McConnell 22nd edition

1. CHAPTER 14
Oligopoly and Strategic Behavior

2. • Oligopoly
• Oligopoly Behavior: A Game-Theory Overview
• Three Oligopoly Models
• Oligopoly and Advertising
• Oligopoly and Efficiency
• Game Theory and Strategic Behavior
14-2
Chapter Contents

3. Oligopoly
• Oligopoly
• A few large producers
• Homogeneous oligopoly: Identical products
• Differentiated oligopoly: Differentiated products
• Entry barriers
• Many oligopoly are results from mergers
LO14.1 14-3

4. Oligopolistic Industries
• Four-firm concentration ratio (national market)
• 40% or more to be an oligopoly
• Shortcomings
• Localized markets
• Interindustry competition
• Import competition
LO14.1 14-4

5. Percentage of Output Produced by Firms in Selected High-
Concentration U.S. Manufacturing Industries
LO14.1
(1)
Industry
(2)
Percentage of
Industry Output
Produced by the
Four Largest Firms
(3)
Herfindahl
Index for the Top 50
Firms
(1)
Industry
(2)
Percentage of
Industry Output
Produced by the
Four Largest Firms
(3)
Herfindahl
Index for the
Top 50 Firms
Household laundry equipment 100 ND︎ Primary aluminum 74 2,089
Household refrigerators and freezers 93 ND︎ Tires 73 1,531
Cigarettes 88 2,897 Bottled water 71 1,564
Beer 88 3,561 Gasoline pumps 70 1,611
Glass containers 86 ND Bar soaps 70 2,250
Phosphate fertilizers 85 3,152 Burial caskets 69 1,699
Small-arms ammunition 84 2,848 Printer toner cartridges 67 1,449
Electric light bulbs 84 3,395 Alcohol distilleries 65 1,394
Aircraft 80 3,287 Turbines and generators 61 1,263
Breakfast cereals 79 2,333 Motor vehicles 60 1,178
Aerosol cans 75 1,667 Primary copper 50 879
14-5

6. Mutual interdependence
• Oligopolist has a limited control over price
• Its output can affect market output or it can set own price.
• Its action affects rival firms in market
• Lower market price
• Draw significant numbers of customers from rivals
• Rival firms respond to one’s action
• Rival’s action will affect the oligopolist in return
14-6

7. Oligopoly Behavior
• Oligopolies display strategic behavior
• Mutual interdependence
• Collusion
• Incentive to cheat
• Many different models are used to analyze various strategic
behaviors
• Game theory and Prisoner’s dilemma
• Kinked-demand
• Collusive pricing
• Price leadership 14-7

8. Game Theory
• Game Theory: is the tool used to analyze strategic
behavior—behavior that recognizes mutual
interdependence and takes account of the expected
behavior of others.
• Settings
• Objectives: Profit maximization
• Strategy: All possible choices of actions
• Pay-offs: Result of own choice and rival’s choice
14-8

9. Payoff Matrix
RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
• 2 competitors (RareAir & Uptown)
• 2 price strategies (High & Low)
• Each strategy has a payoff matrix
(Profits as pay-off for given choices).
• Objective: Profit maximization
LO14.2 14-9

10. Strategy Choice and Payoff
• Given strategy choices, payoffs for two
firms are shown in each square (A, B, C,
D) in which right-upper triangle
(shaded grey) indicates RareAir’s profit
and left-lower triangle (shaded yellow)
indicates Uptown’s profit.
• When RareAir chooses High price and
Uptown chooses Low price, then their
payoffs are shown in “C” square, where
RareAir earns $6 and Uptown earns
$15.
RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
LO14.2 14-10

11. Cooperative Equilibrium
• Cooperative strategy: When both choose “High Price”
strategy, the industry (two firms together) make maximum
profits.
• Cooperative equilibrium (Cartel solution): the industry
achieves the monopolist’s profit
• Incentive to cheat: A player gains if it cheats the cooperative
strategy.
14-11

12. Cooperative Equilibrium in Payoff Matrix
• Cooperative equilibrium: If RareAir
chooses High price and Uptown chooses
High price, then each of them earns $12,
that is, $24 in total in industry, which is
the maximum in industry.
• Incentive to cheat: If Uptown changes to
Low price, while RareAir keeps High price,
Uptown will increase its payoff from $12
to $15. However, this action will lower
RareAir’s payoff from $12 to $6.
• RareAir also has an incentive to cheat,
changing to Low price strategy to increase
own profits at the expense of lower profits
of Uptown.
RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
LO14.2 14-12

13. RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
Low
• If both firms cheat and
select Low price to
increase own profits, then
then end up to “D” where
each firm earn $8 each,
which is worse than the
original cooperative
equilibrium.
LO14.2 14-13
High Low
Cheating and Payoff

14. Nash Equilibrium
• Dominant strategy: the strategy that a player choose
regardless of rival’s actions
• For profit-maximizing player, it should choose “Low Price”
regardless of opponent’s action
• It is the optimal strategy based on rival’s reaction
• Nash equilibrium: Outcome from which neither firm wants
to deviate.
• The resulting pay-off may not be the best for the industry nor
each oligopolist.
14-14

15. Dominant Strategy in Payoff Matrix
• For RareAir, if Uptown chooses High price,
RareAir may choose High price to earn
$12 or choose Low price to earn $15. So,
if Uptown chooses High price, RareAir
should choose Low price.
• If Uptown chooses Low price, RareAir
may choose High price to earn $6 or
choose Low price to earn $8. So, if
Uptown chooses Low price, RareAir
should choose Low price.
• Dominant strategy: Regardless of choice
of Uptown (High or Low), RareAir should
always choose Low price.
RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
LO14.2 14-15

16. Nash Equilibrium in Payoff matrix
• Dominant strategy for RareAir is Low price.
• Dominant strategy for Uptown is Low price.
• Nash equilibrium: If both pursues own
dominant strategy, their payoff is D.
• If RareAir changes to High price, its profit
will decrease from $8 to $6. If Uptown
changes to High price, its profit will
decrease from $8 to $6. Thus, neither firm
will unilaterally change own strategy.
RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
LO14.2 14-16

17. Prisoner’s Dilemma
• Prisoners’ dilemma shows why it is hard to cooperate,
even when it would be beneficial to both players to do
so.
• Both benefit when cooperate
• But, each has an incentive to cheat
• When both cheat, both end up less favorable results.
14-17

18. RareAir’s price strategy
Uptown’spricestrategy
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
Low
•Independently
lowered prices in
expectation of
greater profit leads
to worst combined
outcome.
•Eventually low
outcomes make
firms return to
higher prices.
LO14.2 14-18
High Low
Prisoner’s Dilemma in Payoff Matrix

19. Three Oligopoly Models
• Kinked-demand curve
• Collusive pricing
• Price leadership
• Reasons for three models:
• Diversity of oligopolies
• Complications of interdependence
LO14.3 14-19

20. Kinked-Demand Theory
• Non-collusive (non-cooperative) oligopoly
• Uncertainty about rivals’ reactions:
• Rivals match any price change.
• Rivals ignore any price change.
• Assume combined strategy:
• Match price reductions.
• Ignore price increases.
LO14.3 14-20

21. f f
Kinked-Demand Curve
P0
MR2
D2
D1
MR1
e
g
Rivals ignore
price increase
Rivals match
price decrease
Q0
MC1
MC2
LO14.3 14-21
Quantity
(a)
Price
0
P0
D1
MR1
e
g
Q0
Quantity
(b)
Priceandcosts
0
D2
MR2
The Kinked-Demand Curve

22. How Well Kinked-Demand Model Explains Reality
• Kinked-demand model describes
• Explains why price is inflexible
• However, it cannot explain why
• Prices are not that rigid
• Price war
LO14.3 14-22

23. Overt Collusion
• A cartel is a group of firms or nations that collude:
• Formally agreeing to the price.
• Sets output levels for members.
• Act like monopolist.
• Collusion is illegal in the United States.
• Example: OPEC
LO14.3 14-23

24. Collusion and the Tendency toward Joint-Profit Maximization
• Participating firms in collusion agree to
produce assigned quantities, so that
total quantity produced by group will
be the monopolist output quantity Q0,
which maximizes the group’s total
profits.
• Each firm may be assigned different
quantity, depending on the size or
power of each firm in the industry, so
each firm may earn different profits.
• Each participating firm has an
incentive to cheat the agreement and
produce more than its assignment and
earn more profits.
D
MR = MC
ATC
MC
MR
P0
A0
Q0
Economic
profit
LO14.3 14-24
Quantity
Priceandcosts 0

25. Global Perspective 14.1: OPEC Nations
14-25
LO14.3

26. Obstacles to Collusion
• Demand and cost differences
• Number of firms
• Cheating
• Recession
• New entrants
• Legal obstacles
LO14.3 14-26

27. Credible and Empty Threats
• Credible threats:
• Threat that is believable by the other firm.
• Can establish collusive agreements.
• A strong enforcer can prevent cheating.
• Can generate higher profits.
• May be countered with threat by rival.
• Empty threats:
• A threat that is not believable by rival.
LO14.6 14-27

28. Price Leadership Model
• Price leadership
• Dominant firm initiates price changes.
• Other firms follow the leader.
• Use limit pricing to block entry of new firms.
• Possible price war.
LO14.3 14-28

29. Differentiated Oligopoly
• Oligopolies commonly compete through product
differentiation by
• Development
• Advertising
• Instead of competing in price, they compete through
brand loyalty of customers
• Less easily duplicated than a price change
• Financially able to advertise
LO14.4 14-29

30. Positive Effects of Advertising
• Low-cost way of providing information to
consumers.
• Enhances competition.
• Speeds up technological progress.
• Can help firms obtain economies of scale.
LO14.4 14-30

31. Negative Effects of Advertising
• Can be manipulative.
• Contain misleading claims that confuse consumers.
• Consumers may pay high prices for a good while
forgoing a better, lower priced, unadvertised version
of the product.
LO14.4 14-31

32. The Largest U.S. Advertisers, 2018
Company
Advertising Spending
Millions of $
Comcast $6,122
AT&T 5,362
Amazon 4,470
Proctor & Gamble 4,305
General Motors 3,139
Disney 3,132
Charter 3,042
Alphabet (Google) 2,960
American Express 2,798
Verizon 2,682
14-32
LO14.4

33. Top Ten Brand Names
LO14.4 14-33

34. Oligopoly and Efficiency
• Oligopolies are inefficient:
• Productively inefficient because P > min ATC
• Allocatively inefficient because P > MC
• Qualifications:
• Increased foreign competition
• Limit pricing
• Technological advance
LO14.5 14-34

35. Last Word: Internet Oligopolies
• The Internet became accessible to the average
person in the mid 1990s.
• Today it is dominated by a few very large firms:
Google, Facebook, Amazon, Microsoft, Apple.
• Not satisfied with just revenues generated in their
respective sectors:
• Compete for advertising dollars.
• Compete with electronic devices. 14-35