Market structures. 18. Oligopoly Gene Chang Univ. of Toledo. Examples. Oligopoly Market. Behavior of Oligopoly. Behavior of Oligopoly

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1 Market structures 18. Oligopoly Gene Chang Univ. of Toledo We distinguish the market structure by examining the following characteristics in the industry: Number of firms in the industry Nature of the products: do firms in the industry produce identical products? Barriers of entry: How easy is it for new firms to enter the market? (Information, perfect or imperfect) Oligopoly Market Characteristics of Oligopoly 1. A few firms in the industry Therefore, interdependence 2. Differential (heterogeneous) goods Close but not perfect(?) substitutes 3. Some barriers of entry 4. Information may not be perfect (especially about the rival s s goods) Examples Airline companies Automobile Steel Airplane manufacturers Oil etc. They are usually big companies Behavior of Oligopoly What is the behavior of oligopolies and the market equilibrium? Note the characteristics Interdependence Heterogeneous products Behavior of Oligopoly Like several players in a game, the outcome can not be fully predicted. Hence there is no unique model that summarize all their behaviors. A sub-discipline in Economics: Industrial Organization, studies the issue 1

2 Explains the price rigidity in the oligopolist market In the oligopolist market, firms follow price-cuts cuts by other firms, but reject to follow price-rises. rises. The demand curve is therefore a kinked demand curve P D Qi* Qi The firm will set the price of its product at P, at the kink, and produce Q*. If the firm cuts the price, other rivals follow price-cuts, cuts, hence the quantity of sales increase is minimal Implies that the demand is inelastic downward. Total revenue may decline if cutting the price If the firm raises the price, other rivals does not follow but simply collect those customers driven away from the firm, then the firm s s sale quantity reduction is substantial Implies that the demand is elastic upward. Total revenue may decline if raising the price The firm will set the price of its product at P, at the kink, and produce Q*. Because the possible reactions of its rivals, it is wise for the firm to stick to price P, even as the costs fluctuate. The modern tool used to analyze the oligopolist behavior The several firms in the market are just like the players in a game Each recognizes the chain of actions and reactions of the players Each wants to find the best strategy to maximizes the pay off. 2

3 The basic structure of a game consists of 1. players 2. strategies / moves 3. payoff Each player is assumed to be selfish and tries to maximize his own payoff. Payoff matrix Example: Prisoners dilemma two prisoners who committed a crime and are now questioned by the police in separate cells. A s Confess Remain Silent Prisoners Dilemma Confess A gets 3 years B gets 3 years B goes free B s A goes free Remain Silent B gets 6 years B gets 1 year A Prisoners Dilemma B Confess (better) Confess (-3, -3) (better off) deny (-6, 0) deny (0, -6) (-1, -1) A gets 6 years A gets 1 year What is the likely outcome? Looks that deny-deny is the best payoff for them as a group, but it is an unlikely outcome Recall that each of them is selfish, and only maximize his own payoff Nash Equilibrium It is a state in which no single player has incentive to change his strategy, given the strategies of other players. The Nash equilibrium is both prisoners confess 3

4 Exercise B Left Right Duopoly Only two firms are in the industry A Top ( 4, 5) (2, 6) Bottom (7,3 ) (3,4 ) Figure 3 Jack and Jill s Oligopoly Game Figure 4 An Arms-Race Game Jack s of the United States (U.S.) High Production: 40 Gal. Low Production: 30 gal. Arm Disarm Jack gets $1,600 profit Jack gets $1,500 profit U.S. at risk U.S. at risk and weak Jill s High Production 40 gal. Low Production 30 gal. Jill gets $1,600 profit Jack gets $2,000 profit Jill gets $1,500 profit Jill gets $2,000 profit Jack gets $1,800 profit Jill gets $1,800 profit of the Soviet Union (USSR) Arm Disarm USSR at risk U.S. safe and powerful USSR at risk and weak USSR safe and powerful U.S. safe USSR safe 2007 Thomson South-Western 2007 Thomson South-Western Figure 5 A Common-Resource Game Chevron s Drill Two Wells Drill One Well Drill Two Wells Chevron gets $4 Chevron gets $3 Exxon s Exxon gets $4 Exxon gets $6 Drill One Well Chevron gets $6 Chevron gets $5 Exxon gets $3 Exxon gets $5 Can the oligopolies cooperate? An agreement among the firms in a market about cooperating in quantities and prices Cartel A group of oligopolies who try to behave like a single monopolist and split the benefits among themselves 2007 Thomson South-Western 4

5 Example of Cartels: Organization of Petroleum Exporting Countries (OPEC) A Cartel is inherently unstable Stick to the quota B Stick to the quota (50, 50) Produce more (10, 70) Produce more (70, 10) (20, 20) Cartel is inherently unstable because of the incentive for individual members to cheat in order to make more profits In repeated games the firms may cooperate because a cheater will be penalized by the group. Example: the stability of OPEC is least desirable. It has all bad things a monopoly has but has no merit (such as economy of scale) a monopoly may have. It is illegal in the U.S. Antitrust laws make it illegal to restrain trade or attempt to monopolize a market. Sherman Antitrust Act of 1890 Clayton Antitrust Act of 1914 Some famous cases GE and Westinghouse divide markets American airline and Braniff Airways Controversies over Antitrust Policy Antitrust policies sometimes may not allow business practices that have potentially positive effects: Resale price maintenance Predatory pricing Tying 5

6 Controversies over Antitrust Policy Resale Price Maintenance (or fair trade) occurs when suppliers (like wholesalers) require retailers to charge a specific amount Predatory Pricing occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market Controversies over Antitrust Policy Tying when a firm offers two (or more) of its products together at a single price, rather than separately 6

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