ECON 202: Principles of Microeconomics

1. ECON 202: Principles of Microeconomics Chapter 13 Oligopoly

2. Oligopoly • Oligopoly and Barriers to Entry. • Using Game Theory to Analyze Oligopoly. • Sequential Games and Business Strategy. • The Five Competitive Forces Model. Oligopoly

3. Introduction • Oligopoly is market structure where: • Few competitors. • Identical or differentiated products. • Restrictions to entry. • In case of oligopolistic markets, revenues of the firms depend on actions of other competitors. • If a firm cut its price, number of units sold depends on how other firms react. • If other firms don’t do anything, sell more. • If other firms also cut prices, sales will not increase much or can even decrease. • Marginal revenue depends on actions of other firms. • Approach to analyze oligopolies: game theory. Oligopoly

4. 1. Oligopoly and Barriers to Entry • Oligopolistic markets have few firms • How many firms is “few”? • US Bureau of Census publishes 4-firm concentration ratios per industry. • More than 40% indicates oligopolistic market. • Critics • Consider only sales by national firms • In some industries, competition is mainly local. (restaurants) • Some firms compete in different industries. (Wal Mart in discount department stores, supermarkets and retail toy stores) • Herfindahl-Hirschman Index (HHI) • Sum of squared shares: 302 + 302 + 202 + 202 = 2,600 • HHI > 1,800 : oligopolistic markets. Oligopoly

5. 1. Oligopoly and Barriers to Entry Oligopoly

6. 1. Oligopoly and Barriers to Entry Barriers to entry • Economies of scale Oligopoly

7. 1. Oligopoly and Barriers to Entry • Ownership of a Key Input • Aluminum Company of America (Alcoa) access to high-quality bauxite. • De Beers Company of South Africa access to diamonds. • Government-imposed barriers • Occupational licensing (doctors and dentists) • Restrictions to international trade (tariffs and quotas) • Since entry is restricted, firms can sustain economic profits over a long period. Oligopoly

8. 2. Using Game Theory to Analyze Oligopoly • Game theory: • The study of how people make decisions in situations in which attaining their goals depends on their interactions with others. • Games have three characteristics: • Rules. • Strategies. • Payoffs. Oligopoly

9. 2. Using Game Theory to Analyze Oligopoly • Duopoly: price competition between two firms. • Firms can collude, but is against the law. (Sherman Act) Oligopoly

10. 2. Using Game Theory to Analyze Oligopoly • For each firm, to charge $400 is a dominant strategy. • The best strategy for a player, regardless of what the other players decide. • ($400, $400) is a Nash equilibrium. • A situation where each player is choosing its best strategy, given the others players’ strategies. • A situation where no player has an incentive to change of strategy. • Equilibrium is not best possible result for the firms, but it results because each firm pursues its own interest. • Noncooperative equilibrium. • If firms decide to cooperate and play ($600, $600), then result increases their mutual payoff. • Cooperative equilibrium. Oligopoly

11. 2. Using Game Theory to Analyze Oligopoly • Types of games where individual maximization of payoff leaves everyone worse off are called prisoner’s dilemma. • Nash Equilibrium is (defect, defect). • Challenge to Adam Smith’s idea of self-interest. Oligopoly

12. 2. Using Game Theory to Analyze Oligopoly • In most business situations games are played repeatedly. • Firms can collude implicitly to reach the cooperative equilibrium. • Example: “lowest price guarantee” • Firms send a signal to competitors that if they charge lower price, its strategy will be the same. • Firms have the incentive to keep the high price. Oligopoly

13. 2. Using Game Theory to Analyze Oligopoly Oligopoly

14. 2. Using Game Theory to Analyze Oligopoly • When firms can collude: cartels (OPEC) • However, firms can have incentives to stop cooperation, which makes difficult to sustain agreements. Oligopoly

15. 3. Sequential Games and Business Strategy • Oligopolistic firms can deter the entry of new firms. • Best strategy for WalMart is to build the large store, deterring entry from Target. Oligopoly

16. 3. Sequential Games and Business Strategy • Best strategy for firm is to build the small store and let Target entry the market. Oligopoly

17. 3. Sequential Games and Business Strategy • Bargaining • If TruImage says that will not accept a deal at $20: noncredible threat. Oligopoly

18. 4. The Five Competitive Forces Model • Forces that determine the level of competition in an industry. Oligopoly

19. 4. The Five Competitive Forces Model • Competition from existing firms. • Educational testing service: SAT and ACT vs. GRE. • Threat from potential entrants. • Railways. • Competition from substitute goods or services. • Train vs. flight • Bargaining power of buyers. • Automobile makers and tire suppliers. • Bargaining power of suppliers. • Technicolor and color movies. Oligopoly

20. ECON 202: Principles of Microeconomics Chapter 13 Oligopoly