Wesley. All rights reserved. 48

Network Effects (cont'd) • Positive Market Feedback § Potential for a network effect to arise when an industry’s product catches on • Negative Market Feedback § The tendency for industry sales to spiral downward rapidly when the product falls out of favor Copyright © 2008 Pearson Addison Wesley. All rights reserved. 49

E-Commerce Example: Jumping on the “i” Bandwagon • Apple simultaneously developed i. Tunes and the i. Pod knowing something about market economics. • A key feature that helped i. Tunes catch on with consumers is its ability to store audio data in binary format. • Positive market feedback and network effects have boosted Apple’s market share in music downloads to 70%, and digital music players to 60% of the industry. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 50

Network Effects and Industry Concentration • In some industries, a few firms can potentially reap most of the benefits of positive market feedback. • There is a network effect present in the online auction industry, in which e. Bay, Amazon and Yahoo account for more than 80% of sales. • When a small number of firms secure the bulk of payoffs resulting from positive market feedback, oligopoly is likely to emerge as the prevailing market structure. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 51

Comparing Market Structures • We have looked at perfect competition, pure monopoly, monopolistic competition and oligopoly. • We are in a position to compare the attributes of these four different market structures. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 52

Table 27 -3 Comparing Market Structures Copyright © 2008 Pearson Addison Wesley. All rights

Issues and Applications: The Network Effects of Languages • The use of language is a classic situation in which network effects apply. • Network effects can generate both positive and negative market feedback. • Half of the world’s population uses ten languages as a first or second language. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 54

Figure 27 -5 The Top Ten Languages Used as First or Second Languages Copyright

Summary Discussion of Learning Objectives • The fundamental characteristics of oligopoly § Economies of scale § Barriers to entry § Strategic dependence • Applying game theory to evaluate the pricing strategies of oligopolistic firms § Game theory looks at competition for payoffs § Depends on the strategies that others employ Copyright © 2008 Pearson Addison Wesley. All rights reserved. 56

Summary Discussion of Learning Objectives (cont'd) • The kinked demand theory of oligopolistic price rigidity § If a firm believes that rivals will follow price cuts but not price increases, it will be reluctant to change price. • How firms may deter market entry by potential rivals § Raise entry costs § Limit pricing § Switching policies Copyright © 2008 Pearson Addison Wesley. All rights reserved. 57

Summary Discussion of Learning Objectives (cont'd) • Why network effects and market feedback encourage oligopoly § Network effects arise when a consumer’s demand for a good or service is affected by how many other consumers also use the item. § Oligopoly can arise because a handful of firms may be able to capture all of the positive market feedback. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 58

End of Chapter 27 Oligopoly and Strategic Behavior