Assumptions of the1.5.4 Monopolistic Competition and Oligopoly Oligopoly Model Oligopoly: Oligopoly is a market in which a few large firms produce a homogeneous or differentiated productMarket share Each of the few large firms have a significant share of the total marketCompetition There are few enough firms that collusion (cooperation on prices and other strategies) is possible.Product differentiation Products may be differentiated or homogeneous • Oil is a product produced by a few large firms that is homogenous. One firms output is identical to all other firms. • Laptop computers are a product produced by a few large firms that are differentiated. Sonys laptops have features that set them apart from Dell and HPs.Entry barriers There are significant entry barriers into the oligopolistic market. This means that economic profits can be earned in the long-run if the firms successfully produce goods in demand from consumersInterdependence of Firms Firms are mutually interdependent: each must consider its rivals‟ reactions in response to its decisions about prices, output, and advertising.Concentration ratio Used to measure market dominance. • The four-firm concentration ratio gives the percentage of total industry sales accounted for by the four largest firms. • When the largest four firms in an industry control 40% or more of the market, that industry is considered oligopolistic.
Assumptions of the1.5.4 Monopolistic Competition and Oligopoly Oligopoly Model Barriers to entry in Oligopolistic Markets Significant barriers to entry keep the number of firms small and allow oligopolists to earn economic profits in the long-run. • Economies of scale: may exist due to technology and market share.The capital investment requirement may be very large. Example: Airbus and Boeing • Other barriers to entry: Legal barriers could include patents, copyrights, trademarks. Control of raw materials could prevent other firms from entering a market, preemptive and retaliatory pricing might be used to compete new firms out of the market, traditional brand loyalty may make new entry difficult. • Mergers: Already large firms may merge to increase market share and concentrate power. Mergers are common among large monopolistic firms as they give firms more power over output and price.
Kinked Demand1.5.4 Monopolistic Competition and Oligopoly CurveNon-collusive Oligopolies:Assuming that the firms in an oligopolistic market do NOT cooperate with one otheron prices, we can analyze the demand as seen by an individual seller using a modelcalled the Kinked Demand Curve. Individual firm’s demand P Assumptions: • Assume there only two firms (firm M and firm B) are competing in the fast food market. P1 • Each firm knows that if it lowers its price for a hamburger meal, its competitor will match the price decrease so as to not lose its market D1 share. • Each also knows that if it raises its price the competitor will ignore the price increase so as to capture the D2 MR1 consumers who will switch sellers Q1 Q when one raises its price. MR2 With these assumptions, we can assume that the individual firm faces TWO demand curves, one representing demand if it lowers its price (D2, highly inelastic) and one representing demand if it raises its price (D1, highly elastic).
Kinked Demand1.5.4 Monopolistic Competition and Oligopoly CurveKinked Demand CurveWhen we put the two demand curves for the individual firm together, we get a Kinkeddemand curve, highly elastic above the current price and highly inelastic below thecurrent price.P P P1P1 D1 D2 MR1 D Q1 Q Q1 Q MR2 MR
Kinked Demand1.5.4 Monopolistic Competition and Oligopoly Curve Analysis of the Kinked Demand Curve P • In order to lower its price a firm must increase its output, which means higher costs. • Since demand is inelastic beyond Q1, the P1 firms total revenue will fall as it increases output beyond this point while its total costs increase, meaning profits will decrease. • If the firm wishes to raise its price, it must be aware that demand is highly elastic above P1. D • A price increase when demand is elastic leads to a fall in total revenue Q1 Q MR Implications of analysis Price in non-collusive oligopolistic markets tends to be very sticky. Firms tend not to raise or lower their prices, even with fluctuations in their costs of production, out of fear or losing market share to their competitors.
1.5.4 Monopolistic Competition and Oligopoly Game Theory Collusive Oligopoly – a Game Theory Introduction Game theory studies the behavior of firms in an oligopoly from the perspective of a game. Firms are the "players" that can make "moves". Depending on the moves firms make, they may end up being winners or losers. Blog post: Understanding Oligopoly Behavior – a Game Theory Overview Blog post: Golden Balls, Game Theory and the Prisoner‟s Dilemma A simple example of Game Theory: the Prisoners Dilemma Introduction: Two thieves have been caught Rules of the game: The prisoners are by the cops. placed in two separate interrogation rooms • There is not enough evidence to convict and not allowed to communicate with one them of the crime of assault, which the another. Each prisoner is given the prosecutor suspects they committed. following choices: • But the prosecutor has enough evidence to • If you confess to assault and your accomplice convict them of breaking and entering, a does not, you will go free and your stubborn minor one for which the sentence is only 1 accomplice will receive 20 years in jail year. So the prosecutor must try to get them • If you both confess you will both serve three to confess to the more serious crime. years in jail.
1.5.4 Monopolistic Competition and Oligopoly Game Theory The Dilemma • If both prisoners remain silent, the prosecutor can only convict them for the minor offense, in which case theyll each receive one year in jail. • But if one confesses and the other does not, the one who remained silent will get 10 years in jail, and he knows this. This creates a major incentive to confess, as 10 years is a LONG TIME! • Assuming the prisoners are both rational, self-interested individuals, the most likely "move" the "players" will make is to confess, meaning they both end up getting 3 years in jail. The possible outcomes of the game can be plotted in a "payoff matrix" Prisoner 1 remain silent confess • The "players": Prisoner 1 and remain silent -1 0 Prisoner 2 • The "moves": Confess or -1 -10 Remain silent Prisoner 2 • The "payoffs": possible jail terms resulting from various -10 -3 "moves" by playersconfess 0 -3
1.5.4 Monopolistic Competition and Oligopoly Game Theory Playing the Game Assuming both players know all possible outcomes, which "move" will the prisoners make? Prisoner 1 If Prison 1 remains silent, what should remain silent confess Prisoner 2 do? Remain silent, or Confess remain silent -1 0 If Prison 1 confesses, what should Prisoner 2 do? -1 -10 Remain silent, or ConfessPrisoner 2 What is Prisoner 2s „dominant strategy‟? -10 -3 Remain silent, or Confess confess 0 -3 What is Prisoner 1s „dominant strategy‟? Remain silent, or Confess Dominant Strategies: If a player has a move that will always result in a better payoff than any other move regardless of his opponents move, then that is known as a dominant strategy. In this game, the dominant strategy is always to confess. Both prisoners will get 3 years in jail
1.5.4 Monopolistic Competition and Oligopoly Game Theory Why will the players in the Prisoners Dilemma always confess? • If one move minimizes losses or maximizes winnings regardless of what the other player does, this is a "dominant strategy" • The players will examine the possible moves by his opponent, and ask "what move will make me better off based on my opponents move?" • In the Prisoners Dilemma game, both players have a dominant strategy: CONFESS. Because if either player remains silent, they can always do better by confessing regardless of what the other player does. • The incentive to confess is too strong. Since the prisoners cannot communicate with one another, they cannot agree to remain silent, which would result in a better outcome for both prisoners.
1.5.4 Monopolistic Competition and Oligopoly Game Theory Oligopoly behavior is similar to a game Each firm in an oligopolistic market is interdependent with the other firms in its market. Depending on what one firm does, it will have a major impact on the profits or losses of itself and all other firms in the market. Firms play “games” in which they have to decide on factors such as • Whether to charge a high price or low price • Whether to advertise or not • Whether to offer free warranties or customer service • Whether to open a shop in a certain location Coffee shop AConsider the decision of two coffee dont advertise advertiseshops whether to advertise or not dont advertise $15 $20The "players" are the firms: Two coffee Coffee shop Bshops, Starbucks and San Francisco Coffee. $15 $10The "moves" are the actions the firms cantake: The coffee shops can either advertisearound town or not advertise. advertise $10 $12The "payoffs" are the profits the firms willearn: Advertising increases firms costs, but $20 $12can also increase revenues.
1.5.4 Monopolistic Competition and Oligopoly Game Theory Coffee shop A Analyzing the Payoff Matrix The two coffee shops in this example dont advertise advertise have to decide whether to advertise dont advertise or not $15 $20 • If neither firm advertises, they will Coffee shop B enjoy high profits of $15 $15 $10 • If one advertises and the other doesn‟t, the one that advertised advertise will earn $20 and the one that $10 $12 doesn‟t only $10. • If both advertise they‟ll both earn $20 $12 only $12 What will be the equilibrium outcome of this game? If the firms are able to collude, it is obvious what they will do. Neither will advertise. But this is an unstable equilibrium, meaning that both firms have a strong incentive to cheat since there are big profits to be earned by unilaterally advertising. • Under collusion, both firms enjoy higher profits. • But if each firm acts in its own self-interest, both firms will earn smaller profits.
1.5.4 Monopolistic Competition and Oligopoly Game Theory Alternative ways to analyze Oligopoly behavior Price Leadership: When there exists an implicit understanding by which oligopolists can coordinate prices • Usually a "dominant firm" (typically the largest in the industry) establish the price and smaller firms follow. • Prices tend to be "sticky" upwards, since firms are hesitant to raise their prices and lose market share to rivals. • However, prices are "slippery" downwards, which means if one firm lowers its prices, others will follow suit so they dont lose all their business. Price Wars: When agreements break down, firms may engage in price wars, in which they continually lower their prices and increase output in order to try and attract more customers than their rivals. • This can cause sudden increases in output and decreases in price, temporarily approaching an efficient level. • Once firms realize low prices hurt everyone, price leadership is usually restored, and prices rise once more.
Oligopoly Practice1.5.4 Monopolistic Competition and Oligopoly Question Two Pizzerias, Luigis and Marios, provide all the pizza in the village of Wangi. They must order their menus from the printing company at the beginning of the year and cannot alter the prices on their menus during that year. The prices on the menus are revealed to the public and to the competition only after both companies have received the printed menus from the printer and put them up in the window. Each pizzeria must choose between a high price and a low price for its "supremo-premium pie", the deluxe pizza that the people of Wangi are most eagerly anticipating. The payoff matrix showing the profits that the two firms will experience appears below, with the first entry in each cell indicating Luigis weekly profit and the second entry in each cell indicating Marios weekly profit.1. In which market structure do these firms operate? Marios Pizzeria Explain. high price low price2. If Marios choses a low price, which price is better high price for Luigis $1,000/$700 $700/$600 Luigis Pizzeria3. Identify the dominant strategy for Marios4. Is choosing a low price a dominant strategy for low price Luigis? Explain. $750/$950 $900/$8005. If both firms know all the information in the payoff matrix but do not cooperate, what will be Marios daily profit?