ECON 202: Principles of Microeconomics. Chapter 13 Oligopoly

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1 ECON 202: Principles of Microeconomics Chapter 13 Oligopoly

2 Oligopoly 1. Oligopoly and Barriers to Entry. 2. Using Game Theory to Analyze Oligopoly. 3. Sequential Games and Business Strategy. 4. The Five Competitive Forces Model. Oligopoly 2

3 Introduction Oligopoly is market structure where: Few competitors. Identical or differentiated products. Restrictions to entry. In case of oligopolistic markets, revenues of the firms depend on actions of other competitors. If a firm cut its price, number of units sold depends on how other firms react. If other firms don t do anything, sell more. If other firms also cut prices, sales will not increase much or can even decrease. Marginal revenue depends on actions of other firms. Approach to analyze oligopolies: game theory. Oligopoly 3

4 1. Oligopoly and Barriers to Entry Oligopolistic markets have few firms How many firms is few? US Bureau of Census publishes 4-firm concentration ratios per industry. More than 40% indicates oligopolistic market. Critics Consider only sales by national firms In some industries, competition is mainly local. (restaurants) Some firms compete in different industries. (Wal Mart in discount department stores, supermarkets and retail toy stores) Herfindahl-Hirschman Index (HHI) Sum of squared shares: = 2,600 HHI > 1,800 : oligopolistic markets. Oligopoly 4

5 1. Oligopoly and Barriers to Entry INDUSTRY RETAIL TRADE FOUR-FIRM CONCENTRATION RATIO INDUSTRY MANUFACTURING FOUR-FIRM CONCENTRATION RATIO Discount Department Stores 95% Cigarettes 95% Warehouse Clubs and Supercenters 92% Beer 91% Hobby, Toy, and Game Stores 72% Breakfast Cereal 82% Athletic Footwear Stores 71% Aircraft 81% College Bookstores 70% Automobiles 76% Radio, Television, and Other Electronic Stores 69% Dog and Cat Food 76% Pharmacies and Drugstores 53% Dog and Cat Food 64% Oligopoly 5

6 1. Oligopoly and Barriers to Entry Barriers to entry Economies of scale Oligopoly 6

7 1. Oligopoly and Barriers to Entry Ownership of a Key Input Aluminum Company of America (Alcoa) access to high-quality bauxite. De Beers Company of South Africa access to diamonds. Government-imposed barriers Occupational licensing (doctors and dentists) Restrictions to international trade (tariffs and quotas) Since entry is restricted, firms can sustain economic profits over a long period. Oligopoly 7

8 2. Using Game Theory to Analyze Oligopoly Game theory: The study of how people make decisions in situations in which attaining their goals depends on their interactions with others. Games have three characteristics: Rules. Strategies. Payoffs. Oligopoly 8

9 2. Using Game Theory to Analyze Oligopoly Duopoly: price competition between two firms. Firms can collude, but is against the law. (Sherman Act) Oligopoly 9

10 2. Using Game Theory to Analyze Oligopoly For each firm, to charge $400 is a dominant strategy. The best strategy for a player, regardless of what the other players decide. ($400, $400) is a Nash equilibrium. A situation where each player is choosing its best strategy, given the others players strategies. A situation where no player has an incentive to change of strategy. Equilibrium is not best possible result for the firms, but it results because each firm pursues its own interest. Noncooperative equilibrium. If firms decide to cooperate and play ($600, $600), then result increases their mutual payoff. Cooperative equilibrium. Oligopoly 10

11 2. Using Game Theory to Analyze Oligopoly Types of games where individual maximization of payoff leaves everyone worse off are called prisoner s dilemma. Nash Equilibrium is (defect, defect). Challenge to Adam Smith s idea of self-interest. Oligopoly 11

12 2. Using Game Theory to Analyze Oligopoly In most business situations games are played repeatedly. Firms can collude implicitly to reach the cooperative equilibrium. Example: lowest price guarantee Firms send a signal to competitors that if they charge lower price, its strategy will be the same. Firms have the incentive to keep the high price. Oligopoly 12

13 2. Using Game Theory to Analyze Oligopoly Oligopoly 13

14 2. Using Game Theory to Analyze Oligopoly When firms can collude: cartels (OPEC) However, firms can have incentives to stop cooperation, which makes difficult to sustain agreements. Oligopoly 14

15 3. Sequential Games and Business Strategy Oligopolistic firms can deter the entry of new firms. Best strategy for WalMart is to build the large store, deterring entry from Target. Oligopoly 15

16 3. Sequential Games and Business Strategy Best strategy for firm is to build the small store and let Target entry the market. Oligopoly 16

17 3. Sequential Games and Business Strategy Bargaining If TruImage says that will not accept a deal at $20: noncredible threat. Oligopoly 17

18 4. The Five Competitive Forces Model Forces that determine the level of competition in an industry. Oligopoly 18

19 4. The Five Competitive Forces Model Competition from existing firms. Educational testing service: SAT and ACT vs. GRE. Threat from potential entrants. Railways. Competition from substitute goods or services. Train vs. flight Bargaining power of buyers. Automobile makers and tire suppliers. Bargaining power of suppliers. Technicolor and color movies. Oligopoly 19

20 ECON 202: Principles of Microeconomics Chapter 13 Oligopoly

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