Oligopoly

1. Oligopoly

2. Oligopoly Market Structure – A classification system for the key traits of a market, including • the number of firms, • the similarity of the products they sell, and • the ease of entry and exit Oligopoly • only a few firms (firms have market power, can change price) • offer identical (homogeneous) or similar (differentiated) products • difficult to enter or exit the industry Interdependentunlike participants in perfect competition where firms don’t need to consider actions of other producers in the short run, in oligopoly actions of each firm will impact other firms in the market

3. Market Structure Economists who study industrial organization divide markets into four types: monopoly, oligopoly, monopolistic competition, and perfect competition. Number of Firms Many Firms One Firm Product Type Few Firms Differentiated Identical Perfect Competition Monopolistic Competition Oligopoly Monopoly ½ ton trucks Wireless phones Novels Movies Wheat Corn Tap Water Sewer Services Imperfect Competition

4. Oligopoly Imperfect competition – between perfect competition and monopoly • Oligopoly • Monopolistic competition • Produce a quantity where price is greater then marginal cost • Price will be higher than Perfect Competition • Quantity produced will be less can Perfect Competition

5. Oligopoly Definition • Homogeneous Oligopoly • Steel (U.S. Steel, Arcelor Mittal, Nuco) • Copper (Phelps Dodge, Arasco, Freeport-McMoRan, Southwire) GE or GM both needing Steel and Copper will write specification and no matter which producer wins the business GE and GM will get an identical product. • Differentiated Oligopoly • ½ Ton Truck Market (Ford, GM, Chrysler, Toyota) • Commercial Airline Market (America, United, Southwest, Delta, _________, ___________ Even if you don’t know a thing about ½ ton trucks you can identify every truck producer. How? Trucks are different and each one has the brand name on the vehicle.

6. Markets with Few Sellers A small group of sellers • Tension between cooperation and self-interest • Best to cooperate with other firms to create monopoly profit • However, each firm cares only about its own profit which creates a powerful incentive not to cooperate Two types of Oligopoly • Collusive – market participants work together to greater a better profit outcome • Non-collusive – act as competitors in the market place Duopoly – Oligopoly with only two members

7. Non-collusive Oligopoly firms participate in non-price completion • Unique product features (iPhone, iPad) • Increase transaction cost of switching • Contracts (Wireless phones, insurance, etc…) • Lock-in (FirstName.LastName@yahoo.com)

8. Non-collusive • Non-collusion results in: • Higher quantity • lower price • lower profit • Equilibrium Theory • Game Theory: how people or firms behave in strategic situations • Choose among alternative courses of action • Must consider how others might respond to the action they take • Nash equilibrium: economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen

9. Non-collusive The prisoners’ dilemma • Particular “game” between two captured prisoners • Illustrates why cooperation is difficult to maintain even when it is mutually beneficial Dominant strategy • A strategy that is best for a player in a game regardless of the strategies chosen by the other players Pay-off Table quantifies the value of each outcome in game theory based on participant choices

10. Prisoners’ dilemma Bonnie gets 20 years Bonnie gets 8 years Bonnie gets 1 year Bonnie goes free Clyde gets 8 years Clyde gets 1 year Clyde goes free Clyde gets 20 years In this game between two criminals suspected of committing a crime, the dominate strategy for each is to confess. Why because no matter what the other does confession is the best choice.

11. Prisoners’ dilemma Oligopolies as a prisoners’ dilemma • In trying to reach the monopoly outcome • Firms have self-interest • and do not cooperate even though cooperation would increase profits • each firm has incentive to cheat to maximize profit Example Ford and GM (1/2 ton pick-up trucks) • Differentiated oligopoly • Ford is low cost producer • Discounting vs. Free Features

12. Prisoners’ dilemma GM earns $4 million profit GM earns $3 million profit GM earns $6 million profit GM earns $5 million profit Ford gets $3 million profit Ford gets $4 million profit Ford gets $5 million profit Ford gets $6 million profit In the ½ ton truck market, using the above payoff table, Ford will choice to Rebate and GM to offer free options. While each could earn more by cooperating, cooperation is not a sustainable equilibrium in the ½ ton truck market.

13. Collusive Oligopoly • Collusion is an agreement among firms in a market • Cartel – a group of firms acting in unison • Cartels act as a monopolyto maximize profit • Produce monopoly quantity • Charge monopoly price • Same impacts to society • Collusion for self-interest unlikely to work • Difficult to reach & enforce an agreement • Antitrust laws

14. Economics of Cooperation Why firms sometimes cooperate • Game of repeated prisoners’ dilemma • Repeat the game • Agree on penalties if one cheats • Both need an incentive to cooperate • Encouraging cooperation • Penalty for not cooperating • Return to cooperative outcome after a period of noncooperation

15. Collision Example Organization of Petroleum Exporting Countries (OPEC) • Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela • By 1973: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon • Control about three-fourths of the world’s oil reserves • Tries to raise the price of its product Via a coordinated reduction in quantity produced Cheating Problem:Each member of the cartel • Tempted to increase its production • Get a larger share of the total profit • Cheat on agreement

16. Collision Example • OPEC was successful at maintaining cooperation and high prices from 1973 to 1985: increase in price • Mid-1980s - member countries began arguing about production levels • OPEC became ineffective at maintaining cooperation • Decrease in price • 2007 to 2008 – significant increase in price primarily caused by increased world demand Booming World economy

17. Public Policy Restraint of trade and the antitrust laws • The Sherman Antitrust Act, 1890 Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy • The Clayton Act, 1914 Further strengthened the antitrust laws • The Federal Trade Commission Act, 1914 • Created the Federal Trade Commission (FTC) • Can prevent mergers that impede competition • Can prevent oligopolists from colluding

18. An illegal phone call – Collusion Example Public Policy Robert Crandall – president of American Airlines Howard Putnam – president of Braniff Airways • CRANDALL: I think it’s dumb as hell . . . to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime. • PUTNAM: Do you have a suggestion for me? • CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent. I’ll raise mine the next morning. • PUTNAM: Robert, we . . . • CRANDALL: You’ll make more money, and I will, too. • PUTNAM: We can’t talk about pricing! • CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we want to talk about.

19. Public Policy • Require retailers to charge customers a given price • Might seem anticompetitive • Prevents the retailers from competing on price • Defenders: • Not aimed at reducing competition • Legitimate goal • Some retailers offer service Resale price maintenance (fair trade)

20. Public Policy • Charge prices that are too low • Anticompetitive because price cuts are intended to drive other firms out of the market • Skeptics • Predatory pricing (not a profitable strategy) • Price war (to drive out a rival) • Pricing below cost Predatory pricing

21. Public Policy Tying • Offer two goods together at a single price • Expands market power • Skeptics • Cannot increase market power by binding two goods together • Form of price discrimination • Tying may increase profit

22. Public Policy Example U.S. government case against Microsoft • Central issue: tying Should Microsoft be allowed to integrate its Internet browser into its Windows operating system • The government’s claim: • Microsoft was bundling to expand market power into the market of Internet browsers • Would deter other software companies from entering the market and offering new products

23. Microsoft Case Microsoft responded • New features into old products - natural part of technological progress • Cars - include CD players, air conditioners • Cameras - built-in flashes • Operating systems - added many features to Windows • Previously stand-alone products • Computers - more reliable and easier to use • Integration of Internet technology, • The next natural next step

24. Microsoft Case Disagreement about the extent of Microsoft’s market power • The government • More than 80% of new personal computers • Use a Microsoft operating system • Substantial monopoly power • Microsoft • Software market is always changing • Competitors: Apple Mac & Linux operating systems • Low price illustrates limited market power

25. Microsoft Case • November 1999 ruling Microsoft illegally abused market power • June 2000 Ruling to break Microsoft into two companies Operating system & Applications software • 2001 appeal Overturned the breakup order • September 2001 Justice Department - wanted to settle the case quickly • November 2002 settlement Microsoft accepted some restrictions and the browser remains part of the Windows operating system