OLIGOPOLY Chapter 27

1. Superior Cheese OLIGOPOLYChapter 27 What determines how much market power a firm has? How do firms in an oligopoly set prices and output? What problems does an oligopoly have in maintaining price and profit?

2. What does market power really mean? • Market power is the key to control. • Monopoly is a type of power that all firms dream of, yet pure monopoly is not permitted in our economy. • The next best thing is to PUSH the power base to the very edge of government acceptance. Gaining market share is a common term we hear from businesses and Wall Street.

3. MARKET POWER • Tom Thumb wants to gain market share from Albertsons. • Wal-Mart wants market share from Kmart… boy did they get it! • Central Market wants market share from Whole Foods

4. “Defending the Lead”World-wide PC vender market share for third quarter. DMN- 10/16/08

6. Who is sharing? • What about the auto industry now. Government motors (adv./Ford) Yet Ford 8/2010 sees first monthly increase in sales in 2 years. 10/2010- Ford up 39%. Is auto industry still oligopoly? • Oligopoly is no exception… Outstanding feature of Oligopoly is “fewness” • OLI (derivation actually means few.. (do you remember your Oligarchy in government?) • Oligopoly has few sellers- so few that at least one firm is large enough to INFLUENCE PRICE • The vast amount of GDP is accounted for by firms in oligopolistic industries.

7. AT&T and Verizon • October 19, 2012 • Communiqué from AT&T management that they would “continue to provide retirement benefits, including pensions, to employees and retirees.” • Where many other Fortune 500 companies are not doing this. AT&T wanted to make a statement --- because of market share position, VZ will no doubt follow.

8. Most firms are part of oligopoly or monopolistic competition, with few monopolies or perfect competition. • These two market structures are called imperfect competition. • In these structures, you can find both intense competition and some evidence of monopoly.

9. Oligopoly (cont'd) Oligopoly A market situation in which there are very few sellers. Each seller knows that the other sellers will react to its changes in prices and quantities.

10. Oligopolist • The oligopolist is a price searcher. • It produces the quantity of output at which MR = MC.

11. Characteristics of Oligopoly • Few firms control the market • High barriers to entry • Produce either differentiated or homogeneous products • Lack of available substitutes • Name some examples!

12. Oligopoly (cont'd) Why oligopoly occurs Economies of scale Barriers to entry Mergers Vertical mergers Horizontal mergers

13. Price and Output Under 3 Oligopoly Theories • Cartel Theory - oligopolistic firms act as if there were only one firm in the industry. • Kinked Demand Curve Theory - assumes that if a single firm in the industry cuts prices, other firms will do likewise, but if it raises price, other firms will not follow suit. The theory predicts price stickiness or rigidity. • Price Leadership Theory - the dominant firm in the industry determines price, and all other firms take their price as given.

14. Characteristics of Market Structures

15. More Examples

16. Why are certain industries composed of only a few firms? • Because cost economies and other barriers to entry keep the numbers small (plus mergers keep out the smaller guys) (enter the political key on who decides if mergers are not eliminating competition) • Where economies of scale are substantial, reasonably efficient production will be possible only with a small number of producers… efficiency requires that the productive capacity of each firm be large relative to the total market.

17. Continued • Technological progress has made more and more economies of scale attainable over time. • Other barriers such as the development or persistence of some oligopolies through patents, control of strategic raw materials, in some cases prodigious advertising (Budweiser) outlays which add a financial barrier to entry for other firms.

18. The following = nonprice competition • http://www.youtube.com/watch?v=xD6ghskNKa8 Advertising - Convince the consumer that firm A’s product is a better buy than those of its rivals. • Product differentiation. • Firm A could modify its products to make them appealingly different in order to sell more.

19. Examples of Oligopolies • Aluminum • Automobile • Film • Television • Cell phone • Gas • Beer • Petroleum • Tire • Airline soft drinks, batteries, cigarettes, computer printers, Internet browsers, baby food, cereal, and credit cards.

20. What do we see in the 21St Century? Many big corporations seeking more market share have been following a simple rule. “Don’t build what you can buy.” Reason - to fill some of the empty production space created in the building boon of late 90’s This will allow for movement to capacity production which is more efficient.

21. Oligopoly (cont'd) Vertical Merger The joining of a firm with another to which it sells an output or from which it buys an input Horizontal Merger The joining of firms that are producing or selling a similar product

22. Measuring Market Power • Concentration ratio: the proportion of total industry output produced by the largest firms. • If the industry produces 1 million products and the four biggest firms produce 700,000 of them, the concentration ratio is 70%.

23. Ways to measure degree of Oligopolization Concentration Ratio: Sometimes the market share of one company in the oligopoly is so great that it nearly resembles a monopoly.

24. Table 27-1 Computing the Four-Firm Concentration Ratio Add up top 4 or perhaps 6- divide by total sales in industry. Note: This is calculated by Annual $ sales.

25. E-Commerce Example: Market Concentration in the Personal Computer Industry The computer printer industry generated $201.1 billion in revenues in a recent year, and several firms had a high market share. Of the four: Hewlett-Packard earned $35.0 billion, Dell $27.9 billion, Lenovo $14.1 billion and Acer $13.7 billion. These four firms had a concentration ratio for the computer printer industry of 45.1%

26. Are their other ways to get market power? Sure… several smaller firms can act in unison in the amount they supply and price they charge.. Even in small towns firms can have market power… (ACE Hardware, Krispy Kreme, or the Dunkin’Donut store in Eastjapip, NJ)

27. Key Point Concentration ratio is a quantitative measure of oligopoly The total percentage share of industry SALES of the four leading firms is the industry concentration ratio. (who has higher % of sales Ford, GM, orChrysler?) (the increased foreign trade has minimized the impact of the HHI ratio.) Obviously, the total aggregate sales are compiled. Then the sales for each firm is calculated. Come up with 35% of market share… Then continue on HHI calculation.

28. Herfindahl-Hirschman Index HHI This is the sum of the square of the market shares of each firm in the industry. Example.. Monopolist – one company controls entireindustry = 100% market share. HHI would be 100 (squared) 100x100 = 10,000 (All monopolies have 10,000 HHI) If firm A has 25% and firms B,C,D also have 25 % Take 25 x 25= 625 Add them up (625+625+625+625 =2,500 or the total number of squares for industry power is 2,500 Each firm has 625 squares.

29. HHI again The Herfindahl-Hirshman Index of market equals the sum of the squares of the market shares of each firm in an industry.

30. Market Power

31. Market Power Albertson’s Kroger

32. Oligopoly (cont'd) The more U.S. firms face competition from the rest of the world, the less any current oligopoly will be able to exercise market power.

33. So, where does government enter in this equation? • The Anti-trust division of the Justice Departmentand the applicable IRC has to decide if a gain of X% of the market share is destroying competition or not when a merger is suggested. HP/Compaq (will this destroy the competitive edge for Dell?) 2. In 1992 the Justice Dept decided to use other parameters in determining anti-trust and destructive competition---- barrier to entry. If low, then highly concentrated industry might be compelled to behave more competitively. (hence, contestability and structure were now added to the merger equation.)

34. Oligopoly Behavior • Firm A could lower its price and undercut its rivals. • At the lower price, sales would increase and firm A would increase its market share. • However, others in the oligopoly would immediately notice this ploy. Since they do not want to lose market share to firm A, they would retaliate by lowering their prices also.

35. What is the objective here?

37. Then what happens??? • Retaliation • Oligopolists respond to aggressive marketing by competitors. • Step up marketing efforts. • Cut prices on their product(s). Rather than cut prices which causes a general “off the cliff for all concept.” (hence kinked demand curve) Oligopolists will engage in “non-price competition.” Hint: their products are differentiated for the most part.- American Airlines- more leg room… LOL! 

38. 1000 1000 PRICE (per computer) PRICE (per computer) 0 0 QUANTITY DEMANDED (computers per month) QUANTITY DEMANDED (computers per month) The Kinked Demand Curve Confronting an Oligopolist Demand curve facing oligopolist if rivals match price changes M B $1100 A D 900 C Demand curve facing oligopolist if rivals match price cuts but not price hikes Demand curve facing oligopolist if rivals don't match price changes 8000

39. How does Gateway respond if Dell cuts prices? Rivals’ Response to Price Reductions • The degree to which sales increase when the price is reduced depends on the response of rival oligopolists. • We expect oligopolists to match any price reductions by rival oligopolists. Rivals’ Response to Price Increases • Rival oligopolists may not match price increases in order to gain market share.

40. The Kinked Demand Curve Confronting an Oligopolist • The shape of the demand curve facing an oligopolist depends on the responses of its rivals to a change in the price of its own output. • The demand curve will be kinked if rival oligopolists match price reductions but not price increases.

41. Game Theory • A mathematical technique used to analyze the behavior of decision makers who try to reach an optimal position for themselves through game playing or the use of strategic behavior, are fully aware of the interactive nature of the process at hand, and anticipate the moves of other decision makers.

42. Game Theory • Each oligopolist has to consider the potential responses of rivals when formulating price or output strategies. • The payoff to an oligopolist’s price cut depends on how its rivals respond. • Game theory is the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs.

43. Moves in the economy Pepsi meets to decide how to gain market share If they reduce Pepsi in Plano, and have increased promotion, what will Coke respond with? Are they looking over their shoulder? Will any of that strategy be applied throughout the U.S. or is it effective only regionally. Dr. Pepper… what would strategy be in NE?

44. Price and Output – Cartel Theory • To maximize industry profit, the firms in anoligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.===Illegal in U.S. – OPEC is example of how this works (Cartel) • Drug Cartel in Mexico .

45. Allocation of Market Shares • One way to distribute output is a cartel agreement. • A cartel is a group of firms with an explicit agreement to fix prices and output shares in a particular market. Cartels are illegal in the United States… OPEC (Organization of Petroleum Exporting Countries) is the most famous now.(11 countries) http://www.opec.org/

46. Let’s Look at Cartels Each producer is assigned a % they may produce in the market. These are explicit production-sharing agreements. (most cheat due to high oil prices in market) Saudi Arabia has increasingly violated the % they were assigned by OPEC several times to: increase their market share and to help out the U.S. They may be less willing to do this in the future (continued war/Iraq)(new terrorism problems) (other countries join to ostracize any Arab nation that cooperates with U.S.) (supply/demand) (U.S. reduces dependency on oil… OPEC won’t want to stray too far.

47. The Benefits of Cheating on the Cartel Agreement I • The situation for a representative firm of a cartel: in long-run competitive equilibrium, it produces q1 and charges P1, earning zero economic profits. • As a consequence of the cartel agreement, it reduces output to qC and charges PC. • Its profits are the area CPCAB. • If it cheats on the cartel agreement and others do not, the firm will increase output to qCC and reap profits of FPCDE.

48. PRICE FIXING IS ILLEGAL • The examples are plentiful.The Ivy League schools in 2001 were caught by Justice Dept for fixing prices in biding for students who qualified for financial aid… which they had been doing for over 30 years.

49. Electric Generators - In 1961, General Electric and Westinghouse were convicted of fixing prices on electrical generators. They were charged again in 1972 for continued price fixing. School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states. Price Fixing Examples

50. So, you think they don’t fix prices? • Gasoline – Mobil, Chevron and Shell paid $77 million in 1993 to settle charges that they conspired to fix gasoline prices. • Music CDs – In 2001, the FTC charged AOL-Time Warner and Universal Music with fixing prices on the “Three Tenors” CD. • The airline industry is being investigated as of 3/8/06 to see if they fixed prices on jet fuel purchases.