Download Non-Collusive Oligopoly

Different degrees of Competition
• How can we empirically (based on data) justify an
oligopoly or any market structure of any type?
• The degree of competition can be approximately
determined (with reservations) by the
• CONCENTRATION RATIO: percentage of sales
(revenue) (market share) produced by the largest
firms in the industry (or market)
• Eg. CR 5 = H/O
CR2 =
and so on
Oligopoly
Oligopoly
• Oligopoly is the market structure with a
• few firms, as a result of which they can greatly
influence price and other market factors.
• 1887, from Medieval Latin oligopolium, from
Greek oligos "little, small," in plural, "the few"
(see oligo-) + polein "to sell" (see monopoly)
Assumptions of Oligopoly
• There is a small number of large firms
• There are high barriers to entry – economies of scale, high
start up costs, legal barriers, ads, threats of take over
(M&A), etc.
• Differentiated or homogeneous products – differentiated
includes cars, aircraft, pharmaceuticals, etc; homogenous
include oil, steel, copper, etc.
 the unique feature of Oligopoly:
• There is mutual interdependence among the few
firms – decisions taken by one firm affect other firms in the
industry and leads to strategic behavior
Some real life examples best explained
by Oligopoly
•
•
•
•
•
Car industry
Aircraft industry
Pharmaceutical industry
Oil industry
Financial industry
Interdependence
• Mutual interdependence has 2 important implications for
the behavior of the oligopolistic firms
– Strategic behavior: the plans of action which take into
account a rival’s possible courses of action. Similar to games,
chess, etc., where individual players’ actions are based on the
expected actions and reactions of their rival(s). e.g. if or
assume the rivals follow A, then the firm will follow B
– Conflicting incentives:
collude
• Incentives to
– to agree among competitors to limit
competition usually by fixing prices and therefore lowerng quantity
produced. It reduces uncertainties and maximizes profits for the
industry as a whole
compete
• Incentives to
– a firm also has the incentive to
compete with its rivals in hope that it will capture a portion of their
market share and profits
Nash Equilibrium
Game Theory
• JOHN NASH was a mathematician who developed
GAME THEORY ( NOBEL prize for ECONOMICS)
to explain how firms might behave in more realistic
market forms than perfect competition
• Game theory is a mathematical technique
analyzing the behavior of decision makers who are
dependent on each other and who use strategic
behavior as they try to anticipate the behavior of
their rivals
• Used extensively in other areas: bargaining theory,
contract theory, industrial organization, political
science and business strategy making
A simple game…tell me what grade
you would like:
• RULES:
• If you and your “partner”
(chosen randomly) both
choose A, you both get F
• If you choose A and your
partner chooses C, you
get A and your partner
gets F (and vice-versa)
• If you both choose C, you
both get D
A or C
• Find the PAY-OFF matrix
• Is there a DOMINANT
STRATEGY?
The Prisoner’s Dilemma
Assumptions
You have been caught with your
partner with a stolen car. The
police also suspect that you have
committed a vicious robbery.
Each one of you is held in a
separate cell and it is not possible
for you to communicate with your
partner
The police interviews each partner
separately and makes the following
proposal to each
of
them
• Write down one of the
• “I have enough evidence
about the stolen car on both
of you to send you to prison
for a year. But if you alone
confess to the robbery then
I’ll make a deal with you:
• You will get off with a 3month prison sentence,
while your partner will get
the 10 years.
• But, if you both confess,
you’ll both get 5 years in
prison”
following answers:
•
Either
“I WILL CONFESS”
•
or
• “I WILL NOT CONFESS”
Pay-off Matrix and Strategies
A game in Economics: a duopoly
• Acme and AAA are two
major firms in an
industry. Each must
AAA
decide whether to
Advertises
conduct an advertising
campaign. The returns
from the decision
DEPEND on the decision AAA
Does NOT
of the other.
advertise
• The profits are shown in
the payoff matrix
•  H/O
ACME
Advertises
ACME
Does NOT
advertise
Acme: 150
Acme: -100
AAA:150
AAA: 400
Acme: 400
Acme: 0
AAA: -100
AAA: 0
Game Theory & Oligopoly
Using game theory analysis
• Firms, which are the ‘players’ , will make ‘moves’
(referring to economic decisions such as whether or not to
advertise, whether to offer discounts or certain services,
make changes to their products, charge a high or low
price, or any other of a number of economic actions)
based on the predicted behavior of their competitors.
• If a large firm competing with other large firms
understands the various ‘payoffs’ (referring to the profits
or losses that will result from a particular economic
decision made by itself and its competitors) then it will be
better able to make a rational, profit-maximizing (or loss
minimizing) decision based on the likely actions of its
competitors.
Prisoner’s Dilemma and Nash Equilibrium
REVIEW
• John Nash introduced the idea of a Prisoner’s
dilemma which shows how two rational decision
makers, who use strategic behavior to maximize
profits by trying to guess the rival’s behavior, may
end up being collectively worse off.
• The final position that results from the game is
often called a Nash Equilibrium (dominant strategy
equilibrium). Note: there is a difference between them, however, you do not need to know
it. AP students should recognise a dominant strategy equilibrium which occurs if BOTH players have a
dominant strategy.
(continued)
• The four possible combinations of pricing strategies and their
corresponding profit outcomes (‘payoffs’) for the two firms can be
modeled as follow (this is called the ‘payoff matrix’ where Z is the
currency name
• Each box shows the profit outcomes of different pricing
strategies by the two interdependent firms. If both agree on
high price strategy, they earn 40 million Z but if they both set
low price they earn 20 million. But if one sets low and other
sets high, the firm setting the low price earns 70 million in
comparison to the 10 million of the high price firm. This is
because the low price firm captures a large portion of sales
from its rival
• Now, suppose the two firms begin in box 1 where they are
competing each other on the basis of price (charge low price),
leading to a profit of 20 million Z each
• At this point, they realize that they will both be better off if
they enter into an collusive agreement
(eg a CARTEL)and charge a high price to earn 40 million Z each
• But now, each firm faces a dilemma… why?
(continued)
• Each firm faces a dilemma since each firm realizes that if they
secretly break the high price agreement and charge low price,
it can earn a much higher profit of 70 million Z
• In addition (as the collusive agreement is not necessarily
binding by law), the firm realizes that their rival also has the
same incentive to break the agreement in which case the firm
will only obtain 10 million Z
• Now, what should they do? As each firm tries to “outguess” its
rival it is likely to beat its rival by setting a low price (and also
to avoid being beaten). Since the other firm is also thinking
along the same lines, they will also do the same by setting a
low price. As a result both firms adopt the low price strategy
where they both earn low profits
• This is the Equilibrium where both firms become collectively
worse off.
• It also demonstrates that COLLUSION (CARTELS) are
inherently unstable.
More Equilibria:
Dominant Strategy Equilibrium
• There are more and different types of equilibria in game
theory. Moreover, there can be multiple equilibria in one
game
• One equilibrium is called the dominant strategy equilibrium
• A strategy is dominant if, regardless of what any other
players do, the strategy earns a player a larger payoff than
any other. Hence, a strategy is dominant if it is always
better than any other strategy, for any profile of other
players' actions
• https://www.youtube.com/watch?v=3Y1WpytiHKE
• Do review worksheet
To Sum
• Game theory shows that there is sometimes a
conflict between the pursuit of individual self
interest and the collective firms’ interest. This
conflict is the prisoner’s dilemma. Although
the firms could be better off by cooperating
(colluding); each firm, trying to make itself
better off, ends up making both itself and its
rival worse off
In the context of Oligopoly…
• Game Theory illustrates many of the key aspects of an
oligopolistic firm:
– Mutual interdependence – profits of one firm depend on
the strategies adopted by other firms
– Display of strategic behavior – each firm trying to speculate
about the other firm’s actions and to outguess it
– Conflicting incentives – firms face incentives to collude
(agree, cooperate) and incentives to compete (cheat, break
agreement)
– Price competition and price wars – firms all become worse
off if they match the price cuts of each other in order to
capture more sales
– Incentive to avoid price wars as all firms become worse off.
Strong incentive to compete on the basis of factors other
than price (non-price competition eg differentiated
products, promotions, etc)
Different Types and Models of
Oligopoly Using Economic
Concepts and Analysis
Two Main Types of Oligopoly Models
• Collusive Oligopoly
– Open/formal collusion: cartels
– Tacit/informal collusion: price leadership and
other approaches
• Non-Collusive Oligopoly – the kinked demand
curve model
1. Collusive Oligopoly
Collusive Oligopoly
• Collusion is an agreement between firms to limit
competition, which increases monopoly power and
profits
• The most common form involves price fixing
arrangements such as:
– holding prices constant at some level
– raising prices by some fixed amount
– Bid rigging (dango in Japan)
• Collusion is illegal in most countries as stipulated in
competition law because it limits competition. But in
some countries and depending on the case, collusion
could be established either as:
– Formal collusion: such as a cartel
– Informal collusion: such as price leadership
Open/Formal Collusion: Cartels
• Cartel is a formal and agreement between firms to take
actions to limit competition in order to increase profits
• The agreement may involve:
– Limiting and fixing the quantity produced by each firm which
results in increase in price
– Fixing the price at which output can be sold (eg taxi fares in Japan)
– Setting restrictions on non-price competition (such as advertising)
– Dividing the market according to geographical or other factors
– Agreeing to set up barriers to entry
• In all cases, the objective is to limit competition, increase
the monopoly power of the firms, and increase profits 
good for society??
Real Life Example
• An example of a cartel is OPEC (Organization of Petroleum Exporting
Countries) composed of group of 13 oil producing countries
• OPEC periodically tries to change the world price of oil by altering the
total output/supply of oil in order to maximize the profit of the cartel
– However, the recent situation is that OPEC is not reducing the supply of oil
to counter the decreasing price of oil. Why? Individual economies are trying
to maximize their own profits. The cartel’s power is limited by the rising
shale gas industry in the US, the rising popularity of non-gasoline based
cars, etc.
• Each member country is assigned an output level (quota) that it is
permitted to produce
• This restricted level of output results in high price and consumers of oil
(and society at large) are made worse off
• Led by Saudi Arabia
• 13th member is Indonesia
How to Model Cartels ?
• Suppose the firms in an industry (market)
decide to form a cartel by fixing price
• The cartel limits competition between the
member firms and attempts to maximize joint
profits
• Thus, the cartel members collectively and
jointly behave like a monopoly as shown
below
• The diagram is identical to the case of monopoly
• But now the MR, AR, MC and ATC curves represent curves of the entire
cartel
• The MC curve (or supply curve) is the sum of all the MC curves of the all
the firms in the cartel
• The cartel, just like a monopolist, equates MR with MC to find the cartel’s
profit maximizing output and determine the industry-wide price of Pe
• But allocative and productive inefficiency results
(continued)
• But the challenge now is how to divide the profitmaximizing industry output between the firms
(deciding how much of the total quantity will be
produced by each firm) i.e. setting quotas on the
output of each firm.
• There are again multiple ways to do this (business
strategy and negotiation becomes even more
important)
– Based on historical market share of the industry
– To compete for market share based on non-price
competition
Obstacles to Forming and Maintaining Cartels
• Many factors make it difficult for a cartel to be
established and maintained:
– The incentive to cheat – every firm faces the
incentive to cheat by secretly lowering the price to
increase its market share and profits at the
expense of other firms (can demonstrate with
Game Theory)
– Cost differences between firms – as each firm
faces different cost curves, the price agreed upon
by the cartel is maybe higher or lower than the
average cost curves of different firms. This leads
to difficulty agreeing on a common price.
(continued)
• Firms face different demand curves – this is likely to
happen as firms have different market shares and have
product differentiation. This leads to difficulties in
reaching agreement on common price
• Number of firms – the larger the number of firms, the
more difficult it is to arrive at an agreement on price and
allocation of output
• Possibility of a price war – if one or more firms cheat, it
could lead to a price war where one firm’s price cut is
matched by retaliatory price cuts by other firms and all
firms collectively become worse off
(continued)
• Recessions – during recessions (periods when incomes
and economic activities fall) sales fall and profits are
reduced, which give firms greater incentives to cheat
• Potential entry into the industry – if the cartel earns
large economic profits, this will encourage new firms to
enter. If there are new entrants, increased industry
supply will drive price down. The cartel needs high
barriers to entry that block new entrants.
• Industry lacks a dominant firm – presence of
dominant firms can facilitate reaching agreement e.g.
for OPEC, the dominant member is Saudi Arabia. Lack
of leadership can make agreement difficult
Group III
Tacit/Informal Collusion: Price Leadership
• Tacit collusion (informal collusion) refers to
cooperation that is implicit or understood between the
cooperating firms, without a formal agreement
• Firms turn towards tacit collusion given the difficulties
of establishing and maintaining cartels as well as their
illegality
• The objectives of tacit collusion are also to:
–
–
–
–
–
Coordinate prices
Avoid competitive price cutting
Limit competition
Reduce uncertainties
Increase profits
Price Leadership
• One type of tacit/informal collusion is where a
dominant firm (usually with the largest market share)
sets a price and also initiates any price changes. The
remaining firms become price-takers, accepting the
price that has been established by the leader
• The implicit agreement binds the firms as far as the
price goes, but they can engage in non-price
competition (eg………………………….)
• One characteristic is that the price changes tend to
be infrequent and are undertaken by the leader only
when major demand or cost changes
Obstacles to Sustaining Price
Leadership
• The obstacles to price leadership are similar to the
ones faced by cartels:
– Cost differences between firms, particularly when there
is significant product differentiation
– Some firms may follow and some may not follow in
which case the leader risks losing sales if it initiates an
increase in price
– Firms still face incentives to cheat by lowering price
which could lead to a price war
– High industry profits can attract new firms that will cut
into market shares and profits of the industry
– Depending on where and how it is practiced, it can be
considered illegal
2. Non-Collusive Oligopoly
Non-Collusive Oligopoly:
• In the collusive oligopoly model, prices of oligopolistic
industries tend to be rigid or “sticky” (relatively stable over
long periods of time).
• Moreover, in situations when price do change, they tend to
change together for all the firms in the industry
• BUT price rigidities also appear and can be modeled in
situations of non-collusive oligopoly
• In non-collusive oligopoly, firms do not agree, whether
formally or informally, to fix prices or collaborate in some way
BUT suppose they make some assumptions about how other
firms might react……………………………
Assuming………….
• The firm thinks that, if it
raises its prices, then
other firms will probably
NOT raise their prices--
• It also thinks that if it
lowers prices, then other
firms will probably also
lower prices
•  the KINKED demand
curve
•
Price
Pe……………………………Z ………………………….
Qe
Quantity
(continued)
• And these expectations are reflected in the kinked demand curve
• To understand this demand curve, imagine three firms A, B, and C each
producing output Qe selling at price Pe
• Now, say that firm A considers a price change, but before changing its
price, it tries to predict how firms B and C will react and the
consequences of their reaction
– If A raise its price above P1, it thinks that B and C are unlikely to raise their
prices to attract more customers the demand curve for A is elastic above
Pe. Therefore, A should not raise the price above Pe. Any price increase will
lead to a relatively large decrease in sales and revenues and profits as
customers switch to firms B and C
– Now, if A drops the price below P1, it thinks that B and C are likely to drop
their prices as well in order to maintain their customers. A will only capture
a small increase in share with the decrease in price below Pe the demand
curve for A is inelastic below Pe. For any price decrease, A will obtain only a
small increase in sales and revenues and profits will fall. Therefore, A
should not decrease its price below Pe either
• This line of thought is the same of B and C and the three firms remain at
point Z.
The Kinked Demand Curve
Consider the marginal revenue curve
(GroupVI)
• The Kinked Demand Curve explains the price rigidities of oligopolistic
firms (even if MC curves shift) that do not collude
•
• Under this model, the pricing behavior is strategic and is strongly
influenced by their expectations of how firms will react if they
undertake the price change (as a consequence of the interdependence
between firms)
(continued)
• Non-Collusive Oligopoly with the Kinked Demand
Curve (although that kink does not necessarily
occur) illustrates these points:
– Firms who do not collude are forced to take into account
the actions of their rivals in making decisions. Otherwise
they risk losing their revenue and profits. The kinked
demand curve illustrates the interdependence of the
firms
– Even though the firms do not collude, there is still price
stability and rigidity. Firms are reluctant to change price
as there is a possibility of price war
– Firms do not compete with each other on the basis of
price again to avoid price war which results in lowering
profits for all firms
• firms use non-price competition
Some Limitations of the Model
• The non-collusive kinked demand curve model
has some limitations:
– It cannot explain how the firm arrived at point Z
– It does not explain the pricing behavior of firms
when the economy is subject to inflation and
recession (when prices drop to the point they can
set off price wars)
The Role of Non-Price Competition in Oligopoly
• Oligopolistic firms try to avoid price
competition as they would like to avoid price
wars, which make all firms collectively worse off
with lower profits (shown by Game Theory)
• However, as they somehow fix prices,
oligopolistic firms usually do engage in intense
non-price competition (eg product
developmentproduct differentiation,
advertising, and branding)
Summary Evaluation of Oligopoly
- criticisms and benefits, comparisons with other market
structures -
• Criticisms of Oligopoly: to the extent that oligopolistic
firms succeed in avoiding price competition (collude),
they achieve a considerable degree of monopoly power,
and therefore face the same criticisms as monopoly:
– Higher prices are charged and lower quantities of output
are produced in comparison to competitive markets
– Neither allocative nor productive efficiency is achieved
– Whereas many countries have anti-monopoly laws, the
informalities and difficulty of detecting collusion may allow
them to get away with monopoly power
BUT consider price stability versus price wars… which is
preferable for the consumer?
(continued)
• Benefits of Oligopoly: the benefits of oligopoly are also
similar to the benefits of monopoly
– Economies of scale can be achieved due to the large size of
the firms, leading to lower production costs to benefit the
society and consumers (ie through lower prices)
– Product development and innovation can be pursued due to
the large economic profits and entry barriers. This is more
likely to happen than in a monopoly since firms would like to
avoid price wars and compete on a non-price basis
– Technological innovations which improve efficiency and
lower costs of production may be passed to consumers in the
form of lower prices
– Product development leads to increased product variety,
providing consumers with greater choice and options (as also
occurs in the case of monopolistic competition (not yet
studied) but not monopoly)