Business Economics
Managerial Decisions for Firms
with Market Power
Oligopoly
Thomas & Maurice, Chapter 13
Herbert Stocker
[email protected]
Institute of International Studies
University of Ramkhamhaeng
&
Department of Economics
University of Innsbruck
Oligopoly
Imperfect Competition
Imperfect competition refers to those market
structures that fall between perfect competition
and pure monopoly.
Imperfect competition includes industries in which
firms have competitors but do not face so much
competition that they are price takers.
Oligopoly: Only a few sellers, each offering a similar
or identical product to the others.
Monopolistic Competition: Many firms selling
products that are similar but not identical.
Oligopoly
Economics in Action:
Characteristics of an Oligopoly Market:
Few sellers offering similar or identical products.
Interdependent firms.
Best off cooperating and acting like a monopolist
by producing a small quantity of output and
charging a price above marginal cost.
Share of US industry sales accounted for by the top four firms.
Source: Krugman & Wells
Oligopoly: Example
The
Q
0
1
2
3
4
5
6
7
8
9
table shows a demand-schedule:
P R π
Assume MC = AC = 1
9 0 0
What would on a perfectly
8 8 7
competitive market happen?
7 14 12
6 18 15
Wich quantity would a
5 20 16
monopolist produce?
4 20 15
Now assume, there are two
3 18 12
suppliers (duopoly). Which
2 14 7
quantity should each of
1 8 0
them produce?
0 0 -9
Oligopoly
The duopolists may agree on a monopoly outcome:
Collusion: Sellers engage in collusion when they
cooperate to raise each others’ profits.
Cartel: A cartel is the strongest form of collusion,
an agreement by several producers that increases
their combined profits by telling each one how
much to produce.
They may also engage in non-cooperative
behavior, ignoring the effects of their actions on
each others’ profits.
Oligopoly: Example
In a perfectly competitive market the price would
be driven to where economic profit is zero:
P = MC = 1
Q = 8
The price and quantity in a monopoly market
would be where total profit is maximized:
P = 5
Q = 4
What happens in a duopoly?
Oligopoly
By acting as if they were a single monopolist,
oligopolists can maximize their combined profits.
So there is an incentive to form a cartel.
However, antitrust laws prohibit explicit
agreements among oligopolists as a matter of
public policy.
Additionally, each firm has an incentive to cheat,
to produce more than it is supposed to under the
cartel agreement.
There are two principal outcomes: successful
collusion or behaving non-cooperatively by
cheating.
Oligopoly
Oligopoly
Competing in Quantities
vs. Competing in Prices:
(non-cooperative solution)
The basic insight of the quantity competition
(or the Cournot model) is that when firms are
restricted in how much they can produce, it is
easier for them to avoid excessive competition and
to “divvy up” the market, thereby pricing above
marginal cost and earning profits.
It is easier for them to achieve an outcome that
looks like collusion without a formal agreement.
Competing in Quantities vs.
Competing in Prices:
(non-cooperative solution)
The logic behind the price competition (or the
Bertrand model) is that when firms produce
perfect substitutes and have sufficient capacity to
satisfy demand when price is equal to marginal
cost, then each firm will be compelled to engage
in competition by undercutting its rival’s price
until the price reaches marginal cost – that is,
perfect competition.
Game Theory
Game Theory
Game theory is the study of how people behave
in strategic situations.
Strategic decisions are those in which each
person, in deciding what actions to take, must
consider how others might respond to that action.
Because the number of firms in an oligopolistic
market is small, each firm must act strategically.
Each firm knows that its profit depends not only
on how much it produced but also on how much
the other firms produce.
Occur when managers must make individual decisions
without knowing their rivals’ decisions
The Prisoner’s Dilemma
Assume . . .
Each of two prisoners, held in separate cells, is
offered a deal by the police . . .
It is in the joint interest of both prisoners not to
confess;
but it is in each one’s individual interest to
confess!
In what follows we assume that the payoff matrix is
known to all players (common knowledge).
The Prisoner’ Dilemma:
The prisoners’ dilemma provides insight into the
difficulty in maintaining cooperation.
Often people (firms) fail to cooperate with one
another even when cooperation would make them
better off.
The reward received by a player in a game (e.g.
the profit earned by an oligopolist) is that player’s
payoff.
A payoff matrix shows how the payoff to each of
the participants in a two player game depends on
the actions of both. Such a matrix helps us
analyze interdependence.
The Prisoner’s Dilemma
Decision of Bill
Don’t Confess
Confess
Decision
of Jane
Simultaneous Decisions:
Game Theory
Confess Don’t Conf.
Game Theory
2 years
2 years
1 year
12 years
12 years
1 year
6 years
6 years
The Prisoner’s Dilemma
The Prisoner’s Dilemma
Economists use game theory to study firms’
behavior when there is interdependence between
their payoffs.
The game can be represented with a payoff
matrix.
When each person or firm has an incentive to
cheat, but both are worse off if both cheat, the
situation is known as a prisoners’ dilemma.
In a prisoners’ dilemma each player has an incentive to
choose an action that benefits itself at the other
player’s expense.
When both players act in this way, both are worse off
than if they had chosen different actions.
Decision of the
Soviet Union (USSR)
Disarm
Arm
USA safe &
powerful
Depending on the payoffs, a player may or may
not have a dominant strategy.
An Advertising Game
Decision of the United States (U.S.)
Arm
Disarm
USA
USA
risk
at risk USSR &atweak
USSR
safe
&
at risk
powerful
USSR
at risk
& weak
it’s illegal on contracts are not enforceable.
cooperation is not in the best interest of the individual
player.
USSR
safe
USA
safe
Camel’s Decision
Don’t Adv. Advertise
An Arms-Race Game
An action is a dominant strategy when it is a
player’s best action regardless of the action taken
by the other player.
The Prisoner’s Dilemma has a dominant strategy,
which results in the worst possible outcome.
Cooperation is difficult to maintain, because
Marlboro’s Decision
Advertise
Don’t Adv.
Marlboro
Marlboro
$3 billion
$2 billion
Camel
Camel
profit
profit
$3 billion
$5 billion
profit
profit
Marlboro
Marlboro
$5 billion
$4 billion
Camel
profit
Camel profit
$4
billion
$2 billion
profit
profit
Making Mutually Best Decisions
For all firms in an oligopoly to be predicting
correctly each others’ decisions:
All firms must be choosing individually best actions
given the predicted actions of their rivals, which they
can then believe are correctly predicted
Strategically astute managers look for mutually best
decisions
Nash equilibrium
Nash equilibrium: Set of actions or decisions for
which all managers are choosing their best actions
given the actions they expect their rivals to
choose.
Strategic stability: No single firm can
unilaterally make a different decision & do better.
When a unique Nash equilibrium set of decisions
exists rivals can be expected to make the decisions
leading to the Nash equilibrium.
With multiple Nash equilibria, no way to predict
the likely outcome.
Nash equilibrium
Players who don’t take their interdependence into
account arrive at a Nash, or non-cooperative,
equilibrium.
A Nash equilibrium is the result when each
player in a game chooses the action that
maximizes his or her payoff given the actions of
other players, ignoring the effects of his or her
action on the payoffs received by those other
players.
But if a game is played repeatedly, players may
engage in strategic behavior, sacrificing short-run
profit to influence future behavior.
Sequential Decisions
One firm makes its decision first, then a rival firm,
knowing the action of the first firm, makes its
decision.
The best decision a manager makes today
depends on how rivals respond tomorrow.
Sequential Decisions
First-mover advantage: If letting rivals know
what you are doing by going first in a sequential
decision increases your payoff.
Second-mover advantage: If reacting to a
decision already made by a rival increases your
payoff.
Repeated Strategic Decisions
Cooperation occurs when oligopoly firms make
individual decisions that make every firm better
off than they would be in a (noncooperative)
Nash equilibrium.
With repeated decisions, cheaters can be
punished!
When credible threats of punishment in later
rounds of decision making exist.
Strategic Moves
Strategic Moves: Actions used to put rivals at a
disadvantage
Three types
Commitments
Threats
Promises
Only credible strategic moves matter!
Trigger Strategies
A rival’s cheating “triggers” punishment phase.
Two examples . . .
Grim strategy: Punishment continues forever,
even if cheaters return to cooperation.
Tit-for-tat strategy: Punishes after an episode
of cheating & returns to cooperation if cheating
ends
Tit for Tat
How can a co-operative strategy get an initial
foothold in an environment which is
predominantly non-co-operative?
What type of strategy can thrive in a varied
environment composed of other individuals using
a wide diversity of more or less sophisticated
strategies?
Under what conditions can such a strategy, once
fully established, resist invasion by mutant
strategies (such as cheating)?
Tit for Tat
Tit for Tat: Rules
Never be the first to defect.
Retaliate only after your partner has defected.
Be prepared to forgive after carrying out just one
act of retaliation.
Adopt this strategy only if the probability of
meeting the same player again exceeds 2/3.
Tit for Tat
Robert Axelrod: conducted a computer
tournament where people were invited to submit
strategies (in form of computer programs) for
playing 200 games of prisoner’s dilemma.
The simplest of all strategies submitted by Anatol
Rapoport attained the highest average score: TIT
FOR TAT, a strategy of co-operation based on
reciprocity.
A strategy of ‘tit for tat’ involves playing
cooperatively at first, then following the other
player’s move. This rewards good behavior and
punishes bad behavior.
Tacit collusion
Tacit collusion: coordinated behavior that is an
achieved without a formal agreement.
Tacit collusion practices:
Uniform prices
Penalty for price discounts
Advantage notice of price changes
Information exchanges, . . .
Once an oligopolistic industry has achieved tacit
collusion, individual producers have an incentive
to behave carefully – they don’t want to do
anything to disrupt the collusion. This could
produce a kinked demand curve.
The Kinked Demand Curve
The Kinked Demand Curve
If an oligopolist considers raising the prices its
quantity demanded will depend upon the behavior
of rival firms.
The Kinked Demand Curve is based on the
assumption that other firms will not match price
increases but will match price decreases.
Implies oligopoly prices tend to be ‘sticky’ and not
change as they would in other market structures.
Does not explain why price P ∗ exists initially.
Facilitating Practices
Legal tactics designed to make cooperation more
likely:
Four tactics:
1
2
3
4
Price matching
Sale-price guarantees
Public pricing
Price leadership
The Kinked Demand
Curve illustrates how tacit
collusion can make an
oligopolist unresponsive
to changes in marginal
cost within a certain
range when those changes
are unique to her.
Price Matching
Firm publicly announces that it will match any
lower prices by rivals (usually in advertisements).
Discourages noncooperative price-cutting, because
it eliminates benefit to other firms from cutting
prices.
Sale-Price Guarantees
Firm promises customers who buy an item today
that they are entitled to receive any sale price the
firm might offer in some stipulated future period.
Primary purpose is to make it costly for firms to
cut prices!
Price Leadership
Price leader sets its price at a level it believes will
maximize total industry profit.
Rest of firms cooperate by setting same price.
Does not require explicit agreement,
Public Pricing
Public prices facilitate quick detection of
noncooperative price cuts.
Early detection reduces present value of benefits
of cheating, increases present value of costs of
cheating, and therefore reduces likelihood of
noncooperative price cuts.
Oligopoly
Strategic Entry Deterrence: Policies that prevent
rivals from entering the market
Limit pricing: Established firms can thwart entry
by charging the limit price (or a lower price)
rather than profit- maximization price (assumes
existing firms have lower costs).
Predatory pricing: lowering prices below cost to
drive out existing competitors and scare off
potential entrants.
Success depends on how far the predatory price is
below cost, time period, how many rivals enter the
industry after predation ends, . . .
Oligopoly in Practice
Oligopoly in Practice
The Legal Framework
Oligopolies operate under legal restrictions in the
form of antitrust policy. But many succeed in
achieving tacit collusion.
Tacit collusion is limited by a number of factors,
including
large numbers of firms,
complex pricing, and
conflicts of interest among firms.
Any questions?
Thanks!
When collusion breaks down, there is a price war.
To limit competition, oligopolists often engage in
product differentiation.
When products are differentiated, it is sometimes
possible for an industry to achieve tacit collusion
through price leadership.
Oligopolists often avoid competing directly on
price, engaging in non-price competition through
advertising and other means instead.