MODULE 64: INTRODUCTION TO OLIGOPOLY Schmidty School of Economics. Wednesday, December 4, :20:15 PM Central Standard Time

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1 MODULE 64: INTRODUCTION TO OLIGOPOLY Schmidty School of Economics

2 Learning Targets I Can Understand why oligopolists have an incentive to act in ways that reduce their combined profit. Explain why oligopolies can benefit from collusion. The purpose of this module is to develop the oligopoly market structure. Many of the high-profile industries in the U.S. are oligopolies and all share a common characteristic: mutual interdependence. Firms often find that it could be mutually beneficial to collude or not compete as vigorously as possible because competition drives down profits for all firms.

3 FOUR MARKET MODELS Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Characteristics of Oligopolies: A Few Large Producers (Less than 10) Identical or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms use Strategic Pricing Examples: OPEC, Cereal Companies, Car Producers

4 HOW DO OLIGOPOLIES OCCUR? Oligopolies occur when only a few large firms start to control an industry. High barriers to entry keep others from entering. Types of Barriers to Entry 1. Economies of Scale Ex: The car industry is difficult to enter because only large firms can make cars at the lowest cost 2. High Start-up Costs 3. Ownership of Raw Materials

5 Market Concentration Ratios Industry Four-firm concentration ratio Automotive Vehicles 87.3 Breakfast Cereal 78.4 Computer & Peripherals 49.8 Fiber Optic Cables 66.9 Industrial Gas 63.8 Plastic Bottles 42.3 Plastic & Rubber Products 7.6 Printing Ink 54 Poultry 46.3 Newspapers- Daily 22.1

6 Key Economic Concepts Oligopoly was briefly introduced in Module 57. This module presents a more in-depth study of the market structure. A simply duopoly (two firms) is enough to illustrate mutual interdependence. If these firms compete, they will each receive normal profits. If they collude (or cooperate), they can act like a monopoly by restricting output, raising prices, and earning positive economic profits. There is an incentive for each duopolist to cheat on a collusive agreement to earn even more profits. Because of this incentive, collusion can be an unstable, not to mention an illegal, arrangement.

7 Duffka School of Economics Module Format I. Understanding Oligopoly A. A Duopoly Example B. Collusion and Competition C. Competing with Prices versus Competing with Quantities

8 I. Understanding Oligopoly Module 57 describes oligopoly as a market structure with a few large producers. There is no universal definition of how many producers must exist before we call the market an oligopoly, so we use measures like the HHI to quantify the market concentration. An additional key characteristic of oligopoly is that the firms are interdependent and engage in strategic behavior. Interdependence simply means that the actions of one firm (Honda, for example) have an impact on another large firm (Toyota) and vice versa. If Honda would choose to advertise during the Super Bowl, Toyota would be affected and must decide whether to respond or do nothing. These strategies, and mutually interdependent outcomes, make studying oligopoly both interesting and challenging.

9 Game Theory The study of how people behave in strategic situations An understanding of game theory helps firms in an oligopoly maximize profit.

10 A. A Duopoly Example ü Suppose there are only two gas stations in a small rural town of Boonetuckey. ü These gas stations, Margaret s Gas Stop and Pam s Station, are duopolists in the gasoline market and they each sell 50% of all of the gas in town. ü The demand schedule for gasoline in Boonetuckey is given in the table on the nest. We will assume that the marginal cost of selling a gallon of gas is $1.

11 A. A Duopoly Example If these station owners operated in a perfectly competitive world, P=MC=$1. In this case, the firms would split $1400 of total revenue, so each would earn $700.

12 A. A Duopoly Example But two sellers do not need to behave as perfectly competitive firms. They could decide to collude and charge a price of $4 per gallon and each would sell 800/2 = 400 gallons. At this collusive price, each firm would earn $3200/2 = $1600 of total revenue.

13 A. A Duopoly Example But would such an agreement (to not compete) last? Probably not

14 Game theory helps predict human behavior THE ICE CREAM MAN SIMULATION 1. You are an ice cream salesmen at the beach 2. You have identical prices as another salesmen. 3. Beachgoers will purchase from the closest salesmen 4. People are evenly distributed along the beach. 5. Each morning the two firms pick locations on the beach Where is the best location?

15 Where should you put your firm? B A Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the real-world?

16 Where should you put your firm? A B Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the real-world?

17

18 B. Collusion and Competition Collusive agreement: Margaret and Pam have agreed to only offer 400 gallons each at a price of $4 per gallon. This earns each gas station $1600 in total revenue. Suppose that Margaret does some quick calculations and sees that she can secretly sell an additional 100 gallons of gas, thus cheating on the agreement with Pam. What happens? There are now 900 gallons being sold, pushing the market price down to $3.50 per gallon. Margaret s Total Revenue = $3.50*500 = $1750 which is $150 more than under the agreement. Pam s Total Revenue = $3.50*400 = $1400 which is $100 less than agreed upon.

19 B. Collusion and Competition Pam is HAPPY and selling more gas. Margaret retaliates and price drops even further. Pretty soon, price has fallen all the way to P=MC=$1 and these firms are back to the competitive (or non-cooperative) outcome. It should be clearly noted that explicitly agreeing to collude on the basis of price and/or output is illegal and people can, and do, get fined and/or imprisoned for doing so.

20 C. Competing with Prices versus Competing with Quantities In the above duopoly example, it didn t matter if Margaret cheated by selling 100 additional gallons, or if she lowered the price of gasoline to $3.50. The outcome would have been the same. However, which choice is most likely to be immediately detected by Pam and punished? The price drop. These strategies between duopolists have been studied by economists for many years. Joseph Bertrand ( ) showed that when firms are selling an identical product, oligopolists will repeatedly lower price to undercut the competition. This process ends at the perfectly competitive outcome where P=MC. Augustin Cournot ( ) focused on quantity competition, rather than price competition. Again assuming a homogenous product, duopoly firms choose output to maximize profit, given the output of the rival firm. There exists an equilibrium level of output that allows each firm to earn profits that are below monopoly-level profits, but are above normal profits.

21 Because firms are interdependent There are 3 types of Oligopolies 1. Price Leadership (no graph) 2. Colluding Oligopoly 3. Non Colluding Oligopoly

22 #1. PRICE LEADERSHIP

23 Example: Small Town Gas Stations To maximize profit what will they do? OPEC does this with OIL

24 Collusion is ILLEGAL. Firms CANNOT set prices. Price Leadership Price leadership is a strategy used by firms to coordinate prices without outright collusion General Process: 1. Dominant firm initiates a price change 2. Other firms follow the leader

25 Price Leadership Breakdowns in Price Leadership Temporary Price Wars may occur if other firms don t follow price increases of dominant firm. Each firm tries to undercut each other. Example: Employee Pricing for Ford

26 #2. COLLUDING OLIGOPOLIES

27 Cartel = Colluding Oligopoly A cartel is a group of producers that create an agreement to fix prices high. 1. Cartels set price and output at an agreed upon level 2. Firms require identical or highly similar demand and costs 3. Cartel must have a way to punish cheaters 4. Together they act as a monopoly

28 Firms in a colluding oligopoly act as a monopoly and share the profit P MC ATC D MR Q

29 #3. NON-COLLUDING OLIGOPOLIES

30 Kinked Demand Curve Model The kinked demand curve model shows how noncollusive firms are interdependent If firms are NOT colluding they are likely to react to competitor s pricing in two ways: 1. Match price-if one firm cuts it s prices, then the other firms follow suit causing inelastic demand 2. Ignore change-if one firm raises prices, others maintain same price causing elastic demand

31 If this firm increases it s price, other firms will ignore it and keep prices the same As the only firm with high prices, Qd for this firm will decrease a lot P P 1 P e Elasti c Q 1 Q e D Q

32 If this firm decreases it s price, other firms will match it and lower their prices Since all firms have lower prices, Qd for this firm will increase only a little P P 1 P e Elasti c P 2 Q 1 Q e Q 2 D Q

33 Where is Marginal Revenue? MR has a vertical gap at the kink. The result is that MC can move and Qe won t change. Price is sticky. P P e MC Q MR D Q

34 Practice Question # 1 1. When firms cooperate to raise their joint profits, they are necessarily a. colluding. b. in a cartel. c. a monopoly. d. in a duopoly. e. in a competitive industry.

35 Practice Question # 2 2. Which of the following is most important to oligopoly firms? A. Maximizing revenue B. Beating a competitor even if it means lower profits. C. Maximizing profit regardless of other firms profits. D. Loss minimizing E. Eliminating barriers to entry.

36 Duffka School of Economics Practice Question # 3 3. An agreement among several producers to restrict output and increase profit is necessary for a. cooperation. b. collusion. c. monopolization. d. a cartel. e. competition.

37 Practice Question # 4 4. Oligopolists engage in which of the following types of behavior? I. quantity competition II. price competition III. cooperative behavior a. I only b. II only c. III only d. I and II only e. I, II, and III

38 Duffka School of Economics Practice Question # 5 5. Which of the following will make it easier for firms in an industry to maintain positive economic profit? a. a ban on cartels b. a small number of firms in the industry c. a lack of product differentiation d. low start-up costs for new firms e. the assumption by firms that other firms have variable output levels

39 Duffka School of Economics

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