OLIGOPOLIES

1. OLIGOPOLIES Markets with just a few firms. CONCENTRATION RATIO • Measure of the degree of concentration in a market. • Four-Firm Concentration Ratio - Percentage of output produced by the four largest firms. Rule of thumb - If four-firm concentration ratio is greater than 40%, the market is considered an oligopoly.

2. CONCENTRATION RATIOS IN SELECTED MANUFACTURING INDUSTRIES Industry Four-Firm Eight-Firm Concentration-Ratio % Concentration-Ratio % Cigarettes 93 Not Available Guided Missiles & Space 93 99 Vehicles Beer and Malt Beverage 90 98 Batteries 87 95 Electric Bulbs 86 94 Breakfast Cereals 85 98 Motor Vehicles & Car 84 91 Bodies Greeting Cards 84 88 Engines and Turbines 79 92 Aircraft and Parts 79 93

3. KEY FEATURE OF OLIGOPOLY • Firms act strategically; • Firms in an oligopoly are independent because they sell similar products, and consumers can easily switch from one firm to another; • Actions of one firm affect the profits of other firms in the oligopoly.

4. WHY FIRMS DON’T ENTER A PROFITABLE OLIGOPOLY MARKET • ECONOMIES OF SCALE In some cases, scale economies are not large enough to generate a natural monopoly but are large enough to generate a natural oligopoly, with a few firms serving the entire market. • ARTIFICAL BARRIERS TO ENTRY Government may limit the number of firms in a market by issuing patents or controlling the number of business licenses. • ADVERTISING CAMPAIGN For some markets, a firm cannot enter without a substantial investment in an advertising campaign.

5. CARTEL VERSUS DUOPOLY Dollars Per Trip Market Demand d: duopoly 350 Long-run Average Cost 300 200 Passengers Per Day

6. DUOPOLY PROFIT • Two-hundred passengers a day (100 per airline), • Price of $350, • Average cost of $300, • Per passenger profit $350 - $300 =$50, • Total profit per airline: $50 * 100 = $5,000

7. CARTEL A group of firms that coordinate their pricing decisions, often by charging the same price. This is also known as pricefixing.

8. CARTEL VERSUS DUOPOLY Dollars Per Trip Market Demand m: monopoly or cartel 400 d: duopoly 350 Long-run Average Cost 300 150 200 Passengers Per Day

9. CARTEL PROFIT • One-hundred fifty passengers per day (point m), or 75 passengers per airline, • Price of $400, • Average cost 0f $300, • Per passenger profit $400 - $300 =$100 • Total profit per airline: $100 * 75 = $7,500 The cartel profit exceeds the profit when the two airlines compete.

10. THE GAME TREE • Will firms act independently as duopoly firms, or will they reach a price-fixing agreement ? • Game tree: a graphical tool that provides a visual representation of the consequences of alternative strategies; • Each firm can use the game tree to develop a pricing strategy, knowing that the other firm is picking a price too.

11. PROFITS 1 High Price Y JILL JACK 7,500 7,500 JACK: high or low price 2 High Price Low Price JILL JACK 1,000 8,500 X JILL: high or low price 3 Low Price High Price Z JILL JACK 8,500 1,000 JACK: high or low price 4 JILL JACK 5,000 5,000 Low Price

12. PROFITS WHEN FIRMS PICK DIFFERENT PRICES Jill: Low Price Jack: High Price Price $350 $400 Quantity 170 10 Average Cost $300 $300 Profit Per $50 $100 Passenger Profit $8,500 $1,000

13. PROFITS 1 High Price Y JILL JACK 7,500 7,500 JACK: high or low price 2 High Price Low Price JILL JACK 1,000 8,500 X Jill: (10 pass * $400)-$3000 Jack:(170 pass * $350)-$3000 JILL: high or low price 3 Low Price High Price Z JILL JACK 8,500 1,000 JACK: high or low price Jill:(170 pass * $350)-$3000 Jack: (10 pass * $400)-$3000 4 JILL JACK 5,000 5,000 Low Price

14. THE OUTCOME OF THE PRICE-FIXING GAME • If Jill picks the high price, move along upper branches of tree, reaching rectangle 1 or 2, depending on what Jack does; Although Jill would like Jack to pick high price too, irrational for Jack, since he can make more profit by picking low price; (eliminate rectangle 1) • If Jill Picks low price, move along lower branches of tree, reaching rectangle 3 or 4, depending on Jack’s choice; Jack won’t pick high price, because Jill would gain at his expense; (eliminate rectangle 3)

15. JACK’S DOMINANT STRATEGY Jack will pick the low price, regardless of what Jill does. JILL’S DOMINANT STRATEGY Since Jill knows that Jack will always choose the lower price, it would be irrational for Jill to choose the higher price and allow Jack to gain at her expense. Jill also chooses the lower price.

16. DUOPOLIST’S DILEMMA Although both firms would be better off if they picked the high price, each firm picks the low price.

17. GUARANTEED PRICE MATCHING To eliminate the incentive for underpricing, one firm can guarantee that it will match its competitor’s price. Jack can respond to Jill’s promise to match price in either of two ways: • Pick the high price, each will earn $7,500; • Pick the low price, each will earn $5,000; Jack won’t have to think long before choosing the high price.

18. RETALIATION STRATEGIES Firms use several strategies to maintain a price-fixing agreement. Three which involve punishing a firm that underprices the other firm are: • Duopoly price, • Grim trigger, • Tit-for-tat

19. DUOPOLY PRICE • Jill picks high price until Jack underprices her; • Once underpriced, Jill picks duopoly price for remaining lifetime of firm; • Less profitable than cartel outcome, but more profitable than being underpriced.

20. GRIM TRIGGER • When underpriced, Jill drops price to level at which each firm earns zero economic profit forever.

21. TIT-FOR-TAT • Starting with second month, Jill picks price Jack picked in the previous month; • The cartel price will persist as long as Jack picks cartel price; • Cartel breaks down if Jack underprices Jill; • To restore cartel outcome, Jack must pick cartel price, allowing Jill to underprice him for a month.

22. Price in $$ JACK JILL 400 350 1 2 3 4 5 Month Underpricing Underpricing Outcome Cartel Duopoly Cartel

23. PRICE-FIXING LAW • Under the Sherman Anti-Trust Act of 1890 and subsequent legislation, explicit price fixing is illegal. • It is illegal for firms to discuss their pricing strategies or their methods of punishing a firm that underprices other firms.

24. PRICE LEADERSHIP • Under this arrangement, a group of firms selects a firm to serve as a price leader. • The other firms in the arrangement will match the price of the leader. • Implicit agreements allow firms to cooperate without discussing pricing strategies.

25. PRICE LEADERSHIP • Implicit pricing relationship relies on indirect signals, which may be misinterpreted: • If one firm suddenly drops price, may be interpreted as: Change in market conditions -- both firms may benefit from a lower price; Underpricing -- first firm is trying to increase market share at second’s expense: result could be a price war.

26. KINKED-DEMAND CURVE MODEL Price $ h 8 k 6 4 10 30 33 Quantity sold per day

27. KINKED-DEMAND MODEL • This model gets its name from assumptions about how firms in an oligopoly respond when one firm changes its price. Assume each firm starts with a $6 price: • If one firm increases price, other firms will not change their price; the quantity will decrease by a large amount (from 30 to 10) for this firm. • If one firm decreases price, other firms will too; the quantity will increase by a small amount (from 30 to 33) for this firm.

28. KINKED-DEMAND MODEL Assumptions: • The demand curve has a kink at the prevailing price; • It is relatively flat (elastic) for higher prices because other firms will not match price; • It is relatively steep (inelastic) for lower prices because other firms will match lower price; • Once price is established, it tends to persist because there is a large penalty for increasing price and a small benefit for decreasing price

29. KINKED-DEMAND MODEL Starting in 1947, various studies of oligopolies have failed to find compelling evidence to support the kinked-demand model of oligopoly.

30. ENTRY DETERRENCE GAME How a monopolist might try to prevent a second firm from entering its market. It begins with a secure monopoly operating on the marginal principle (marginal revenue = marginal cost

31. Price $ ENTRY DETERRENCE AND LIMITING PRICE Market Demand m: secure monopoly 400 300 150 Passengers per day

32. ENTRY DETERRENCE AND LIMITING PRICE If Jane discovers a second airline is about to enter market, she can: • Act passively and allow the second airline to enter (create a duopoly), • Try to prevent the second airline from entering (maintain monopoly).

33. Price $ ENTRY DETERRENCE AND LIMITING PRICE Market Demand m: secure monopoly 400 d: duopoly 350 300 150 180 200 Passengers per day

34. ENTRY DETERRENCE AND LIMITING PRICE If Jane produces a large quantity , and Dick enters anyway, the total output of the two firms is very large: • the market moves down along the demand curve to point h, • a price of $290 and quantity of 260, • price is less than average cost, • each firm would lose $1,300.

35. ENTRY DETERRENCE AND LIMITING PRICE If Jane produces a large quantity , and Dick stays out, the total output is substantially less: • the market moves down along the demand curve to point i, • a price of $370 and quantity of 180, • Jane makes $12,600 profit, • $70 per passenger profit * 180 passengers.

36. Price $ ENTRY DETERRENCE AND LIMITING PRICE Market Demand m: secure monopoly 400 370 i: insecure monopoly d: duopoly 350 300 290 h: large quantity and two firms 150 180 200 260 Passengers per day

37. PROFITS Enter: p = $350 1 Y JANE DICK 5,000 5,000 DICK: enter or stay out Stay out: p = $400 2 Small Quantity JANE DICK 15,000 0 X JANE: small quantity or large output 3 Enter: p = $290 Z JANE DICK -1,300 -1,300 DICK: enter or stay out Large Quantity Stay Out: p = $370 4 JANE DICK 12,600 0

38. CONTESTABLE MARKETS A market in which firms can enter and leave without incurring large costs. The few firms in a contestable market will be continually threatened by the entry of new firms, so prices and profits will be relatively low. In a perfectly contestable market, firms can enter and exit at zero cost. In this case, the price will be the same as a perfectly-competitive market price.

39. ANTITRUST POLICY The government uses antitrust policy to regulate the business practices of markets dominated by a few firms. The government’s objective is to prevent a few firms from dominating the market and charging relatively high prices.

40. THREE WAYS FIRMS CAN INCREASE MARKET SHARESUBJECT TO GOVERNMENT SCRUTINY • Trust, • Merger, • Predatory Pricing

41. TRUST The owners of several companies transfer their decision-making powers to a small group of trustees. The trustees then make the decisions for all of the firms of the trust. The firms in a trust act as a single large firm: The industry that appears to have many firms may in fact be a virtual monopoly.

42. MERGER The merging of two firms increases market concentration: • A duopoly becomes a monopoly, • A three-firm market becomes a duopoly.

43. PREDATORY PRICING Predatory pricing works as follows: • One firm (the predator) sets its price low enough that the predator and its prey (a second firm) loses money; • The second firm goes out of business; • The first firm (the predator) increases its price to restore its profits.

44. A BRIEF HISTORY OF ANTI-TRUST LEGISLATION DATE LEGISLATION DESCRIPTION 1890 Sherman Act Made it illegal to monopolize a market or engage in practices which resulted in “restraint of trade.” 1914 Clayton Act Outlawed specific practices that discourage competition. 1914 Federal Trade Established to enforce anti-trust laws. Commission 1936 Robinson- Prohibited selling products at Patman Act “unreasonably low prices” with the intent of reducing competition. 1950 Celler-Kefauver Outlawed asset-purchase merger Act that would substantially reduce competition. 1980 Hart-Scott-Rodino Extended anti-trust legislation to Act proprietorships and partnerships.

45. TRADE BARRIERS AND MARKET CONCENTRATION • Reducing trade barriers, such as tariffs, increases competition. • As competition increases, market concentration decreases.

46. DEREGULATION AND CONCENTRATION The deregulation of air travel eliminated the government’s artificial barriers to entry, but other barriers have led to increased concentration in some markets.