Degrees of Power

1. Ch 10 - Oligopoly Degrees of Power • We classify firms into specific market structures based on the number and relative size of firms in an industry. • Market structure – The number and relative size of firms in an industry.

2. Degrees of Power • In imperfect competition, individual firms have some power in a particular product market. • Oligopolyis a market in which a few firms produce all or most of the market supply of a particular good or service.

3. Characteristics of Market Structures

4. Characteristics of Market Structures

5. Determinants of Market Power • Market power increases: • The fewer the number of firms in the market. • The larger the relative size of the firms in the market. • The higher the entry barriers. • The fewer the substitutes.

6. Measuring Market Power • The standard measure of market power is the concentration ratio. • The concentration ratio is a measure of market power that relates the size of firms to the size of the market. • Theconcentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).

7. Initial Market Shares of Microcomputer Producers

8. The Battle for Market Shares • In an oligopoly, increased sales on the part of one firm will be noticed immediately by the other firms. • Increases in the market share of one oligopolist necessarily reduce the shares of the remaining oligopolists.

9. Increased Sales at Reduced Prices • Lowering price may expand total market sales and increase the sales of an individual firm without affecting the sales of its competitors. • There simply isn’t any way that a firm can do so without causing alarms to go off in the industry.

10. Retaliation • One way oligopolists market their products is through product differentiation. • Product differentiation – Features that make one product appear different from competing products in the same market. • An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price. • This is why oligopolists avoid price competition and instead pursue nonprice competition.

11. The Kinked Demand Curve • Close interdependence – and the limitations it imposes on price and output decisions – is a characteristic of oligopoly. • 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. • Rival oligopolists may not match price increases in order to gain market share.

12. The Kinked Demand Curve • The shape of the demand curve facing an oligopolist depends on how its rivals responded 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.

13. 1000 PRICE (per computer) 0 QUANTITY DEMANDED (computers per month) The Kinked Demand Curve 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

14. 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.

15. Game Theory • Each oligopolist is uncertain about its rival’s behavior. • The collective interests of the oligopoly are protected if no one cuts the market price. • But an individual oligopolist could lose if it holds the line on price when rivals reduce price.

16. Oligopoly vs. Competition • Oligopolists may try to coordinate their behavior in a way that maximizes industry profits. • An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit. • To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.

17. Price or Cost (dollars per unit) 0 Quantity (units per period) Maximizing Oligopoly Profits Industry marginal cost Industry average cost Profit- maximizing price Market demand Profits Average cost at profit- maximizing output J Industry marginal revenue Profit-maximizing output

18. Sticky Prices • Prices in oligopoly industries tend to be stable. • Like all producers, oligopolists want to maximize profits by producing where MR = MC.

19. Sticky Prices • The kinked demand curve is really a composite of two separate demand curves. • There is a gap in an oligopolist’s marginal revenue (MR) curve. • As a result, modest shifts of the cost curve will have no impact on the production decision of an oligopolists.

20. S A Price (dollars per computer) F d1 G mr2 mr1 d2 0 H 8000 Quantity Demanded (computers per month) An Oligopolist’s Marginal Revenue Curve The kink in the demand curve The MR gap

21. Marginal revenue MC2 MC1 MC3 Price or Cost (dollars per unit) 0 Quantity (units per period) The Cost Cushion

22. Price Fixing • The most explicit form of coordination among oligopolists is called price fixing. • Price fixing is an explicit agreement among producers regarding the price(s) at which a good is to be sold.

23. Examples of 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. • Baby Formula – Two makers of baby formula agreed to pay $5 million in 1992 to settle Florida charges that they had fixed prices on baby formula.

24. Examples of Price Fixing • Coca Cola – The Coca-Cola Bottling Co. of North Carolina agreed to pay a fine and give consumers discount coupons to settle charges of conspiring to fix soft-drink prices from 1982 to 1985. • Laser Eye Surgery – The FTC charged VISX and Summit Technology with price-fixing that raised the price of surgery by $500 per eye.

25. Other pricing patterns • Price leadership - an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry. • A cartel - a group of firms with an explicit agreement to fix prices and output shares in a particular market. • Predatory pricing - temporary price reductions designed to alter market shares or drive out competition.

26. Other Issues Nonprice Competition • Advertising not only strengthens brand loyalty, but also makes it expensive for new producers to enter the market. Training • Early market entry can create an important barrier to later competition. • Customers of training-intensive products (such as computer hardware and software) become familiar with a particular system.

27. Other Issues Network Economies • The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.

28. The Herfindahl-Hirshman Index • TheHerfindahl-Hirshman index(HHI) is a measure of industry concentration that accounts for number of firms and size of each. • For policy purposes, the Justice Department decided it would draw the line at a value of 1,800.

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

30. The Herfindahl-Hirshman Index Highly concentrated market (HHI>1800)