Economics for Managers by Paul Farnham

Chapter 9 Market Structure: Oligopoly

© 2005 Prentice Hall, Inc. 9.1 Oligopoly

A market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals’ actions into considerati on wh en d evel opi ng their competitive strategies

© 2005 Prentice Hall, Inc. 9.2 Characteristics of an Oligopo ly

ƒ Firms have market power derived from barriers to entry ƒ However, a small number of firms compete with each other ƒ Each firm doesn’t have to consider the actions of other firms, thus, behavior is interdependent

© 2005 Prentice Hall, Inc. 9.3 Noncooperative Oligopol y Mod el s

Assumes that firms pursue profit- maximizinggg strategies based on assumptions about rivals’ behavior and the impact of this behavior on the gi ven fi rm’ s st rat egi es 1. Kinked demand curve model 2. Game theory models 3. Strategic entry deterrence

© 2005 Prentice Hall, Inc. 9.4 Kinked Demand Curve MMdlodel

ƒ Assumes that a firm is faced with two demand curves, assuming that other firms will not match price increases but will match price decreases ƒ If the firm considers raising the price above P1, its quantity demanded will depend upon the behavior of ri val firms

© 2005 Prentice Hall, Inc. 9.5 Kinked Demand Curve MMdlodel

ƒ Assumes that managers will inflict maximum damage on other firms ƒ Implies oligopoly prices tend to be “sticky” and not change as they would in other market structures

ƒ Does not explain why price P1 exists initially

© 2005 Prentice Hall, Inc. 9.6 Kinked Demand Curve

Figure 9.1 MC

P 1 MR2 D2 = Rivals don’t follow

D = rivals follow MR1 1 0 Q1 Q

© 2005 Prentice Hall, Inc. 9.7 Game Theory Models

ƒ Mathematically analyzes situations in which players make various strategic moves and have different outcomes or payoffs associated with those moves ƒ Dooatstategyminant strategy: results in best outcome to a given player

© 2005 Prentice Hall, Inc. 9.8 Nash Equilibrium

ƒ Strategies for which all players are choosing their best strategy, given actions of other players ƒ Proves useful when there is only one unique equilibrium in the game ƒ There may be multiple Nash equilibrium

© 2005 Prentice Hall, Inc. 9.9 Strategic Entry DtDeterrence

Policies that prevent rivals from entering the market • Limit pricing: charging a price lower than the profit-maximizing price • Predatory pricing : lowering prices below cost to drive out existing competitors and scare off potential entrants

© 2005 Prentice Hall, Inc. 9.10 Limit Pricing Model Figure 9.2

Potential Entrant Established Firm MC ATCEN PM A C PL PL B ATC ATCM ATC L F

0 0 Q1 Q2 Q

© 2005 Prentice Hall, Inc. 9.11 Limit Pricing Model

ƒ Assumes existing firms have lower costs ƒ Attracts other firms into the industry ƒ Established firms can thwart entry by charging the limit price (or a lower price) rather than profit- maximization price

© 2005 Prentice Hall, Inc. 9.12 Predatory Pricing Figure 9.3

K PUS T L P J R S J G PC LRAC = LRMC M PP N Demand MR 0 QUS QPP QC QP E Q

© 2005 Prentice Hall, Inc. 9.13 Determinates of Successful PdtPredatory PPiiricing

ƒ How far the predatory price is below cost ƒ Period of time in which the predatory price is in effect ƒ Rate of return used for judging the investment in predatory pricing ƒ How many rivals enter the industry after predation ends ƒ Time over which recouppging of p rofits occurs

© 2005 Prentice Hall, Inc. 9.14 Cooperative Oligopoly MdlModels

ƒ Focus on cooperative behavior among rivals ƒ Two types • CtlCartels • Tacit collusion

© 2005 Prentice Hall, Inc. 9.15 Cartels

ƒ Firms that get together and agree to coordinate behavior regarding pricing and output decisions ƒ Joint profit maximization: strategy that maximiz espoes profi tsots for acatebuta cartel but m ay create incentives for individual members to cheat ƒ HiHorizont tlal summati on of margi nal cost curve: calculated from marginal cost curve for the cartel

© 2005 Prentice Hall, Inc. 9.16 Allocation Rule for Joint Profit Max im iza tion

MC1 = MC2 = MC3

where

MC1 = Firm #1’ s margi nal cost

MC2 = Firm #2 ’ s marginal cost

MCC = Cartel’s marginal cost

© 2005 Prentice Hall, Inc. 9.17 When a Cartel is Success flful

ƒ It can raise market price without inducing significant competition from non-cartltel memb ers ƒ The expected punishment from fithtlilltiforming the cartel is low relative to the expected gains ƒ The cost s of est abli shi ng and enforcing agreement are low relative to the gains

© 2005 Prentice Hall, Inc. 9.18 Tacit Collusion

ƒ Tacit collusion: coordinated behavior that is an achieved without a formal agreement ƒ Tacit collusion practices: • Uniform prices • Penalty for price discounts • Advantage notice of price changes • Information exchanges • Swaps and exchanges

© 2005 Prentice Hall, Inc. 9.19 Managerial Rule of Thumb: Coordinate d Act ions

Managers must • Coordinate efforts, but within constraints of antitrust legislation • Recogggnize incentives for cheating in coordinated behavior • Remember that even coordinated efforts are fleeti ng, gi ven th e dynamic and competitive nature of a market environment

© 2005 Prentice Hall, Inc. 9.20 Summary of Key Terms

ƒ CtlCartel ƒ Cooperative oligopoly models ƒ Dominant strategy ƒ Game theory ƒ Horizontal summation of marginal cost curves ƒ Joint profit maximization ƒ Kinked demand curve model

© 2005 Prentice Hall, Inc. 9.21 Summary of Key Terms

ƒ Limit pricing ƒ Nash equilibrium ƒ Noncooperative oligopoly models ƒ Oliggyopoly ƒ Predatory pricing ƒ Strategic entry deterrence ƒ Tacit collusion

© 2005 Prentice Hall, Inc. 9.22 Do you have any questions?

© 2005 Prentice Hall, Inc. 9.23