Imperfect Competition. Business Economics. Oligopoly. Oligopoly. Oligopoly

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1 Business Economics Imperfect Competition Managerial Decisions for Firms with Market Power Thomas & Maurice, Chapter 13 Herbert Stocker Institute of International Studies University of Ramkhamhaeng & Department of Economics University of Innsbruck Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly. Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers. : Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition: Many firms selling products that are similar but not identical. Economics in Action: Characteristics of an Market: Few sellers offering similar or identical products. Interdependent firms. Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost. Share of US industry sales accounted for by the top four firms. Source: Krugman & Wells

2 : Example The table shows a demand-schedule: Q P R π Assume MC = AC = What would on a perfectly competitive market happen? Wich quantity would a monopolist produce? Now assume, there are two suppliers (duopoly). Which quantity should each of them produce? : Example In a perfectly competitive market the price would be driven to where economic profit is zero: P = MC = 1 Q = 8 The price and quantity in a monopoly market would be where total profit is maximized: P = 5 Q = 4 What happens in a duopoly? The duopolists may agree on a monopoly outcome: Collusion: Sellers engage in collusion when they cooperate to raise each others profits. Cartel: A cartel is the strongest form of collusion, an agreement by several producers that increases their combined profits by telling each one how much to produce. They may also engage in non-cooperative behavior, ignoring the effects of their actions on each others profits. 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, antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy. Additionally, each firm has an incentive to cheat, to produce more than it is supposed to under the cartel agreement. There are two principal outcomes: successful collusion or behaving non-cooperatively by cheating.

3 Competing in Quantities vs. Competing in Prices: (non-cooperative solution) 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. Competing in Quantities vs. Competing in Prices: (non-cooperative solution) 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. Game Theory Game Theory Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action. Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce.

4 Game Theory Simultaneous Decisions: Occur when managers must make individual decisions without knowing their rivals decisions Game Theory The Prisoner Dilemma: The prisoners dilemma provides insight into the difficulty in maintaining cooperation. Often people (firms) fail to cooperate with one another even when cooperation would make them better off. The reward received by a player in a game (e.g. 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. The Prisoner s Dilemma The Prisoner s Dilemma Assume... Each of two prisoners, held in separate cells, is offered a deal by the police... It is in the joint interest of both prisoners not to confess; but it is in each one s individual interest to confess! In what follows we assume that the payoff matrix is known to all players (common knowledge). Decision of Jane Don t Conf. Confess Decision of Bill Don t Confess Confess 2 years 1 year 2 years 12 years 12 years 6 years 1 year 6 years

5 The Prisoner s Dilemma The Prisoner s 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. When each person or firm has an incentive to cheat, but both are worse off if both cheat, the situation is known as a prisoners dilemma. In a prisoners dilemma each player has an incentive to choose an action that benefits itself at the other player s expense. When both players act in this way, both are worse off than if they had chosen different actions. An action is a dominant strategy when it is a player s best action regardless of the action taken by the other player. The Prisoner s Dilemma has a dominant strategy, which results in the worst possible outcome. Cooperation is difficult to maintain, because it s illegal on contracts are not enforceable. cooperation is not in the best interest of the individual player. Depending on the payoffs, a player may or may not have a dominant strategy. An Arms-Race Game An Advertising Game Decision of the Soviet Union (USSR) Disarm Arm Decision of the United States (U.S.) Arm Disarm USSR at risk USSR at risk & weak USA USA at risk at risk USSR & weak safe & powerful USA safe & powerful USSR safe USA safe Camel s Decision Don t Adv. Advertise Marlboro s Decision Advertise Don t Adv. Marlboro Marlboro $3 billion $2 billion Camel profit Camel profit $3 billion $5 billion profit profit Marlboro Marlboro $5 billion $4 billion Camel profit profit $2 billion profit Camel $4 billion profit

6 Making Mutually Best Decisions For all firms in an oligopoly to be predicting correctly each others decisions: All firms must be choosing individually best actions given the predicted actions of their rivals, which they can then believe are correctly predicted Strategically astute managers look for mutually best decisions Nash equilibrium Players who don t take their interdependence into account arrive at a Nash, or non-cooperative, equilibrium. A Nash 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. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. Nash equilibrium Sequential Decisions Nash equilibrium: Set of actions or decisions for which all managers are choosing their best actions given the actions they expect their rivals to choose. Strategic stability: No single firm can unilaterally make a different decision & do better. When a unique Nash equilibrium set of decisions exists rivals can be expected to make the decisions leading to the Nash equilibrium. With multiple Nash equilibria, no way to predict the likely outcome. One firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decision. The best decision a manager makes today depends on how rivals respond tomorrow.

7 Sequential Decisions Strategic Moves First-mover advantage: If letting rivals know what you are doing by going first in a sequential decision increases your payoff. Second-mover advantage: If reacting to a decision already made by a rival increases your payoff. Strategic Moves: Actions used to put rivals at a disadvantage Three types Commitments Threats Promises Only credible strategic moves matter! Repeated Strategic Decisions Trigger Strategies Cooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (noncooperative) Nash equilibrium. With repeated decisions, cheaters can be punished! When credible threats of punishment in later rounds of decision making exist. A rival s cheating triggers punishment phase. Two examples... Grim strategy: Punishment continues forever, even if cheaters return to cooperation. Tit-for-tat strategy: Punishes after an episode of cheating & returns to cooperation if cheating ends

8 Tit for Tat How can a co-operative strategy get an initial foothold in an environment which is predominantly non-co-operative? What type of strategy can thrive in a varied environment composed of other individuals using a wide diversity of more or less sophisticated strategies? Under what conditions can such a strategy, once fully established, resist invasion by mutant strategies (such as cheating)? Tit for Tat Robert Axelrod: conducted a computer tournament where people were invited to submit strategies (in form of computer programs) for playing 200 games of prisoner s dilemma. The simplest of all strategies submitted by Anatol Rapoport attained the highest average score: TIT FOR TAT, a strategy of co-operation based on reciprocity. A strategy of tit for tat involves playing cooperatively at first, then following the other player s move. This rewards good behavior and punishes bad behavior. Tit for Tat Tit for Tat: Rules Never be the first to defect. Retaliate only after your partner has defected. Be prepared to forgive after carrying out just one act of retaliation. Adopt this strategy only if the probability of meeting the same player again exceeds 2/3. Tacit collusion Tacit collusion: coordinated behavior that is an achieved without a formal agreement. Tacit collusion practices: Uniform prices Penalty for price discounts Advantage notice of price changes Information exchanges,... Once an oligopolistic industry has achieved tacit collusion, individual producers have an incentive to behave carefully they don t want to do anything to disrupt the collusion. This could produce a kinked demand curve.

9 The Kinked Demand Curve The Kinked Demand Curve If an oligopolist considers raising the prices its quantity demanded will depend upon the behavior of rival firms. The Kinked Demand Curve is based on the assumption that other firms will not match price increases but will match price decreases. Implies oligopoly prices tend to be sticky and not change as they would in other market structures. Does not explain why price P exists initially. The Kinked Demand Curve 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. Facilitating Practices Price Matching Legal tactics designed to make cooperation more likely: Four tactics: 1 Price matching 2 Sale-price guarantees 3 Public pricing 4 Price leadership Firm publicly announces that it will match any lower prices by rivals (usually in advertisements). Discourages noncooperative price-cutting, because it eliminates benefit to other firms from cutting prices.

10 Sale-Price Guarantees Public Pricing Firm promises customers who buy an item today that they are entitled to receive any sale price the firm might offer in some stipulated future period. Primary purpose is to make it costly for firms to cut prices! Public prices facilitate quick detection of noncooperative price cuts. Early detection reduces present value of benefits of cheating, increases present value of costs of cheating, and therefore reduces likelihood of noncooperative price cuts. Price Leadership Price leader sets its price at a level it believes will maximize total industry profit. Rest of firms cooperate by setting same price. Does not require explicit agreement, Strategic Entry Deterrence: Policies that prevent rivals from entering the market Limit pricing: Established firms can thwart entry by charging the limit price (or a lower price) rather than profit- maximization price (assumes existing firms have lower costs). Predatory pricing: lowering prices below cost to drive out existing competitors and scare off potential entrants. Success depends on how far the predatory price is below cost, time period, how many rivals enter the industry after predation ends,...

11 in Practice in Practice The Legal Framework Oligopolies operate under legal restrictions in the form of antitrust policy. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors, including large numbers of firms, complex pricing, and conflicts of interest among firms. When collusion breaks down, there is a price war. To limit competition, oligopolists often engage in product differentiation. 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 non-price competition through advertising and other means instead. Any questions? Thanks!

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