micro economics chapter 14 1

14
Oligopoly and Strategic Behavior

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.


Oligopoly

• A few large producers
• Homogeneous or differentiated products
• Limited control over price
• Mutual interdependence
• Strategic behavior
• Entry barriers
• Mergers
LO3


Oligopolistic Industries

• Four-firm concentration ratio
• 40% or more to be oligopoly
• Shortcomings
• Localized markets
• Inter-industry competition
• World price
• Dominant firms – Herfindahl Index
LO3

High Concentration Industries
(3)
(1)

(3)

Herfindahl

(1)

4-Firm Concentration Ratio

Index

Industry

Household laundry equipment

100

ND

Household refrigerators and freezers

93

ND

Cigarettes

88

Beer

Industry

(2)

(2)

Herfindahl

4-Firm Concentration Ratio

Index

Primary aluminum

74

2089

Tires

73

1531

2897

Bottled water

71

1564

88

3561

Gasoline pumps

70

1611

Glass containers

86

ND

Bar soaps

70

2250

Phosphate fertilizers

85

3152

Burial caskets

69

1699

Small-arms ammunition

84

2848

Printer toner cartridges

67

1449

Electric light bulbs

84

3395

Alcohol distilleries

65

1394

Aircraf

80

3287

Turbines and generators

61

1263

Breakfast cereals

79

2333

Motor vehicles

60

1178

Aerosol cans

75

1667

Primary copper

50

879

LO1


Oligopoly Behavior

• Game theory
• Profit matrix
– Shows the profits for each firm based on the firm’s actions and his rivals
actions.

• Collusion
– Incentive to cheat
– Prisoner’s dilemma

LO3


Game Theory

RareAir’s price strategy
High

Low

A

B

Uptown’s price strategy

$12

$15

High
$12

C

$6

$6

D
$8

Low
$15

LO1

$8


3 Oligopoly Models

• Kinked Demand Curve
• Collusive Pricing
• Price Leadership
• Reasons for 3 models
• Diversity of oligopolies
• Complications of interdependence

LO5


Kinked Demand Curve

• Criticisms
• Explains inflexibility, not price
• Prices are not that rigid
• Price wars

LO6


Overt Collusion

• Collusion reduces uncertainty, improves control of price, profits

rise, and prevents entry of firms

• Cartels - a group of firms or nations that collude
• Formally written agreement
• Sets output levels and price for members
• OPEC

LO6


Covert Collusion

• Gentleman’s agreements
• Informal understandings often in social settings between firms
about price and output

LO6


Obstacles to Collusion

• Demand and cost differences
• Number of firms
• Cheating
• Recession
• New entrants
• Legal obstacles
• Golden Balls
LO6

Global Perspective

LO6


Price Leadership Model

• Price Leadership
• Dominant firm initiates price changes
• Communicates price change
• Other firms follow the leader
• Use limit pricing to block entry of new firms
• Possible price war

LO6


Positive Effects of Advertising

• Low cost way of providing information to customers
• Enhances competition
• Speeds up technological progress
• Helps firms attain economies of scale

LO7


Negative Effects of Advertising

• Can be manipulative
• Contains misleading claims that confuse consumers
• Consumers may pay high prices for a good while forgoing a
better, lower priced, unadvertised good

LO7


Oligopoly and Efficiency

• Oligopolies are inefficient
• Productively inefficient P > minATC
• Allocatively inefficient P > MC
• Qualifications
• Increased foreign competition
• Limit pricing
• Technological advance
LO7


One-Time Game: Strategy

• One-time game
• Simultaneous game
• Positive sum game

LO7


One-Time Game: Strategy

• One-time game
• Simultaneous game
• Positive sum game

LO7


One-Time Game

Dramco’s price strategy

International

A

B
$5

$11

C

$5

LO7

National

$11

National

Chipco’s price strategy

International

$20

$20

D
$17

$17


A One-Time Game: Equilibrium

• Nash Equilibrium
•

•
•

LO7

Outcome from which neither firm wants to deviate
Current strategy viewed as optimal
Stable and persistent outcome

Credible and Empty Threats

• Credible threats
•
•
•
•
•

Threat is believable
Can be used for collusion
A strong enforcer can prevent cheating
Can generate higher profits
May be countered by rival firm

• Empty threats
•
LO7

Threat is not believable


Repeated Games

• Game recurs
• May cooperate and choose not to compete strongly
• Rival reciprocates

LO7


Repeated Game with Reciprocity

LO7

ThirstQ’s advertising strategy

Promo budget

Normal budget

Promo budget

Normal budget

A

B

A

B

$10

C

$8

$16

$16

D
$12

$12

$11

Promo budget

$8

Normal budget

$10

2Cool’s advertising strategy

Promo budget
Normal budget

2Cool’s advertising strategy

ThirstQ’s advertising strategy

$10

$11

C

$10

$14

$15

D
$13

$13


Sequential Game

• Firms move sequentially
• Final outcome is dependent on who moves first
• First Mover Advantage
•
•
•

LO7

Advantages for the firm that is first
May be better prepared

May preempt entry of rival


First-Mover Advantages

Big Box strategies

Don’t build

Build

A

B

Build

C

$0

LO7

$0

-$5

Don’t build

Huge Box strategies

-$5

$12

$12

D
$0

$0