INTRODUCTION OLIGOPOLY CHARACTERISTICS OF MARKET STRUCTURES DEGREES OF POWER DETERMINANTS OF MARKET POWER

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1 INTRODUCTION Questions examined in this chapter include: What determines how much market power a firm has? How do firms in an oligopoly set prices and output? What problems does an oligopoly have in maintaining price and profit? Chapter 10 OLIGOPOLY 2 DEGREES OF POWER CHARACTERISTICS OF MARKET STRUCTURES Most firms possess some market power. We classify firms into specific market structures based on the number and relative size of firms in an industry. Market structure The number and relative size of firms in an industry. In imperfect competition, individual firms have some power in a particular product market. Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service. 3 4 CHARACTERISTICS OF MARKET STRUCTURES DETERMINANTS OF MARKET POWER The determinants of market power include: Number of producers. Size of each firm. Barriers to entry. Availability of substitute goods. 5 6

2 DETERMINANTS OF MARKET POWER The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product flows. The barriers to entry determine to what extent the market is a contestable market. Contestable market An imperfectly competitive industry subject to potential entry if prices or profits increase. DETERMINANTS OF MARKET POWER The availability of substitute goods weakens any firm s market power. The standard measure of market power is the concentration ratio. The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). The concentration ratio is a measure of market power that relates the size of firms to the size of the market. 7 8 MEASUREMENT PROBLEMS OLIGOPOLY BEHAVIOR Market power isn t necessarily associated with firm size. A small firm could possess a lot of power in a relatively small market. A high concentration ratio or large firm size is not the only way to achieve market power. Many smaller firms acting in unison can achieve the same result. Measurements do not convey the extent to which market power may be concentrated in a local market. 9 Market structure affects market behavior and outcomes. Assume that the computer market has three oligopolists. 10 INITIAL EQUILIBRIUM INITIAL CONDITIONS IN COMPUTER MARKET Initial conditions and market shares of each firms are described in the following slides. Market share - The percentage of total market output produced by a single firm. Price (per computer) $1000 Market demand ,000 Quantity Demanded (computers per month) 12

3 INITIAL MARKET SHARES OF MICROCOMPUTER PRODUCERS THE BATTLE FOR MARKET SHARES In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms. Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists INCREASED SALES AT REDUCED PRICES Increases in sales by lowering the price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. However, there simply isn t any way that a firm can do so without causing alarms to go off in the industry. RETALIATION Oligopolists respond to aggressive marketing by competitors. Step up marketing efforts. Cut prices on their product(s). One way oligopolists market their products is through product differentiation. Product differentiation Features that make one product appear different from competing products in the same market RETALIATION RIVALRY FOR MARKET SHARES An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price. This is why oligopolists avoid price competition and instead pursue nonprice competition. Price (per computer) $ F G Market demand ,000 25,000 Quantity Demanded (computers per month) 18

4 THE KINKED DEMAND CURVE Close interdependence and the limitations it imposes on price and output decisions is a characteristic of oligopoly. The degree to which sales increase when the price is reduced depends on the response of rival oligopolists. We expect oligopolists to match any price reductions by rival oligopolists. Rival oligopolists may not match price increases in order to gain market share. THE KINKED DEMAND CURVE CONFRONTING AN OLIGOPOLIST The shape of the demand curve facing an oligopolist depends on the responses of its rivals to a change in the price of its own output. The demand curve will be kinked if rival oligopolists match price reductions but not price increases THE KINKED DEMAND CURVE CONFRONTING AN OLIGOPOLIST GAME THEORY PRICE (per computer) $ B Demand curve facing oligopolist if rivals match price cuts but not price hikes Demand curve facing oligopolist if rivals match price changes M A C D Demand curve facing oligopolist if rivals don't match price changes Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies. The payoff to an oligopolist s price cut depends on how its rivals respond. Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs QUANTITY DEMANDED (computers per month) GAME THEORY Each oligopolist is uncertain about its rival s behavior. OLIGOPOLY PAYOFF MATRIX The payoff to an oligopolist s price cut depends on how its rivals respond. The collective interests of the oligopoly are protected if no one cuts the market price. But an individual oligopolist could lose if it holds the line on price when rivals reduce price

5 OLIGOPOLY VS. COMPETITION Oligopolists may try to coordinate their behavior in a way that maximizes industry profits. PRICE AND OUTPUT An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit. Price discounting can destroy oligopoly profits. When it occurs, rival oligopolists seek to end it as quickly as possible. To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares MAXIMIZING OLIGOPOLY PROFITS STICKY PRICES Price or Cost (dollars per unit) Profitmaximizing price Profits Industry marginal cost Industry average cost Market demand Average cost J at profitmaximizing Industry marginal output revenue Profit-maximizing output 0 Quantity (units per period) 27 Prices in oligopoly industries tend to be stable. Like all producers, oligopolists want to maximize profits by producing where MR = MC. The kinked demand curve is really a composite of two separate demand curves. 28 STICKY PRICES AN OLIGOPOLIST S MARGINAL REVENUE CURVE There is a gap in an oligopolist s marginal revenue (MR) curve. As a result, modest shifts of the cost curve will have no impact on the production decision of an oligopolists. 29 Price (dollars per computer) S A F G mr 2 mr H Quantity Demanded (computers per month) d 2 d 1 30

6 THE COST CUSHION COORDINATION PROBLEMS Price or Cost (dollars per unit) 0 Marginal revenue Quantity (units per period) MC 2 MC 1 MC 3 31 There is an inherent conflict in the joint and individual interests of oligopolists. Each oligopolist wants industry profits to be maximized. Each oligopolist wants to maximize it s own market share. To avoid self-destructive behavior, each oligopolist must coordinate production decisions so that: 1. Industry output and price are maintained at profit-maximizing levels. 2. Each oligopolistic firm is content with its market share. 32 PRICE FIXING EXAMPLES OF PRICE FIXING The most explicit form of coordination among oligopolists is called price fixing. Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold. 33 School Milk Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states. Cola The Coca-Cola Bottling Co. of North Carolina agreed to pay a fine and give consumers discount coupons to settle charges of conspiring to fix soft-drink prices from 1982 to Gasoline Mobil, Chevron and Shell paid $77 million in 1993 to settle charges that they conspired to fix gasoline prices. 34 PRICE LEADERSHIP ALLOCATION OF MARKET SHARES Some oligopolists use price leadership rather than explicit agreements to coordinate their prices. Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry. When oligopolists raise their prices, they have to deal with how the loss of output will be distributed among them. One way to distribute output is a cartel agreement. A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market

7 ALLOCATION OF MARKET SHARES An oligopolist may resort to predatory pricing when market shares are not being divided in a satisfactory manner. Predatory pricing - temporary price reductions designed to alter market shares or drive out competition. BARRIERS TO ENTRY Above-normal profits cannot be maintained over the long-run unless barriers to entry exist. Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market PATENTS Patents prevent potential competitors from setting up shop. They either have to develop an alternative method for producing a product or receive permission from the patent holder to use the patented process. DISTRIBUTION CONTROL The control of distribution outlets can be accomplished through selective discounts, longterm supply contracts, or expensive gifts at Christmas. Visa and MasterCard prevent banks that issue their credit cards from offering rival cards. Frito-Lay elbows out competing snacks by paying high fees to rent shelf space in grocery stores METHODS OF ACCESS RESTRICTION A firm can limit competition by acquiring competitors through mergers and acquisition. Patents are issued by the federal government. Licensing requirements imposed by government limit competition. Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market. TRAINING Early market entry can create an important barrier to later competition. Customers of training-intensive products (such as computer hardware and software) become familiar with a particular system. Switching to a different product may entail significant cost. This cost is a barrier to entry to any competing product trying to enter the market

8 NETWORK ECONOMIES The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable. For example, software developers prefer to write Windows based programs rather than for rival operating systems. ANTITRUST GUIDELINES Market power contributes to market failure when it leads to resource misallocations or greater inequity. Market failure is an imperfection in the market mechanism that prevents optimal outcomes INDUSTRY BEHAVIOR Antitrust law is government intervention designed to alter market structure or prevent abuse of market power. There are several problems with the behavioral approach to antitrust law: Limited government resources. Public apathy. Difficulty of proving collusion. OBJECTIONS TO ANTITRUST Public efforts to alter market structure have been less frequent than efforts to alter market behavior. Some argue that we shouldn t punish those who achieved monopolies through hard work and innovation. Noncompetitive behavior, not industry structure, should be the only concern of antitrust OBJECTIONS TO ANTITRUST Big firms are needed for U.S. firms to succeed in international markets that are often dominated by foreign monopolies and oligopolies. Both domestic and foreign firms will try to enter a profitable industry. Eventually, competitive forces will prevail. THE HERFINDAHL-HIRSHMAN INDEX The broad mandates of the anti-trust laws must be transformed into specific guidelines for government intervention. The Herfindahl-Hirschman index (HHI) is a measure of industry concentration that accounts for number of firms and size of each

9 THE HERFINDAHL-HIRSHMAN INDEX THE HERFINDAHL-HIRSHMAN INDEX The Herfindahl-Hirshman Index of market equals the sum of the squares of the market shares of each firm in an industry. 49 For policy purposes, the Justice Department decided it would draw the line at a value of 1,800. In 1992, the Justice Department decided to begin looking not only at existing market structure, but also at the entry barriers. If entry barriers were low enough, even a highly concentrated industry might be compelled to behave more competitively. The FTC now also looks to see if a proposed merger will allow for greater efficiencies and lower costs. 50 OLIGOPOLY End of Chapter 10

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