CHAPTER

2. 14 Oligopoly: Firms in Less Competitive Markets CHAPTER Chapter Outline and Learning Objectives

3. Competition in the Computer Market • An industry with only a few firms is an oligopoly, in which a firm’s profitability depends on its interactions with other firms. • In these industries, firms must develop business strategies, which involve not just deciding what price to charge and how many units to produce but also how much to advertise, which new technologies to adopt, how to manage relations with suppliers, and which new markets to enter. • Because there are relatively few firms competing in an oligopolistic industry, they must continually react to each other’s actions or risk losing significant sales. • In 2011, Samsung introduced the Series 9 notebook and Dell introduced the XPS 15z laptop, both intended to compete with Apple’s MacBook Air. • AN INSIDE LOOK on page 534 discusses how Intel produced the Ultrabook to respond to consumer demand.

4. Economics in Your Life Why Can’t You Find a Cheap PlayStation 3? You and your roommates have just moved into a great apartment and decide to treat yourselves to a PlayStation 3 320GB game system—provided that you can find one at a relatively low price. First you check Amazon and find a price of $349.99. Then you check Best Buy, and the price there is also $349.99. Then you check Target; $349.99 again! Finally, you check Wal-Mart, and you find a lower price: $349.96, a whopping discount of $0.03. See if you can answer these questions by the end of the chapter: Why isn’t one of these big retailers willing to charge a lower price? What happened to price competition?

5. In analyzing oligopoly, we cannot rely on the same types of graphs we used in analyzing perfect competition and monopolistic competition for two reasons: We need to use economic models that allow us to analyze the more complex business strategies of large oligopoly firms. Even in determining the profit-maximizing price and output for an oligopoly firm, demand curves and cost curves are not as useful as in the cases of perfect competition and monopolistic competition. The approach we use to analyze competition among oligopolists is called game theory, which can be used to analyze any situation in which groups or individuals interact.

6. Oligopoly and Barriers to Entry 14.1 LEARNING OBJECTIVE Show how barriers to entry explain the existence of oligopolies.

7. Oligopoly A market structure in which a small number of interdependent firms compete. One measure of the extent of competition in an industry is the concentration ratio which states the fraction of each industry’s sales accounted for by its four largest firms. Most economists believe that a four-firm concentration ratio greater than 40 percent indicates that an industry is an oligopoly. Because the concentration ratio has some flaws, some economists prefer another measure of competition, known as the Herfindahl-Hirschman Index.

8. Examples of Oligopolies in Retail Trade and Manufacturing Table 14.1 Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits.

9. Economies of scale The situation when a firm’s long-run average costs fall as the firm increases output. FIGURE 14.1 Economies of Scale Help Determine the Extent of Competition in an Industry An industry will be competitive if the minimum point on the typical firm’s long-run average cost curve (LRAC1) occurs at a level of output that is a small fraction of total industry sales, such as Q1. The industry will be an oligopoly if the minimum point comes at a level of output that is a large fraction of industry sales, such as Q2.

10. Ownership of a Key Input If production of a good requires a particular input, then control of that input can be a barrier to entry. Government-Imposed Barriers Many large firms employ lobbyists to convince state legislators and members of Congress to pass laws favorable to the economic interests of the firms. Patent The exclusive right to a product for a period of 20 years from the date the patent is filed with the government. Governments restrict competition through occupational licensing. Governments also impose barriers to entering some industries by imposing tariffs and quotas on foreign competition. A tariff is a tax on imports, and a quota limits the quantity of a good that can be imported into a country. In an oligopoly, barriers to entry prevent—or at least slow down—entry, which allows firms to earn economic profits over a longer period.

11. Using Game Theory to Analyze Oligopoly 14.2 LEARNING OBJECTIVE Use game theory to analyze the strategies of oligopolistic firms.

12. Game theory The study of how people make decisions in situations in which attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of a firm depend on its interactions with other firms. • Games share three key characteristics: • 1. Rules that determine what actions are allowable • 2. Strategies that players employ to attain their objectives in the game • 3. Payoffs that are the results of the interactions among the players’ strategies Business strategy Actions that a firm takes to achieve a goal, such as maximizing profits. The payoffs are the profits a firm earns as a result of how its strategies interact with the strategies of other firms.

13. A Duopoly Game: Price Competition between Two Firms Game theory can be used to analyze price competition in a duopoly—an oligopoly with two firms. A Duopoly Game Figure 14.2 Dell’s profits are in blue, and Apple’s profits are in red. Dell and Apple would each make profits of $10 million per month on sales of desktop computers if they both charged $1,200. However, each firm has an incentive to undercut the other by charging a lower price. If both firms charge $1,000, they would each make a profit of only $7.5 million per month.

14. Payoff matrix A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Collusion An agreement among firms to charge the same price or otherwise not to compete. Dominant strategy A strategy that is the best for a firm, no matter what strategies other firms use. The result of a dominant strategy is an equilibrium in which each firm is maximizing profits, given the price chosen by the other firm. Neither firm can increase its profits by changing its price, given the price chosen by the other firm. Nash equilibrium A situation in which each firm chooses the best strategy, given the strategies chosen by other firms. Don’t Let This Happen to You Don’t Misunderstand Why Each Firm Ends Up Charging a Price of $1,000 Notice that charging $1,000 is the most profitable strategy for each firm, no matter which price the other firm decides to charge. • Your Turn:Test your understanding by doing related problem 2.14 at the end of this chapter. MyEconLab

15. Firm Behavior and the Prisoner’s Dilemma Cooperative equilibrium An equilibrium in a game in which players cooperate to increase their mutual payoff. Noncooperative equilibrium An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoner’s dilemma A game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off. If the police lack other evidence, they may separate two suspects and offer each a reduced prison sentence in exchange for confessing to the crime and testifying against the other suspect. Because each suspect has a dominant strategy to confess to the crime, they will both confess and serve a jail term, even though they would have gone free if they had both remained silent. • Your Turn:Test your understanding by doing related problem 2.14 at the end of this chapter. MyEconLab

16. Solved Problem 14.2 Is Advertising a Prisoner’s Dilemma for Coca-Cola and Pepsi? • Coca-Cola and Pepsi both advertise aggressively, but would they be better off if they didn’t? • Their commercials are usually not designed to convey new information about their products. • Instead, they are designed to capture each other’s customers. • Construct a payoff matrix using the following hypothetical information: • If neither firm advertises, Coca-Cola and Pepsi both earn profits of $750 million per year. • If both firms advertise, Coca-Cola and Pepsi both earn profits of $500 million per year. • If Coca-Cola advertises and Pepsi doesn’t, Coca-Cola earns profits of $900 million and Pepsi earns profits of $400 million. • If Pepsi advertises and Coca-Cola doesn’t, Pepsi earns profits of $900 million and Coca-Cola earns profits of $400 million. • a. If Coca-Cola wants to maximize profit, will it advertise? • Briefly explain. • b. If Pepsi wants to maximize profit, will it advertise? • Briefly explain. • c. Is there a Nash equilibrium to this advertising game? • If so, what is it?

17. Solved Problem 14.2 Is Advertising a Prisoner’s Dilemma for Coca-Cola and Pepsi? Solving the Problem Step 1: Review the chapter material. Step 2: Construct the payoff matrix. Step 3: Answer part a. by showing that Coca-Cola has a dominant strategy of advertising. If Pepsi doesn’t advertise, then Coca-Cola will make $900 million if it advertises but only $750 million if it doesn’t. If Pepsi advertises, then Coca-Cola will make $500 million if it advertises but only $400 million if it doesn’t. Therefore, advertising is a dominant strategy for Coca-Cola.

18. Solved Problem 14.2 Is Advertising a Prisoner’s Dilemma for Coca-Cola and Pepsi? Step 4: Answer part b. by showing that Pepsi has a dominant strategy of advertising. Pepsi is in the same position as Coca-Cola, so it also has a dominant strategy of advertising. Step 5: Answer part c. by showing that there is a Nash equilibrium for this game. Both firms advertising is a Nash equilibrium. Given that Pepsi is advertising, Coca-Cola’s best strategy is to advertise. Given that Coca-Cola is advertising, Pepsi’s best strategy is to advertise. Therefore, advertising is the optimal decision for both firms, given the decision by the other firm. This is another example of the prisoner’s dilemma game. Coca-Cola and Pepsi would be more profitable if they both refrained from advertising, thereby saving the enormous expense of television and radio commercials and newspaper and magazine ads. Each firm’s dominant strategy is to advertise, however, so they end up in an equilibrium where both advertise, and their profits are reduced. • Your Turn:For more practice, do related problems 2.11, 2.12, and 2.13 at the end of this chapter. MyEconLab

19. MakingtheConnection Is There a Dominant Strategy for Bidding on eBay? The payoff in winning an auction is equal to the difference between the subjective value you place on the product being auctioned and the amount of the winning bid. eBay is run as a second-price auction, where the winning bidder pays an amount equal to the bid of the second-highest bidder. It may seem that your best strategy when bidding on eBay is to place a bid well below the subjective value you place on the item in the hope of winning it at a low price. In fact, bidders on eBay have a dominant strategy of entering a bid equal to the maximum value they place on the item. • Your Turn:Test your understanding by doing related problem 2.15 at the end of this chapter. MyEconLab

20. Can Firms Escape the Prisoner’s Dilemma? Figure 14.3 Changing the Payoff Matrix in a Repeated Game Wal-Mart and Target can change the payoff matrix for selling PlayStation 3 game consoles by advertising that each will match its competitor’s price. This retaliation strategy provides a signal that one store charging a lower price will be met automatically by the other store charging a lower price. In the payoff matrix in panel (a), there is no matching offer, and each store benefits if it charges $300 when the other charges $400. In the payoff matrix in panel (b), with the matching offer, the companies have only two choices: They can charge $400 and receive a profit of $10,000 per month, or they can charge $300 and receive a profit of $7,500 per month. The equilibrium shifts from the prisoner’s dilemma result of both stores charging the low price and receiving low profits to both stores charging the high price and receiving high profits.

21. In a repeated game, the losses from not cooperating are greater than in a game played once, and players can also employ retaliation strategies against those who don’t cooperate. Lost profit increases the incentive for store managers to cooperate by implicitly colluding since explicit collusion is illegal. An enforcement mechanism, such as a store’s offer to match prices offered by competing stores, guarantees that if one store fails to cooperate by charging a lower price, the competing stores will automatically punish that store by also charging the lower price. Price leadership A form of implicit collusion in which one firm in an oligopoly announces a price change and the other firms in the industry match the change.

22. MakingtheConnection With Price Collusion, More Is Not Merrier As with other oligopolies, if all airlines cut prices, industry profits will decline. Airlines therefore continually adjust their prices while at the same time monitoring their rivals’ prices and retaliating against them either for cutting prices or failing to go along with price increases. In recent years, though, mergers in the airline industry have increased the possibility of implicit collusion by reducing the number of airlines flying between two cities. When more airlines enter the market, competition increases, ticket prices drop significantly, and the opportunities for price collusion are greatly reduced. When JetBlue enters a market, other airlines often cut their ticket prices. • Your Turn:Test your understanding by doing related problems 2.16, 2.17, and 2.18 at the end of this chapter. MyEconLab

23. Cartels: The Case of OPEC Cartel A group of firms that collude by agreeing to restrict output to increase prices and profits. Figure 14.4 Oil Prices, 1972 to mid-2011 The blue line shows the price of a barrel of oil in each year. The red line measures the price of a barrel of oil in terms of the purchasing power of the dollar in 2011. By reducing oil production, OPEC was able to raise the world price of oil in the mid-1970s and early 1980s. Sustaining high prices has been difficult over the long run, however, because OPEC members often exceed their output quotas.

24. Figure 14.5 The OPEC Cartel with Unequal Members Because Saudi Arabia can produce much more oil than Nigeria, its output decisions have a much larger effect on the price of oil. In the figure, Low Output corresponds to cooperating with the OPEC-assigned output quota, and High Output corresponds to producing at maximum capacity. Saudi Arabia has a dominant strategy to cooperate and produce a low output. Nigeria, however, has a dominant strategy not to cooperate and instead produce a high output. Therefore, the equilibrium of this game will occur with Saudi Arabia producing a low output and Nigeria producing a high output.

25. Sequential Games and Business Strategy 14.3 LEARNING OBJECTIVE Use sequential games to analyze business strategies.

26. Business situations where one firm will act first, and then other firms will respond can be analyzed using sequential games. Deterring Entry We can analyze a sequential game by using a decision tree. Decision nodes are points in a decision tree where the firms must make decisions. The decisions made are shown beside arrows that point to terminal nodes, which show the resulting rates of return.

27. Figure 14.6 The Decision Tree for an Entry Game Apple earns its highest return if it charges $1,000 for its very thin, very light laptop and Dell does not enter the market. But at that price, Dell will enter the market, and Apple will earn only 16 percent. If Apple charges $800, Dell will not enter because Dell will suffer an economic loss by receiving only a 5 percent return on its investment. Therefore, Apple’s best decision is to deter Dell’s entry by charging $800. Apple will earn an economic profit by receiving a 20 percent return on its investment. Note that the dashes(—) indicate the situation where Dell does not enter the market and so makes no investment and receives no return.

28. Solved Problem 14.3 Is Deterring Entry Always a Good Idea? Like any other business strategy, deterring entry is a good idea only if it has a higher payoff than alternative strategies. Use the following decision tree to decide whether Apple should deter Dell from entering the market for very thin, very light laptops. Assume that each firm must earn a 15 percent return on its investment to break even. Solving the Problem Step 1: Review the chapter material.

29. Solved Problem 14.3 Is Deterring Entry Always a Good Idea? Step 2: Determine how Dell will respond to Apple’s decision. If Apple charges $1,000 for its very thin, very light laptops, Dell will not enter the market because the return on its investment represents an economic loss. If Apple charges $800, Dell will enter because it will earn a return that represents an economic profit. Step 3: Given how Dell will react, determine which strategy maximizes profits for Apple. If Apple charges $1,000, it will have deterred Dell’s entry, and the rate of return on its investment will be 20 percent. If Apple charges $800, Dell will enter, but because these low prices will substantially increase the market for these laptops, Apple will actually earn a higher return of 24 percent, splitting the market with Dell at a lower price than it would have earned having the whole market to itself at a high price. Step 4: State your conclusion. Like any other business strategy, deterrence is worth pursuing only if the payoff is higher than for other strategies. In this case, expanding the market for very thin, very light laptops by charging a lower price has a higher payoff for Apple, even given that Dell will enter the market. • Your Turn:For more practice, do related problem 3.3 at the end of this chapter. MyEconLab

30. Bargaining Figure 14.7 The Decision Tree for a Bargaining Game Dell earns the highest profit if it offers a contract price of $20 per copy and TruImage accepts the contract. TruImage earns the highest profit if Dell offers it a contract of $30 per copy and it accepts the contract. TruImage may attempt to bargain by threatening to reject a $20-per-copy contract. But Dell knows this threat is not credible because once Dell has offered a $20-per-copy contract, TruImage’s profits are higher if it accepts the contract than if it rejects it. A subgame-perfect equilibrium is a Nash equilibrium in which no player can make himself or herself better off by changing his decision at any decision node.

31. The Five Competitive Forces Model 14.4 LEARNING OBJECTIVE Use the five competitive forces model to analyze competition in an industry.

32. FIGURE 14.8 The Five Competitive Forces Model Michael Porter’s model identifies five forces that determine the level of competition in an industry: (1) competition from existing firms, (2) the threat from new entrants, (3) competition from substitute goods or services, (4) the bargaining power of buyers, and (5) the bargaining power of suppliers.

33. Competition from Existing Firms Competition among firms in an industry can lower prices and profits. Competition in the form of advertising, better customer service, or longer warranties can also reduce profits by raising costs. The Threat from Potential Entrants Firms face competition from companies that currently are not in the market but might enter. We have already seen how actions taken to deter entry can reduce profits. Some of these actions include advertising to create product loyalty, introducing new products—such as slightly different cereals or toothpastes—to fill market niches, and setting lower prices to keep profits at a level that makes entry less attractive.

34. Competition from Substitute Goods or Services Firms are always vulnerable to competitors introducing a new product that fills a consumer need better than their current product does. The Bargaining Power of Buyers If buyers have enough bargaining power, they can insist on lower prices, higher-quality products, or additional services. The Bargaining Power of Suppliers If many firms can supply an input and the input is not specialized, the suppliers are unlikely to have the bargaining power to limit a firm’s profits. As with other competitive forces, the bargaining power of suppliers can change over time.

35. MakingtheConnection Can We Predict Which Firms Will Continue to Be Successful? Is it possible to draw general conclusions about which business strategies are likely to be successful in the future? A number of business analysts have tried to identify strategies that have made firms successful and have recommended those strategies to other firms. Many successful strategies can be copied—and, often, improved on—by competitors. Even in oligopolies, competition can quickly erode profits and even turn a successful firm into an unsuccessful one. It remains difficult to predict which currently successful firms will maintain their success. Although its business strategy had once been widely admired, Circuit City declared bankruptcy in 2009. • Your Turn:Test your understanding by doing related problem 4.5 at the end of this chapter. MyEconLab

36. Economics in Your Life Why Can’t You Find a Cheap PlayStation 3? At the beginning of this chapter, we asked you to consider why the price of the PlayStation 3 320GB game system is almost the same at every large retailer, from Amazon to Wal-Mart. Why don’t these retailers seem to compete on price for this type of product? In this chapter, we have seen that if big retailers were engaged in a one-time game of pricing PlayStations, they would be in a prisoner’s dilemma and would probably all charge a low price. However, we have also seen that pricing PlayStations is actually a repeated game because the retailers will be selling the game system in competition over a long period of time. In this situation, it is more likely that the retailers will arrive at a cooperative equilibrium, in which they will all charge a high price; this is good news for the profits of the retailers but bad news for consumers! This is one of many insights that game theory provides into the business strategies of oligopolists.

37. AN INSIDE LOOK Can Intel’s “Ultrabook” Competewith Apple’s MacBook Air? Figure 1 Apple should develop a model to compete with the Ultrabook Figure 2 Apple should not develop a model to compete with the Ultrabook