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ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 27: Oligopoly and Strategic Behavior Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. Oligopoly Oligopoly A market situation in which there are very few sellers Each seller knows that the other sellers will react to its changes in prices and quantities 2 Oligopoly Characteristics of oligopoly Small number of firms Interdependence Strategic dependence A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry 3 Oligopoly Why oligopoly occurs Economies of scale Barriers to entry Mergers Vertical Merger The joining of a firm with another to which it sells an output or from which it buys an input Horizontal Merger The joining of firms that are producing or selling a similar product 4 Oligopoly Determining the Existence of an Oligopoly Concentration Ratio The percentage of all sales contributed by the leading four or leading eight firms in an industry It is difficult to specify an arbitrary absolute number to demonstrate the existence of an oligopoly, but it is a good indicator. Verification is usually based on the observed strategies and behavior of the firms of the industry. 5 Computing the Four-Firm Concentration Ratio Firm Annual Sales ($ Millions) 1 2 3 4 5 through 25 150 100 80 70 50 Total 450 Total number of firms in Industry = 25 400 = 88.9% Four-firm concentration ratio = 450 Table 27-1 6 E-Commerce Example: Concentration in the Search-Engine Industry Internet search-engines collect revenue through advertisements posted on their websites. To measure the concentration ratio in this industry, economists count the number of searches conducted on each site. 7 E-Commerce Example: Concentration in the Search-Engine Industry The four most frequently used searchengines are Google, Yahoo, AOL Time Warner, and MSN. The four-firm concentration ratio in this industry is 91 percent, indicating that it qualifies as an oligopoly. 8 Oligopoly, Inefficiency, and Resource Allocation Oligopolistic firms have some degree of market power, which means each one can affect the market price. This creates some inefficiency in resource allocation. But to the extent that U.S. oligopolies must compete with firms from other countries, their market power is limited. 9 Strategic Behavior and Game Theory Explaining the pricing and output behavior of oligopoly markets Reaction Function The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry 10 Strategic Behavior and Game Theory Game Theory A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly 11 Strategic Behavior and Game Theory Cooperative Game A game in which the players explicitly cooperate to make themselves better off Noncooperative Game A game in which the players neither negotiate nor cooperate in any way 12 Strategic Behavior and Game Theory Zero-Sum Game A game in which any gains within the group are exactly offset by equal losses by the end of the game Negative-Sum Game A game in which players as a group lose at the end of the game Positive-Sum Game A game in which players as a group are better off at the end of the game 13 Strategic Behavior and Game Theory Strategies in noncooperative games Strategy Any rule that is used to make a choice Any potential choice that can be made by players in a game Dominant Strategies Strategies that always yield the highest benefit 14 Example: The Prisoner’s Dilemma You and your partner rob a bank and get caught. 15 Prisoner’s Dilemma You are separated and given these options: Both confess and get five years in jail Neither confess and get two years One confess and the other does not Confessor goes free One who does not confess gets ten years Assume you are Sam reacting to the possible actions of Carol. 16 The Prisoners’ Dilemma Payoff Matrix Figure 27-1 17 The Prisoners’ Dilemma Payoff Matrix Confessing is better than not confessing. Figure 27-1 18 The Prisoners’ Dilemma Payoff Matrix Confessing is better than not confessing. Confessing is better than not confessing. Figure 27-1 19 Strategic Behavior and Game Theory Applying game theory to pricing strategies Would you choose a high price or a low price? Remember No collusion 20 Pricing Dilemma The firms are separated and given these options: Both charge high price and each gets $6 million Both charge low price and each gets $4 million One charges low price and the other high Lower priced firm gets $8 million Higher priced firm gets $2 million Assume you are Firm #2 reacting to the possible actions of Firm #1 21 Strategic Behavior and Game Theory Figure 27-2 22 Strategic Behavior and Game Theory Low is better than high. Figure 27-2 23 Strategic Behavior and Game Theory Low is better than high. Low is better than high. Figure 27-2 24 Strategic Behavior and Game Theory Opportunistic Behavior Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains An example might be writing a check that you know will bounce Not realistic Consequences tend to be more obvious We make repeat transactions 25 Strategic Behavior and Game Theory Tit-for-Tat Strategic Behavior In game theory, cooperation that continues so long as the other players continue to cooperate 26 Price Rigidity and the Kinked Demand Curve Price and Marginal Revenue per Unit Panel (a) d1 A P0 d1 q0 Figure 27-3, Panel (a) Quantity per Time Period 27 Price Rigidity and the Kinked Demand Curve Panel (a) Price and Marginal Revenue per Unit d2 d1 is relatively elastic • if one firm raises its price the others will not and it will lose market share d1 A P0 d1 d2 q0 Figure 27-3, Panel (a) Quantity per Time Period d2 is relatively inelastic • if one firm lowers its price the others lower their price so gain in sales is small 28 Price Rigidity and the Kinked Demand Curve Panel (a) Price and Marginal Revenue per Unit d2 d1 is relatively elastic • if one firm raises its price the others will not and it will lose market share d1 A P0 d1 MR 1 d2 q0 Figure 27-3, Panel (a) Quantity per Time Period d2 is relatively inelastic • if one firm lowers its price the others lower their price so gain in sales is small 29 Price Rigidity and the Kinked Demand Curve Panel (a) Price and Marginal Revenue per Unit d2 d1 is relatively elastic • if one firm raises its price the others will not and it will lose market share d1 A P0 d1 MR 1 MR2 d2 q0 Figure 27-3, Panel (a) Quantity per Time Period d2 is relatively inelastic • if one firm lowers its price the others lower their price so gain in sales is small 30 Price Rigidity and the Kinked Demand Curve Price and Marginal Revenue per Unit Panel (b) d1 P0 MR 1 The kinked demand curve indicates the possibility of price rigidity A d2 MR 2 q0 Figure 27-3, Panel (b) Quantity per Time Period 31 Price Rigidity and the Kinked Demand Curve Price, Marginal Revenue, and Marginal Cost per Unit d1 P0 MR1 MC ' MC MC" Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR d2 MR2 q0 Quantity per Time Period Figure 27-4 32 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Price Leadership A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices Price leadership behavior is apparent in the overnight package delivery industry 33 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Price War A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices 34 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Markets where price wars are common Cigarettes Long-distance telephone companies Airlines Diapers Frozen foods PC hardware and software 35 Deterring Entry Into an Industry Entry Deterrence Strategy - Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm Increasing entry cost Threat of price wars Government regulations Strategies – A group of colluding sellers will set the highest common price without new firms seeking to enter the industry Raising switching costs for customers Limit-Pricing Non-compatible software Non-transferability of college courses 36 Network Effects and Industry Concentration A network effect is a situation in which a consumer’s inclination to use an item depends on how many others use it. In an industry selling products subject to network effects, a small number of firms may be able to secure the bulk of the payoffs resulting from positive market feedback. Oligopoly is likely to emerge as the prevailing market structure. 37 Comparing Market Structures Market Structure Number of Sellers Unrestricted Entry and Exit Ability to Set Price Long-Run Economic Profits Possible Product Nonprice Differentiation Competition Examples Perfect competition Numerous Yes None No None None Agriculture, roofing nails Monopolistic competition Many Yes Some No Considerable Yes Toothpaste toilet paper, soap, retail trade Oligopoly Few Partial Some Yes Frequent Yes Recorded music, college textbooks Pure monopoly One Not for entry Considerable Yes None (product is unique) Yes Some electric companies, some local telephone companies Table 27-3 38 ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 27: Oligopoly and Strategic Behavior Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.
