Lecture Managerial economics - Chapter 5: Oligopoly

We’ve modeled 2 ends of the market structure: Competitive market and monopoly. Now we look at cases in between ( N = small ). Oligopoly is market or industry dominated by a small number of firms, whose decisions (price, output, marketing) are interdependent. In chapter 5, we will discuss this problem.

Week 5

Oligopoly

We’ve modeled 2 ends of the market structure

• Competitive market ( N = ∞ )

• Monopoly ( N = 1)Now we look at cases in between ( N = small )

Oligopoly: Market or industry dominated by a small number

of firms, whose decisions (price, output, marketing) are interdependent

• More than 1 firm, but industry is highly concentrated

• Examples

– Coke vs Pepsi– Boeing vs Airbus– Auto Industry

 The higher the CR, the greater the degree of market power

by a small number of firms Benchmarks:

 Effective Monopoly: CR1 > 90% (only 2-3% of GDP)

 Effectively Competitive: CR4 < 40% (top four firms have individual markets shares averaging less than 10%) 75% of GDP

 Loose Oligopoly: 40% < CR4 < 60% (monopolistic

competition) 12% of GDP

Concentration and Prices

 Department of Justice is concerned with how mergers affect consumers because of the following possible outcome:

 Ceteris paribus, the higher the concentration the higher the prices and the higher the profits.

 High prices could be because of collusion or just because of reduced competition

 The fewer the firms, the less the intense, cutthroat

competition, and the more likely that prices will be high

 The higher the entry barriers, the higher the expected

prices

 More formally, we have P = f (Cost, Demand, and Seller Concentration)

Game Theory

Game theory is a way to model strategic interactions

• Developed by John Nash, watch “Beautiful Mind”

The Prisoners’ Dilemma Game: A Classic Example

• Two prisoners suspected of committing a crime are in custody

• They are put into 2 separate interrogation rooms (no communication between prisoners)

• If they both keep silence, then both will only get 1 year time in jail

• If both confess, they will both get 3 years

• If A confesses and B keeps silence, A gets out of jail and

B gets 5

The Prisoners’ Dilemma Game

Convention rules

• 2 players, 2 actions : Draw a 2 by 2 matrix

• Write first player’s actions (confess / silence) in left of matrix (above & below)

• Write second player’s actions (confess / silence) on top (left & right)

What is the Equilibrium Outcome?

Equilibrium: No one has incentive to move from the

Dominant Strategies

No matter what Prisoner 2 chooses, Prisoner 1 always finds it better to confess

• Confessing is also always Prisoner 2’s best strategy … try it yourself

Dominant Strategy: an action that is best no matter

what strategy a rival adopts

• Prisoner 1’s dominant strategy is to confess

• Prisoner 2’s dominant strategy is also to confess

• Equilibrium is (confess, confess).

• Lesson: if you have a dominant strategy, always play it Not all games have dominant strategy.

• it is not always the case that a player has a dominant strategy

• it is not always the case that a game has any dominant strategies

Perspective on Game Theory

The basic question

• if my rivals act to maximize their objective, how should I take their behavior into account when making my own decisions? Applications

• Any situation where there are a small number (2, 3, 4) of players with small number of actions

–Business Strategy

» OPEC game: How much to produce?

–Sports Game

» In football, Pass or Run?

» In baseball, Throw a Strike or Ball?

OPEC Game

Suppose OPEC has 12 members (Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela).

• They all produce identical oil.

• Each county decides how many barrels to produce

• Price will be determined by P = $(1400 – Total Quantity).

–If total number of barrels > 1400, then P = 0.

• Unit cost for each country = Qi + 100 –e.g If country A produces 50 barrels, unit cost is $150 for A choose the number of barrels (Qi) to produce.

• You’ll collect the quantities from each member and calculate P

• Each member’s profit = P * Qi – (Qi+100)*Qi

Equilibrium: Outcome with no incentive

to move

• Not necessarily the optimal outcome

• Sometimes, there could be more than one equilibrium

First Movers Advantage

Wal-Mart’s Preemptive Strategy

Super Jumbo Jet War between Airbus and Boeing

Wal-Mart’s Preemptive Strategy

Background:

• Sam Walton started in 1969

• During 70s and 80s, large discount chains went bankrupt.

• Wal-Mart kept growing (153 stores in 1976 to

1009 in 1986).

What is the key to Wal-Mart’s success in 1970s?

Wal-Mart’s Preemptive Strategy (70s)

Wal-Mart realized that

• A small town with population less than 100,000 can

Strategy:

• Preempt the market by entering the market first

– This is more subtle than you may think – Wal-Mart must commit to itself

Wal-Mart’s Entry Deterrence Strategy Since 80s, many small towns expanded to accommodate more than 1 discount stores.

To enjoy monopoly status in such market, Wal-Mart must prevent other stores from entering the market.

What are the Wal-Mart’s Entry Deterrence Strategies in 90s?

• It takes 6 years to design a new jet.

• R&D cost is $10 billion Airbus announced they will develop the new super

Entry Deterrence

How to deter potential competitors’ entrance?

• How to build a barrier to entry?

• Wal-Mart’s entry deterrence example

Wal-Mart’s Entry Deterrence Strategy

Situation

• In 70s, Wal-Mart was the only discount store in a small size town.

• Since 1980s, town has grown into a medium size and now can accommodate 2 discount stores.

Market size increased from $2 mil to $4 mil

K-mart

• Potential Entrant: consider opening a store in that midsize town

• Actions: Enter or Stay Out

Wal-Mart:

• Incumbent: the only discount store (monopoly) in the town

• If K-mart enters, Wal-Mart has 2 actions

– i) shares the market at monopoly price (cartel), or

Payoff Structure

• K-mart stays out and Wal-Mart charges monopoly price,

– Wal-Mart’s profit is $4 mil and K-mart earns $0.

• K-mart enters by paying entry cost of $1.6 mil (K-mart moves first) i> If Wal-Mart shares the market with K-mart (monopoly price)

→ Wal-Mart’s profit is $2 mil (half), K-mart’s profit is $0.4 mil ( =

$2 mil - $1.6 mil entry cost)

ii> If Wal-Mart fights by charging low price and sell more,

→ revenue goes up by $0.3 mil but has to pay $1 mil (sunk cost) to increase the capacity

• K-mart stays out and Wal-Mart charges low price (unlikely),

Wal-Mart’s Strategy: Threat K-mart

Wal-Mart announces to K-mart

“If you enter, I’ll lower the price so you will lose money!”

• Will this threat work?

Wal-Mart’s Threat Fails

• Wal-Mart threats if K-mart enters, Wal-Mart will fight and charge low price.

– Is this credible based on the above matrix payoff structure?

→ i.e Will Wal-Mart really charge low price, if K-mart enters?

Answer: NO, b/c monopoly price gives higher profit ($2 mil)

than low price ($1.3mil).

• K-mart will enter the market, knowing that Wal-Mart will not

fight.

• Wal-Mart’s threat to fight is not credible.

How to Make a Credible Threat?

Bluffing vs Credible Threat

• Bluffing: When called, backing off the action

• Credible Threat: When called, take the action

• In business world, bluffing doesn’t work!

How do you make your threat credible?

• By building reputation

• By taking the action first (first movers advantage)

Making Credible Threat #1

Build a reputation to fight in other markets

• Suppose Wal-Mart has 10 stores in 10 towns and K-martentered one of them

– Wal-Mart lowers price (fights) for that market

– It will get $1.3 mil instead of $2 mil in that market

→ $.7 mil loss in one market– But it signals K-mart that Wal-Mart will fight

• Wal-Mart’s threat to fight becomes credible at the expense

of loss in one market– K-mart will not enter the other 9 markets

–Wal-Mart enjoys monopoly profit of $4 mil in other 9 markets

Making Credible Threat #2

In the previous game, K-mart moved first

• K-mart can make decision based on Wal-Mart’s reaction– disadvantage to Wal-Mart

– If Wal-Mart moves first, it will change the whole dynamics

• Wal-Mart expands capacity before K-mart makes decision– Wal-Mart pays sunk cost of $1 mil to increase the

capacity

– If K-mart enters, Wal-Mart is now better off to fight

Empirical Evidence

Two key current strategies for Wal-Mart (90s)

• Price Matching & Lowest Price Guarantee

–Marketing strategy –Builds reputation to fight and makes threat credible

• Supply Chain Management

–Production/Operations strategy –Huge investment in their distribution system to increase capacity

→ Lowest cost provider –Slack capacity in many stores

→ Some may think this slack capacity is inefficient for Mart

Wal-→ But it serves as a threat to other stores

Other Examples of Slack Capacity

“Starbucks on Every Corner”

• Starbucks open new shops on every corner

• Over investment?

– Maybe, but it may intentionally do so to create slack capacity

– Barrier to entry– Enjoy monopoly status

Cleaners

• Buy huge capacity dry cleaning machine

– Demand is 10,000 clothes/week but capacity can handle 20,000 clothes

– Inefficient?

» No It works as a threat to other potential cleaners

 A cooperative group of firms

In Prisoners’ Dilemma, prisoners cannot

achieve the optimal outcome (1 year, 1 year)

by keeping silence.

Why not?

Can they cooperate and achieve the optimal outcome?

Prisoners’ Dilemma and 2 Firm Collusion

How can they achieve optimal?

Can the firms promise to cooperate?

• No, if this game is a one shot game.

• Both players have incentive to cheat.

In a repeated game, cooperation is often possible

• invest in a reputation of not cheating, which may improve cooperation

• If A finds B is cheating, then punish B heavily (safety net)

Otherwise, both have incentive to cheat even in repeated game

Cartel: A successful cooperation among firms

• The outcome will be optimal for the firms

• All firms behave like 1 monopoly, even if there are more than 1 firm.

• Adopt monopoly pricing and share the market (quota)

– no firms cheat by undercutting the monopoly price

Cartel vs Tacit Collusion

Cartel: A group of firms that join together to make explicit

agreements on pricing strategy.

• Illegal in US for domestic trade

• Legal for foreign trade Examples:

• Organization of Petroleum Exporting Countries (OPEC)

• De Beers, a diamond cartel

• In reality, there are many but we simply don’t know b/c it’s illegal in US

Tacit Collusion

• Cooperation without any explicit price agreement

What Makes a Cartel or Tacit

Collusion Easier?

2 key elements of a cartel / tacit collusion

• It should detect whether a member is cheating or

• relatively few firms

• stable cost & demand

• few choice variables with strategic implications

“Cartels Come in Many Shapes and Sizes”

Why couldn’t Brazil and Columbia form a coffee cartel?

Advertising within oligopoly

Optimal amount of advertising?

There is a tradeoff between increased sales from additional advertising versus the cost of advertising

Firm should increase advertising as long as MR from

advertising is > MC of advertising, stop when MR = MC, or when Marginal Profits with respect to Advertising is 0

1. Product Differentiation Advertising can be used to

emphasize real or perceived differences (Bayer aspirin, Stoly's Vodka, Brand-name vs generic drugs, etc.), to promote product differentiation and brand-name loyalty

In economic terms, advertising and increased product

differentiation:

a) decreases substitutability and

Advertising within oligopoly (cont.)

2 Informational Advertising Giving customers more and better

information about competing goods.

With limited or imperfect information, some customers might

charge high prices or deliver low quality or poor service and not lose market share

Informational advertising can lead to better informed customers,

lower and more competitive prices, improved quality, and lower industry profits

Advertising is sometimes criticized for being wasteful

Positive side of advertising is that it efficiently provides valuable

information to consumers, to help in deciding which products

to buy and informs consumers of price reductions, e.g most advertising is announcing price cuts, sales, promotions, rebates,

Game Theory: Summary

Game theory develops a mindset:

• modeling strategic interactions between firms –consider the strategy & reactions of rivals

Modern Business Strategy

• dynamic interactions between rivals

• commitment to enter (first mover’s advantage)

• credibility/reputation

• cooperation/collusion