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Econ606 chapter 14 2020
- 1. CHAPTER 14 Oligopoly andStrategic Behavior
- 2. • Oligopoly • OligopolyBehavior: A Game-Theory Overview • Three Oligopoly Models • Oligopoly and Advertising • Oligopoly and Efficiency • Game Theory and Strategic Behavior 14-2 Chapter Contents
- 3. Oligopoly • Oligopoly • Afew large producers • Homogeneous oligopoly: Identical products • Differentiated oligopoly: Differentiated products • Entry barriers • Many oligopoly are results from mergers LO14.1 14-3
- 4. Oligopolistic Industries • Four-firmconcentration ratio (national market) • 40% or more to be an oligopoly • Shortcomings • Localized markets • Interindustry competition • Import competition LO14.1 14-4
- 5. Percentage of OutputProduced by Firms in Selected High- Concentration U.S. Manufacturing Industries LO14.1 (1) Industry (2) Percentage of Industry Output Produced by the Four Largest Firms (3) Herfindahl Index for the Top 50 Firms (1) Industry (2) Percentage of Industry Output Produced by the Four Largest Firms (3) Herfindahl Index for the Top 50 Firms Household laundry equipment 100 ND︎ Primary aluminum 74 2,089 Household refrigerators and freezers 93 ND︎ Tires 73 1,531 Cigarettes 88 2,897 Bottled water 71 1,564 Beer 88 3,561 Gasoline pumps 70 1,611 Glass containers 86 ND Bar soaps 70 2,250 Phosphate fertilizers 85 3,152 Burial caskets 69 1,699 Small-arms ammunition 84 2,848 Printer toner cartridges 67 1,449 Electric light bulbs 84 3,395 Alcohol distilleries 65 1,394 Aircraft 80 3,287 Turbines and generators 61 1,263 Breakfast cereals 79 2,333 Motor vehicles 60 1,178 Aerosol cans 75 1,667 Primary copper 50 879 14-5
- 6. Mutual interdependence • Oligopolisthas a limited control over price • Its output can affect market output or it can set own price. • Its action affects rival firms in market • Lower market price • Draw significant numbers of customers from rivals • Rival firms respond to one’s action • Rival’s action will affect the oligopolist in return 14-6
- 7. Oligopoly Behavior • Oligopoliesdisplay strategic behavior • Mutual interdependence • Collusion • Incentive to cheat • Many different models are used to analyze various strategic behaviors • Game theory and Prisoner’s dilemma • Kinked-demand • Collusive pricing • Price leadership 14-7
- 8. Game Theory • GameTheory: is the tool used to analyze strategic behavior—behavior that recognizes mutual interdependence and takes account of the expected behavior of others. • Settings • Objectives: Profit maximization • Strategy: All possible choices of actions • Pay-offs: Result of own choice and rival’s choice 14-8
- 9. Payoff Matrix RareAir’s pricestrategy Uptown’spricestrategy A B C D $12 $12 $15 $6 $8 $8 $6 $15 High High Low Low • 2 competitors (RareAir & Uptown) • 2 price strategies (High & Low) • Each strategy has a payoff matrix (Profits as pay-off for given choices). • Objective: Profit maximization LO14.2 14-9
- 10. Strategy Choice andPayoff • Given strategy choices, payoffs for two firms are shown in each square (A, B, C, D) in which right-upper triangle (shaded grey) indicates RareAir’s profit and left-lower triangle (shaded yellow) indicates Uptown’s profit. • When RareAir chooses High price and Uptown chooses Low price, then their payoffs are shown in “C” square, where RareAir earns $6 and Uptown earns $15. RareAir’s price strategy Uptown’spricestrategy A B C D $12 $12 $15 $6 $8 $8 $6 $15 High High Low Low LO14.2 14-10
- 11. Cooperative Equilibrium • Cooperativestrategy: When both choose “High Price” strategy, the industry (two firms together) make maximum profits. • Cooperative equilibrium (Cartel solution): the industry achieves the monopolist’s profit • Incentive to cheat: A player gains if it cheats the cooperative strategy. 14-11
- 12. Cooperative Equilibrium inPayoff Matrix • Cooperative equilibrium: If RareAir chooses High price and Uptown chooses High price, then each of them earns $12, that is, $24 in total in industry, which is the maximum in industry. • Incentive to cheat: If Uptown changes to Low price, while RareAir keeps High price, Uptown will increase its payoff from $12 to $15. However, this action will lower RareAir’s payoff from $12 to $6. • RareAir also has an incentive to cheat, changing to Low price strategy to increase own profits at the expense of lower profits of Uptown. RareAir’s price strategy Uptown’spricestrategy A B C D $12 $12 $15 $6 $8 $8 $6 $15 High High Low Low LO14.2 14-12
- 13. RareAir’s price strategy Uptown’spricestrategy AB C D $12 $12 $15 $6 $8 $8 $6 $15 High Low • If both firms cheat and select Low price to increase own profits, then then end up to “D” where each firm earn $8 each, which is worse than the original cooperative equilibrium. LO14.2 14-13 High Low Cheating and Payoff
- 14. Nash Equilibrium • Dominantstrategy: the strategy that a player choose regardless of rival’s actions • For profit-maximizing player, it should choose “Low Price” regardless of opponent’s action • It is the optimal strategy based on rival’s reaction • Nash equilibrium: Outcome from which neither firm wants to deviate. • The resulting pay-off may not be the best for the industry nor each oligopolist. 14-14
- 15. Dominant Strategy inPayoff Matrix • For RareAir, if Uptown chooses High price, RareAir may choose High price to earn $12 or choose Low price to earn $15. So, if Uptown chooses High price, RareAir should choose Low price. • If Uptown chooses Low price, RareAir may choose High price to earn $6 or choose Low price to earn $8. So, if Uptown chooses Low price, RareAir should choose Low price. • Dominant strategy: Regardless of choice of Uptown (High or Low), RareAir should always choose Low price. RareAir’s price strategy Uptown’spricestrategy A B C D $12 $12 $15 $6 $8 $8 $6 $15 High High Low Low LO14.2 14-15
- 16. Nash Equilibrium inPayoff matrix • Dominant strategy for RareAir is Low price. • Dominant strategy for Uptown is Low price. • Nash equilibrium: If both pursues own dominant strategy, their payoff is D. • If RareAir changes to High price, its profit will decrease from $8 to $6. If Uptown changes to High price, its profit will decrease from $8 to $6. Thus, neither firm will unilaterally change own strategy. RareAir’s price strategy Uptown’spricestrategy A B C D $12 $12 $15 $6 $8 $8 $6 $15 High High Low Low LO14.2 14-16
- 17. Prisoner’s Dilemma • Prisoners’dilemma shows why it is hard to cooperate, even when it would be beneficial to both players to do so. • Both benefit when cooperate • But, each has an incentive to cheat • When both cheat, both end up less favorable results. 14-17
- 18. RareAir’s price strategy Uptown’spricestrategy AB C D $12 $12 $15 $6 $8 $8 $6 $15 High Low •Independently lowered prices in expectation of greater profit leads to worst combined outcome. •Eventually low outcomes make firms return to higher prices. LO14.2 14-18 High Low Prisoner’s Dilemma in Payoff Matrix
- 19. Three Oligopoly Models •Kinked-demand curve • Collusive pricing • Price leadership • Reasons for three models: • Diversity of oligopolies • Complications of interdependence LO14.3 14-19
- 20. Kinked-Demand Theory • Non-collusive(non-cooperative) oligopoly • Uncertainty about rivals’ reactions: • Rivals match any price change. • Rivals ignore any price change. • Assume combined strategy: • Match price reductions. • Ignore price increases. LO14.3 14-20
- 21. f f Kinked-Demand Curve P0 MR2 D2 D1 MR1 e g Rivalsignore price increase Rivals match price decrease Q0 MC1 MC2 LO14.3 14-21 Quantity (a) Price 0 P0 D1 MR1 e g Q0 Quantity (b) Priceandcosts 0 D2 MR2 The Kinked-Demand Curve
- 22. How Well Kinked-DemandModel Explains Reality • Kinked-demand model describes • Explains why price is inflexible • However, it cannot explain why • Prices are not that rigid • Price war LO14.3 14-22
- 23. Overt Collusion • Acartel is a group of firms or nations that collude: • Formally agreeing to the price. • Sets output levels for members. • Act like monopolist. • Collusion is illegal in the United States. • Example: OPEC LO14.3 14-23
- 24. Collusion and theTendency toward Joint-Profit Maximization • Participating firms in collusion agree to produce assigned quantities, so that total quantity produced by group will be the monopolist output quantity Q0, which maximizes the group’s total profits. • Each firm may be assigned different quantity, depending on the size or power of each firm in the industry, so each firm may earn different profits. • Each participating firm has an incentive to cheat the agreement and produce more than its assignment and earn more profits. D MR = MC ATC MC MR P0 A0 Q0 Economic profit LO14.3 14-24 Quantity Priceandcosts 0
- 25. Global Perspective 14.1:OPEC Nations 14-25 LO14.3
- 26. Obstacles to Collusion •Demand and cost differences • Number of firms • Cheating • Recession • New entrants • Legal obstacles LO14.3 14-26
- 27. Credible and EmptyThreats • Credible threats: • Threat that is believable by the other firm. • Can establish collusive agreements. • A strong enforcer can prevent cheating. • Can generate higher profits. • May be countered with threat by rival. • Empty threats: • A threat that is not believable by rival. LO14.6 14-27
- 28. Price Leadership Model •Price leadership • Dominant firm initiates price changes. • Other firms follow the leader. • Use limit pricing to block entry of new firms. • Possible price war. LO14.3 14-28
- 29. Differentiated Oligopoly • Oligopoliescommonly compete through product differentiation by • Development • Advertising • Instead of competing in price, they compete through brand loyalty of customers • Less easily duplicated than a price change • Financially able to advertise LO14.4 14-29
- 30. Positive Effects ofAdvertising • Low-cost way of providing information to consumers. • Enhances competition. • Speeds up technological progress. • Can help firms obtain economies of scale. LO14.4 14-30
- 31. Negative Effects ofAdvertising • Can be manipulative. • Contain misleading claims that confuse consumers. • Consumers may pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product. LO14.4 14-31
- 32. The Largest U.S.Advertisers, 2018 Company Advertising Spending Millions of $ Comcast $6,122 AT&T 5,362 Amazon 4,470 Proctor & Gamble 4,305 General Motors 3,139 Disney 3,132 Charter 3,042 Alphabet (Google) 2,960 American Express 2,798 Verizon 2,682 14-32 LO14.4
- 33. Top Ten BrandNames LO14.4 14-33
- 34. Oligopoly and Efficiency •Oligopolies are inefficient: • Productively inefficient because P > min ATC • Allocatively inefficient because P > MC • Qualifications: • Increased foreign competition • Limit pricing • Technological advance LO14.5 14-34
- 35. Last Word: InternetOligopolies • The Internet became accessible to the average person in the mid 1990s. • Today it is dominated by a few very large firms: Google, Facebook, Amazon, Microsoft, Apple. • Not satisfied with just revenues generated in their respective sectors: • Compete for advertising dollars. • Compete with electronic devices. 14-35