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Chapter 27
Oligopoly and
Strategic Behavior
Introduction
On a typical day, United Parcel Service will
transport over 10 million packages. UPS and
its main rival, FedEx Ground, earn more than
three-fourths of total revenue earned in the
ground delivery of packages.
How can an economic model explain the
dominance of only two firms in one industry?
Slide 27-2
Learning Objectives
 Outline the fundamental characteristics
of oligopoly
 Understand how to apply game theory
to evaluate the pricing strategies of
oligopolistic firms
 Explain the kinked demand theory of
oligopolistic price rigidity
Slide 27-3
Learning Objectives
 Describe theories of how firms may
deter market entry by potential rivals
 Illustrate why network effects and
market feedback can explain why
some industries are oligopolies
Slide 27-4
Chapter Outline
 Oligopoly
 Strategic Behavior and Game Theory
 Price Rigidity and the Kinked Demand
Curve
Slide 27-5
Chapter Outline
 Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Deterring Entry into an Industry
 Network Effects
 Comparing Market Structures
Slide 27-6
Did You Know That...
 Intel is the predominant seller of
microprocessor chips, with a global market
share of 80 percent?
 Industries such as this, with one
predominant seller and several smaller
competitors, are not monopolies.
 They are described by the term oligopoly.
Slide 27-7
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
Slide 27-8
Oligopoly
 Characteristics of oligopoly
– Small number of firms
– Interdependence
• Strategic dependence
Slide 27-9
Oligopoly
 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
Slide 27-10
Oligopoly
 Why oligopoly occurs
– Economies of scale
– Barriers to entry
– Mergers
• Vertical mergers
• Horizontal mergers
Slide 27-11
Oligopoly
 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
Slide 27-12
Oligopoly
 Measuring industry concentration
– Concentration Ratio
• The percentage of all sales contributed by the
leading four or leading eight firms in an
industry
Slide 27-13
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
Slide 27-14
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.
Slide 27-15
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.
Slide 27-16
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.
Slide 27-17
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
Slide 27-18
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
Slide 27-19
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
Slide 27-20
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
Slide 27-21
Strategic Behavior
and Game Theory
 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
Slide 27-22
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
Slide 27-23
Example: The Prisoner’s Dilemma
 You and your partner rob a bank and
get caught.
Slide 27-24
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
Slide 27-25
Prisoner’s Dilemma
 What would you do?
– Remember
• No cooperation
Slide 27-26
The Prisoners’ Dilemma
Payoff Matrix
Figure 27-1
Slide 27-27
Strategic Behavior
and Game Theory
 Applying game theory to pricing
strategies
– Would you choose a high price or a low
price?
• Remember
– No collusion
Slide 27-28
Strategic Behavior
and Game Theory
Figure 27-2
Slide 27-29
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
Slide 27-30
Strategic Behavior
and Game Theory
 Opportunistic behavior
– Implies a noncooperative game
– Not realistic
• We make repeat transactions
Slide 27-31
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
Slide 27-32
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)
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
Quantity per Time Period
Slide 27-33
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
Slide 27-34
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
Slide 27-35
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
Slide 27-36
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
Slide 27-37
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Markets where price wars are common
– Cigarettes
– Long-distance telephone companies
– Airlines
Slide 27-38
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Markets where price wars are common
– Diapers
– Frozen foods
– PC hardware and software
Slide 27-39
Example:
A Price War in Diapers
 In 2001, the makers of Huggies
disposable diapers reduced the size of
its packages by one diaper, but left the
package price unchanged.
 This increased the effective diaper
price by 5 percent.
Slide 27-40
Example:
A Price War in Diapers
 The response from Pampers, the main
competitor, was to cut prices by 15 percent.
 Huggies soon followed with a price
reduction, and a price war ensued.
 As would be expected, there was a benefit
to consumers as package prices fell and
coupons were made widely available.
Slide 27-41
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
Slide 27-42
Deterring Entry Into an Industry
 Increasing entry cost
– Threat of price wars
– Government regulations
• Environmental regulation
• Safety standards
Slide 27-43
Deterring Entry Into an Industry
 Limit-Pricing Strategies
– A model that hypothesizes that a group of
colluding sellers will set the highest
common price they believe they can
charge, without new firms seeking to enter
the industry
Slide 27-44
Deterring Entry Into an Industry
 Raising switching costs for customers
– Examples
• Non-compatible software
• Non-transferability of college courses
Slide 27-45
Example: QWERTY and High
Switching Costs
 The QWERTY keyboard was designed
to solve a mechanical problem of the
tendency for typewriter keys to jam.
 Now that the mechanical problem no
longer exists, why does this keyboard
layout persist?
Slide 27-46
Network Effects
 A network effect is a situation in which
a consumer’s inclination to use an item
depends on how many others use it.
 For example, the value of a fax
machine increases as there are more
fax machines in use.
Slide 27-47
Network Effects
 Positive Market Feedback
– Potential for a network effect to arise when an
industry’s product catches on
 Negative Market Feedback
– The tendency for industry sales to spiral
downward rapidly when the product falls out of
favor
Slide 27-48
Network Effects and Industry
Concentration
 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.
Slide 27-49
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
Slide 27-50
Issues and Applications:
Oligopoly in the Ground-Shipping Business
 In the industry of shipping packages by
ground, the four-firm concentration ratio in
the U.S. is 100 percent.
 The four firms are UPS, FedEx Ground, the
U.S. Postal Service, and DHL.
 Among these four firms, there is strategic
dependence regarding both prices and
delivery schedules.
Slide 27-51
Issues and Applications:
Oligopoly in the Ground-Shipping Business
 FedEx Ground is willing to deliver on
Saturdays.
 Each of the four delivery services employs
computer technology to speed the pace of
delivery and to allow customers to track
packages in shipment.
 This industry fits the definition of oligopoly,
with four firms competing interdependently.
Slide 27-52
Summary Discussion
of Learning Objectives
 The fundamental characteristics of oligopoly
– Economies of scale
– Barriers to entry
– Strategic dependence
 Applying game theory to evaluate the pricing
strategies of oligopolistic firms
– Game theory looks at competition for payoffs
• That depends on the strategies that others employ
Slide 27-53
Summary Discussion
of Learning Objectives
 The kinked demand theory of oligopolistic
price rigidity
– If a firm believes that rivals will follow price cuts
but not price increases, it will be reluctant to
change price.
 How firms may deter market entry by
potential rivals
– Raise entry costs
– Limit pricing
– Switching policies
Slide 27-54
Summary Discussion
of Learning Objectives
 Why network effects and market
feedback encourage oligopoly:
– Network effects arise when a consumer’s
demand for a good or service is affected
by how many other consumers also use
the item
– Oligopoly can arise because a handful of
firms may be able to capture all of the
positive market feedback
Slide 27-55
End of
Chapter 27
Oligopoly and
Strategic Behavior