THIRD EDITION. ECONOMICS and. MICROECONOMICS Paul Krugman Robin Wells. Chapter 14. Oligopoly

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1 THIRD EDITION ECONOMICS and MICROECONOMICS Paul Krugman Robin Wells Chapter 14 Oligopoly

2 WHAT YOU WILL LEARN IN THIS CHAPTER The meaning of oligopoly, and why it occurs Why oligopolists have an incentive to act in ways that reduce their combined profit, and why they can benefit from collusion How our understanding of oligopoly can be enhanced by using game theory, especially the concept of the prisoners dilemma How repeated interactions among oligopolists can help them achieve tacit collusion How oligopoly works in practice, under the legal constraints of antitrust policy

3 The Prevalence of Oligopoly In addition to perfect competition and monopoly, oligopoly and monopolistic competition are also important types of market structure. They are forms of imperfect competition. Oligopoly is a common market structure. It arises from the same forces that lead to monopoly, except in a weaker form. It is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.

4 ECONOMICS IN ACTION Is It An Oligopoly or Not? To get a better picture of market structure, economists often use a measure called the Herfindahl Hirschman Index, or HHI. The HHI for an industry is the square of each firm s share of market sales summed over the firms in the industry. For example, if an industry contains only 3 firms and their market shares are 60%, 25%, and 15%, then the HHI for the industry is: HHI = = 4,450

5 ECONOMICS IN ACTION Is It An Oligopoly or Not? According to Justice Department guidelines, an HHI below 1,000 indicates a strongly competitive market, between 1,000 and 1,800 indicates a somewhat competitive market, and above 1,800 indicates an oligopoly. In an industry with an HHI above 1,000, a merger that results in a significant increase in the HHI will receive special scrutiny and is likely to be disallowed.

6 Some Oligopolistic Industries

7 Understanding Oligopoly Some of the key issues in oligopoly can be understood by looking at the simplest case, a duopoly. An oligopoly consisting of only two firms is a duopoly. Each firm is a duopolist. With only two firms in the industry, each would realize that by producing more, it would drive down the market price. So each firm would, like a monopolist, realize that profits would be higher if it limited its production. So how much will the two firms produce?

8 Understanding Oligopoly One possibility is that the two companies will engage in collusion. Sellers engage in collusion when they cooperate to raise each others profits. The strongest form of collusion is a cartel, an agreement by several producers to obey output restrictions to increase their joint profits. They may also engage in noncooperative behavior, ignoring the effects of their actions on each others profits.

9 Understanding Oligopoly By acting as if they were a single monopolist, oligopolists can maximize their combined profits. So, there is an incentive to form a cartel. However, each firm has an incentive to cheat to produce more than it is supposed to under the cartel agreement. So, there are two principal outcomes: successful collusion or behaving noncooperatively by cheating. When firms ignore the effects of their actions on each others profits, they engage in noncooperative behavior. It is likely to be easier to achieve informal collusion when firms in an industry face capacity constraints.

10 Competing in Prices vs. Competing in Quantities Firms may decide to engage in quantity competition or price competition. The basic insight of the quantity competition (or the Cournot model) is that when firms are restricted in how much they can produce, it is easier for them to avoid excessive competition and to divvy up the market, thereby pricing above marginal cost and earning profits. It is easier for them to achieve an outcome that looks like collusion without a formal agreement.

11 Competing in Prices vs. Competing in Quantities The logic behind the price competition (or the Bertrand model) is that when firms produce perfect substitutes and have sufficient capacity to satisfy demand when price is equal to marginal cost, then each firm will be compelled to engage in competition by undercutting its rival s price until the price reaches marginal cost that is, perfect competition.

12 GLOBAL COMPARISON Europe Levels the Playing Field for Coke and Pepsi In the United States, Coke and Pepsi have maintained relatively similar market shares: 44% versus 32% in In that same year, thanks to the exclusivity deals that Coke regularly signed with shops, bars, and restaurants across Europe, Coke s market shares in Europe were several times Pepsi s, as you can see in the following graph that is, until European regulators finally made their move, also in Not surprisingly, Pepsi applauded the change in European policy toward exclusive dealing.

13 GLOBAL COMPARISON Europe Levels the Playing Field for Coke and Pepsi Coke and Pepsi Market Shares Coke Pepsi 75% 68% 60% 50 51% 44% 32% 25 5% 6% 5% 0 Belgium France Germany United States

14 ECONOMICS IN ACTION The Great Vitamin Conspiracy In the late 1990s, some of the world s largest drug companies agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspiracy began in 1989 when the Swiss company Roche and the German company BASF began secret talks about setting prices and dividing up markets for bulk vitamins sold mainly to other companies.

15 ECONOMICS IN ACTION The Great Vitamin Conspiracy How could it have happened? The main answer probably lies in different national traditions about how to treat oligopolists. The United States has a long tradition of taking tough legal action against price-fixing. European governments, however, have historically been much less stringent.

16 ECONOMICS IN ACTION Bitter Chocolate? Millions of chocolate lovers around the world have been spending more and more to satisfy their cravings, and regulators in Germany, Canada, and the United States have become suspicious. They are investigating whether the seven leading chocolate companies including Mars, Kraft Foods, Nestle, Hershey, and Cadbury have been colluding to raise prices. The amount of money involved could well run into the billions of dollars.

17 ECONOMICS IN ACTION Bitter Chocolate? Many of the nation s largest grocery stores and snack retailers are convinced that they have been the victims of collusion. They claim that the chocolate industry has responded to stagnant consumer sales by price-fixing, an allegation the chocolate makers have vigorously denied.

18 ECONOMICS IN ACTION Bitter Chocolate? What s clear is that chocolate candy prices have been soaring, climbing by 17% from 2008 to 2010, while sales fell by about 7%. Chocolate makers defend their actions, contending that they were simply passing on increases in their costs. However, critics claim that the price of cocoa beans, the main ingredient in chocolate, was stable from 2003 to 2007 and that sugar prices were similarly stable during that time, except for a brief spike in 2005, a period in which chocolate prices were rising.

19 ECONOMICS IN ACTION To prove collusion, there must be some evidence of conversations or written agreements. Such evidence has emerged in our chocolate case. According to the Canadian press, 13 Cadbury executives voluntarily provided information to the courts about contacts between the companies, including a 2005 episode in which a Nestle executive handed over a brown envelope containing details about a forthcoming price hike to a Cadbury employee. And, according to affidavits submitted to a Canadian court, top executives at Hershey, Mars, and Nestle met secretly in coffee shops, in restaurants, and at conventions to set prices.

20 The Prisoners Dilemma When the decisions of two or more firms significantly affect each others profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. The reward received by a player in a game such as the profit earned by an oligopolist is that player s payoff. A payoff matrix shows how the payoff to each of the participants in a two-player game depends on the actions of both. Such a matrix helps us analyze interdependence.

21 A Payoff Matrix ADM Ajinomoto Produce 30 million pounds Ajinomoto makes $180 million profit. Produce 40 million pounds Ajinomoto makes $200 million profit. Produce 30 million pounds ADM makes $180 million profit Ajinomoto makes $160 million profit. ADM makes $150 million profit Ajinomoto makes $150 million profit. Produce 40 million pounds ADM makes $200 million profit ADM makes $160million profit

22 The Prisoners Dilemma Economists use game theory to study firms behavior when there is interdependence between their payoffs. The game can be represented with a payoff matrix. Depending on the payoffs, a player may or may not have a dominant strategy. When each firm has an incentive to cheat, but both are worse off if both cheat, the situation is known as a prisoners dilemma.

23 The Prisoners Dilemma The game is based on two premises: 1) Each player has an incentive to choose an action that benefits itself at the other player s expense. 2) When both players act in this way, both are worse off than if they had acted cooperatively.

24 The Prisoners Dilemma Thelma Louise Don t confess Confess Louise gets 5-year sentence. Louise gets 2-year sentence. Don t confess Thelma gets 5-year sentence. Thelma gets 20-year sentence. Louise gets 20-year sentence. Louise gets 15-year sentence. Confess Thelma gets 2-year sentence. Thelma gets 15-year sentence.

25 The Prisoners Dilemma An action is a dominant strategy when it is a player s best action regardless of the action taken by the other player. Depending on the payoffs, a player may or may not have a dominant strategy. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players.

26 Overcoming the Prisoners Dilemma Repeated Interaction and Tacit Collusion Players who don t take their interdependence into account arrive at a Nash, or noncooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion.

27 Overcoming the Prisoners Dilemma Repeated Interaction and Tacit Collusion Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. When firms limit production and raise prices in a way that raises each others profits, even though they have not made any formal agreement, they are engaged in tacit collusion.

28 ADM How Repeated Interaction Can Support Collusion Ajinomoto Tit for tat Tit for tat Ajinomoto makes $180 million profit each year. Always cheat Ajinomoto makes $200 million profit 1 st year, $160 profit each later year. ADM makes $180 million profit each year. ADM makes $150 million profit 1 st year, $160 million profit each later year. Always cheat Ajinomoto makes $150 million profit 1 st year, $160 million profit each later year. Ajinomoto makes $160 million profit each year. ADM makes $200 million profit 1 st year, $160 million profit each later year. ADM makes $160 million profit each year.

29 The Kinked Demand Curve An oligopolist who believes she will lose a substantial number of sales if she reduces output and increases her price, but will gain only a few additional sales if she increases output and lowers her price away from the tacit collusion outcome, faces a kinked demand curve very flat above the kink and very steep below the kink. It illustrates how tacit collusion can make an oligopolist unresponsive to changes in marginal cost within a certain range when those changes are unique to her.

30 The Kinked Demand Curve Price, cost marginal revenue P * W Tacit collusion outcome MC 1 MC 2 X 1. Any marginal cost in this region Y Q * MR Z D Quantity 2. corresponds to this level of output

31 FOR INQUIRING MINDS Prisoners of the Arms Race Between World War II and the late 1980s, the United States and the Soviet Union were locked in a struggle that never broke out into open war. During this Cold War, both countries spent huge sums on arms, sums that were a significant drain on the U.S. economy and eventually proved a crippling burden for the Soviet Union, whose underlying economic base was much weaker. Both nations would have been better off if they had both spent less on arms. Yet the arms race continued for 40 years. Why?

32 FOR INQUIRING MINDS Prisoners of the Arms Race As political scientists were quick to notice, one way to explain the arms race was to suppose that the two countries were locked in a classic prisoners dilemma. Each government would have liked to achieve decisive military superiority, and each feared military inferiority. But both would have preferred a stalemate with low military spending to one with high spending. However, each government rationally chose to engage in high spending.

33 FOR INQUIRING MINDS Prisoners of the Arms Race If its rival did not spend heavily, its own high spending would lead to military superiority; not spending heavily would lead to inferiority if the other government continued its arms buildup. So, the countries were trapped. The answer to this trap could have been an agreement not to spend as much; indeed, the two sides tried repeatedly to negotiate limits on some kinds of weapons. But these agreements weren t very effective. In the end the issue was resolved as heavy military spending hastened the collapse of the Soviet Union in 1991.

34 ECONOMICS IN ACTION The Rise and Fall and Rise of OPEC OPEC includes 13 national governments (Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela) and it controls 40% of the world s oil exports and 80% of its proven reserves. In any given year it is in their combined interest to keep output low and prices high.

35 ECONOMICS IN ACTION The Rise and Fall and Rise of OPEC So how successful is the cartel? OPEC first demonstrated its muscle in 1974: in the aftermath of a war in the Middle East, several OPEC producers limited their output and they liked the results so much that they decided to continue the practice.

36 ECONOMICS IN ACTION The Rise and Fall and Rise of OPEC By the mid-1980s, however, there was a growing glut of oil on world markets, and cheating by cash-short OPEC members became widespread. The result, in 1985, was that producers who had tried to play by the rules got fed up and collusion collapsed. The cartel began to act effectively again at the end of the 1990s, thanks largely to the efforts of Mexico s oil minister to orchestrate output reductions. The cartel s actions helped raise the price of oil from less than $10 a barrel in 1998 to a range of $20 to $30 a barrel in 2003.

37 The Ups and Downs of Oil Cartels

38 Oligopoly in Practice Oligopolies operate under legal restrictions in the form of antitrust policy. Antitrust policies are efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors, including: large numbers of firms complex products and pricing scheme bargaining power of buyers conflicts of interest among firms

39 GLOBAL COMPARISON The European Union is believed to be stricter in imposing antitrust actions than the United States. Companies prefer the American system and the accompanying figure clarifies why. In recent years, on average, fines for unfair competition have been higher in the European Union than in the United States. Contrasting Approaches to Anti-Trust Regulation

40 Product Differentiation and Price Leadership When collusion breaks down, there is a price war. To limit competition, oligopolists often engage in product differentiation, which is an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry. When products are differentiated, it is sometimes possible for an industry to achieve tacit collusion through price leadership. Oligopolists often avoid competing directly on price, engaging in nonprice competition through advertising and other means instead.

41 Product Differentiation and Price Leadership In price leadership, one firm sets its price first, and other firms then follow. Firms that have a tacit understanding not to compete on price often engage in intense nonprice competition, using advertising and other means to try to increase their sales.

42 ECONOMICS IN ACTION Price Wars of Christmas The toy aisles of American retailers have often been the scene of cut-throat competition. During the 2011 Christmas shopping season, Target priced the latest Elmo doll at 89 cents less than Walmart (for those with a coupon), and $6 less than Toys R Us. So extreme is the price cutting that since 2003 three toy retailers KB Toys, FAO Schwartz, and Zany Brainy have been forced into bankruptcy. What is happening? The turmoil can be traced back to trouble in the toy industry itself as well as to changes in toy retailing in the form of Internet sales.

43 ECONOMICS IN ACTION Price Wars of Christmas Besides the Internet, there have also been new entrants into the toy business: Walmart and Target have expanded their number of stores and have been aggressive price - cutters. The result is much like a story of tacit collusion sustained by repeated interaction run in reverse: because the overall industry is in a state of decline and there are new entrants, the future payoff from collusion is shrinking. The predictable outcome is a price war.

44 ECONOMICS IN ACTION Price Wars of Christmas Since retailers depend on holiday sales for nearly half of their annual sales, the holidays are a time of particularly intense price-cutting. Traditionally, the biggest shopping day of the year has been the day after Thanksgiving. But in an effort to expand sales and undercut rivals, retailers particularly Walmart have now begun their pricecutting earlier in the fall.

45 Summary 1. Many industries are oligopolies: there are only a few sellers. In particular, a duopoly has only two sellers. Oligopolies exist for more or less the same reasons that monopolies exist, but in weaker form. They are characterized by imperfect competition: firms compete but possess market power.

46 Summary 2. Predicting the behavior of oligopolists poses something of a puzzle. The firms in an oligopoly could maximize their combined profits by acting as a cartel, setting output levels for each firm as if they were a single monopolist; to the extent that firms manage to do this, they engage in collusion. But each individual firm has an incentive to produce more than it would in such an arrangement to engage in noncooperative behavior.

47 Summary 3. The situation of interdependence, in which each firm s profit depends noticeably on what other firms do, is the subject of game theory. In the case of a game with two players, the payoff of each player depends both on its own actions and on the actions of the other; this interdependence can be represented as a payoff matrix. Depending on the structure of payoffs in the payoff matrix, a player may have a dominant strategy an action that is always the best regardless of the other player s actions.

48 Summary 4. Duopolists face a particular type of game known as a prisoners dilemma; if each acts independently in its own interest, the resulting Nash equilibrium (or noncooperative equilibrium) will be bad for both. However, firms that expect to play a game repeatedly tend to engage in strategic behavior, trying to influence each other s future actions. A particular strategy that seems to work well in such situations is tit for tat, which often leads to tacit collusion.

49 Summary 5. The kinked demand curve illustrates how an oligopolist that faces unique changes in its marginal cost within a certain range may choose not to adjust its output and price in order to avoid a breakdown in tacit collusion. 6. In order to limit the ability of oligopolists to collude and act like monopolists, most governments pursue an antitrust policy designed to make collusion more difficult. In practice, however, tacit collusion is widespread.

50 Summary 7. A variety of factors make tacit collusion difficult: large numbers of firms, complex products and pricing, differences in interests, and bargaining power of buyers. When tacit collusion breaks down, there is a price war. Oligopolists try to avoid price wars in various ways, such as through product differentiation and through price leadership, in which one firm sets prices for the industry. Another is through nonprice competition, like advertising.

51 KEY TERMS Oligopoly Oligopolist Imperfect competition Duopoly Duopolist Collusion Cartel Noncooperative behavior Interdependence Game theory Payoff Payoff matrix Prisoners dilemma Dominant strategy Nash equilibrium Noncooperative equilibrium Strategic behavior Tit for tat Tacit collusion Antitrust policy Price war Product differentiation Price leadership Nonprice competition