McGraw-Hill/Irwin

©2008 The McGraw-Hill Companies, All Rights Reserved

OligopolyOligopoly

Chapter 10Chapter 10

2

Market Structure

Most firms possess some market power.

3

Degrees of Power

We classify firms into specific market structures based on the number and relative size of firms in an industry.

Market structure – The number and relative size of firms in an industry.

4

Degrees of Power

In imperfect competition, individual firms have some power in a particular product market.

Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service.

LO1

5

Characteristics of Market Structures

Market Structure

Characteristics Perfect

Competition Monopolistic Competition Oligopoly

Number of firms Very large number

Many Few

Barriers to entry None Low High

Market power (control over price

None Some Substantial

Type of product Standardized Differentiated

Standardized or differentiated

LO1

6

Characteristics of Market Structures

Market Structure

CharacteristicsPerfect

Competition Duopoly Monopoly

Number of firms Very largenumber

Two One

Barriers to entry None High High

Market power(control over price

None Substantial Substantial

Type of product Standardized Standardizedordifferentiated

Unique

LO1

7

Determinants of Market Power

The determinants of market power include:

Number of producers.

Size of each firm.

Barriers to entry.

Availability of substitute goods.

LO1

8

Determinants of Market Power

Market power increases:

LO1

The fewer the number of firms in the market.

The larger the relative size of the firms in the market.

The higher the entry barriers.

The fewer the substitutes.

9

Determinants of Market Power

Barriers to entry determine to what extent the market is a contestable market.

Contestable market – An imperfectly competitive industry subject to potential entry if prices or profits increase.

LO1

10

Measuring Market Power

The standard measure of market power is the concentration ratio.

The concentration ratio is a measure of market power that relates the size of firms to the size of the market.

LO1

11

Concentration Ratio

The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).

LO1

12

Firm Size

Market power isn’t necessarily associated with firm size.

A small firm could possess a lot of power in a relatively small market.

LO1

13

Measurement Problems

Many smaller firms acting in unison can achieve market power.

Concentration ratios do not convey the extent to which market power may be concentrated in a local market.

LO1

14

Oligopoly Behavior

Market structure affects market behavior and outcomes.

Assume that the computer market has three oligopolists.

LO1

15

Initial Equilibrium

Initial conditions and market shares of each firms are described in the following slides.

Market share - The percentage of total market output produced by a single firm.

LO2

16

Initial Conditions in Computer Market

20,0000

$1000

Market demand

Quantity Demanded (computers per month)

Pri

ce (

per

com

pute

r)

Industry output

LO2

17

Initial Market Shares of Microcomputer Producers

Producer Output Market Share

Universal Electronics 8,000 40.0%

World Computers 6,500 32.5%

International Semiconductor

5,500 27.5%

Total industry output 20,000 100.0%

18

The Battle for Market Shares

In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms.

LO2

19

Increased Sales at the Prevailing Market Price

Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists.

LO2

20

Increased Sales at Reduced Prices

Lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors.

There simply isn’t any way that a firm can do so without causing alarms to go off in the industry.

LO2

21

Retaliation

Oligopolists respond to aggressive marketing by competitors.

Step up marketing efforts.

Cut prices on their product(s).

LO2

22

Retaliation

One way oligopolists market their products is through product differentiation.

Product differentiation – Features that make one product appear different from competing products in the same market.

23

Retaliation

An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price.

This is why oligopolists avoid price competition and instead pursue nonprice competition.

LO3

24

Rivalry for Market Shares

FG

Marketdemand

$1000900

0 20,000 25,000Quantity Demanded (computers per month)

Pric

e (p

er c

ompu

ter)

LO3

25

The Kinked Demand Curve

Close interdependence – and the limitations it imposes on price and output decisions – is a characteristic of oligopoly.

LO2

26

Rivals’ Response to Price Reductions

The degree to which sales increase when the price is reduced depends on the response of rival oligopolists.

We expect oligopolists to match any price reductions by rival oligopolists.

LO2

27

Rivals’ Response to Price Increases

Rival oligopolists may not match price increases in order to gain market share.

LO2

28

The Kinked Demand Curve Confronting an Oligopolist

The shape of the demand curve facing an oligopolist depends on how its rivals responded to a change in the price of its own output.

The demand curve will be kinked if rival oligopolists match price reductions but not price increases.

LO2

29

1000

PR

ICE

(pe

r co

mpu

ter)

QUANTITY DEMANDED (computers per month)0

The Kinked Demand Curve Confronting an Oligopolist

Demand curve facing oligopolist if rivals match price changes

Demand curvefacing oligopolist ifrivals don't matchprice changes

Demand curve facing oligopolist if rivals match price cuts but not price hikes

MA

CD

B$1100

900

8000

LO2

30

Game Theory

Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies.

The payoff to an oligopolist’s price cut depends on how its rivals respond.

LO3

31

Game Theory

Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.

LO3

32

Game Theory

Each oligopolist is uncertain about its rival’s behavior.

The collective interests of the oligopoly are protected if no one cuts the market price.

But an individual oligopolist could lose if it holds the line on price when rivals reduce price.

LO3

33

The Payoff Matrix

A payoff matrix is a table showing the risks and rewards of alternative decision options.

The payoff to an oligopolist’s price cut depends on how its rivals respond.

LO3

34

The Payoff Matrix

The decision to initiate a price cut requires a risk assessment.

X=

cutsprice from

loss ofSize

matchingrivals

of Probabilityvalue

Expected

X+

cutprice

lonefrom Gain

matching notrivals

of Probability

LO3

35

Oligopoly Payoff Matrix

Rivals’ Actions

Universal’s Options

Reduce Price Don’t Reduce

Price

Reduce price Small loss for everyone

Huge gain for Universal; rivals lose

Don’t reduce price

Huge loss for Universal; rivals gain

No change

LO3

36

Oligopoly vs. Competition

Oligopolists may try to coordinate their behavior in a way that maximizes industry profits.

LO3

37

Price and Output

An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit.

Oligopoly firms must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.

LO3

38

Pric

e or

Cos

t (d

olla

rs p

er u

nit)

Quantity (units per period)0

Maximizing Oligopoly Profits

Industrymarginal

cost

Industry average

cost

Marketdemand

Industry marginalrevenue

Profits

J

Profit-maximizing

price

Average costat profit-

maximizingoutput

Profit-maximizing output

LO3

39

Coordination Problems

There is an inherent conflict in the joint and individual interests of oligopolists.

Each oligopolist wants industry profits to be maximized.

Each oligopolist wants to maximize it’s own market share.

LO3

40

Coordination Problems

To avoid self-destructive behavior, each oligopolist must coordinate production decisions so that:

Industry output and price are maintained at profit-maximizing levels.

Each oligopolistic firm is content with its market share.

LO3

41

Price Fixing

The most explicit form of coordination among oligopolists is called price fixing.

Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold.

LO3

42

Examples of Price Fixing

Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators.

They were charged again in 1972 for continued price fixing.

LO3

43

Examples of Price Fixing

School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states.

LO3

44

Examples of Price Fixing

Vitamin C – The four Chinese suppliers of most of the vitamin C to the U.S. market tripled the price in 2001.

LO3

Baby Formula – Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula.

45

Examples of Price Fixing

Perfume – Thirteen companies paid $55 million in 2006 for fixing prices.

LO3

Art Auction Commissions – In 2000, Southeby’s and Christie’s paid $512 million in fines for fixing commissions throughout the 1990s.

46

Examples of Price Fixing

Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD.

LO3

47

Examples of Price Fixing

Laser Eye Surgery – The FTC charged VISX and Summit Technology with price-fixing that raised the price of surgery by $500 per eye.

LO3

48

Examples of Price Fixing

Memory chips – In 2005, the world’s largest memory-chip (DRAM) makers (Samsung, Micron, Infineon, and Hynix) admitted they fixed prices and paid $700 million in criminal fines.

LO3

49

Price Leadership

Price leadership is an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry.

LO3

50

Allocation of Market Shares

One way to allocate market share is a cartel agreement.

A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market.

LO3

51

Allocation of Market Shares

An oligopolist may resort to predatory pricing when market shares are not being divided in a satisfactory manner.

Predatory pricing - temporary price reductions designed to alter market shares or drive out competition.

LO3

52

Barriers to Entry

Above-normal profits cannot be maintained over the long-run unless barriers to entry exist.

Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market.

53

Patents

Patents prevent potential competitors from setting up shop.

Competitors have to develop an alternative method for producing a product or receive permission from the patent holder to use the patented process.

54

Distribution Control

The control of distribution outlets can be accomplished through selective discounts, long-term supply contracts, or expensive gifts at Christmas.

55

Mergers and Acquisition

A firm can limit competition by acquiring competitors through mergers and acquisition.

56

Government Regulation

Patents are issued by the federal government.

Licensing requirements imposed by government limit competition.

57

Nonprice Competition

Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market.

58

Training

Early market entry can create an important barrier to later competition.

Customers of training-intensive products (such as computer hardware and software) become familiar with a particular system.

59

Network Economies

The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.

60

Antitrust Enforcement

Market power contributes to market failure when it leads to resource misallocations or greater inequity.

Market failure is an imperfection in the market mechanism that prevents optimal outcomes.

61

Industry Behavior

Antitrust is government intervention designed to alter market structure or prevent abuse of market power.

62

Industry Behavior

There are several problems with the behavioral approach to antitrust law:

Limited government resources.

Public apathy.

Difficulty of proving collusion.

63

Industry Structure

Former Supreme Court Chief Justice Earl Warren observed:

“An industry which doesn’t have a competitive structure will not have competitive behavior.”

64

Objections to Antitrust

Some argue that we shouldn’t punish those who achieved monopolies through hard work and innovation.

Noncompetitive behavior, not industry structure, should be the only concern of antitrust.

65

The Herfindahl-Hirshman Index

The Herfindahl-Hirshman index (HHI) is a measure of industry concentration that accounts for number of firms and size of each.

66

The Herfindahl-Hirshman Index

The Herfindahl-Hirshman Index is computed by summing the squares of the market shares of each firm in an industry.

67

The Herfindahl-Hirshman Index

For policy purposes, the Justice Department decided it would draw the line at a value of 1,800.

68

Contestability

Contestability as well as structure now motivates antitrust decisions.

If entry barriers are low enough, even a highly concentrated industry might be compelled to behave more competitively.

69

Behavioral Guidelines: Cost Savings

The FTC now also looks to see if a proposed merger will allow for greater efficiencies and lower costs.

McGraw-Hill/Irwin

©2008 The McGraw-Hill Companies, All Rights Reserved

OligopolyOligopoly

End of Chapter 10End of Chapter 10