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 Oligopoly Introduction We’ve modeled 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 firm, but industry is highly concentrated • Examples – Coke vs Pepsi – Boeing vs Airbus – Auto Industry Concentration Concentration ratio: One measure of industry concentration CR4=% of Total Industry Sales accounted for by the four largest firms CR20=% of Total Industry Sales accounted for by the twenty largest firms 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 Tight Oligopoly: CR4 > 60% (10% 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 separate interrogation rooms (no communication between prisoners) • If they both keep silence, then both will only get year time in jail • If both confess, they will both get years • If A confesses and B keeps silence, A gets out of jail and B gets years and vice versa What will be the outcome? The Prisoners’ Dilemma Game Convention rules • players, actions : Draw a by 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) • Write the payoffs in each cell First player’s payoff first What is the Equilibrium Outcome? Equilibrium: No one has incentive to move from the outcome • (confess, confess) : If any deviates, he will get years instead of years • The optimal outcome (silence, silence) is not an equilibrium Principle : Equilibrium outcome is not always optimal Dominant Strategies No matter what Prisoner chooses, Prisoner 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 = • 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 10 Making Credible Threat #1 Build a reputation to fight in other markets • Suppose Wal-Mart has 10 stores in 10 towns and K-mart entered 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 markets –Wal-Mart enjoys monopoly profit of $4 mil in other markets 24 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 25 – If K-mart enters, Wal-Mart is now better off to fight low price threat becomes credible – slack capacity / sunk cost as a barrier to entry Barriers to Entry • government regulation • patents • slack capacity / sunk costs • network externality 26 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 WalMart → But it serves as a threat to other stores 27 Other Examples of Slack Capacity “Starbucks on Every Corner” • Starbucks open new shops on every corner • Over investment? – Maybe, but it may intentionally 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 28 Cartel A cooperative group of firms 29 Introduction In Prisoners’ Dilemma, prisoners cannot achieve the optimal outcome (1 year, year) by keeping silence Why not? Can they cooperate and achieve the optimal outcome? 30 Prisoners’ Dilemma and Firm Collusion 31 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 monopoly, even if there are more than firm • Adopt monopoly pricing and share the market (quota) – no firms cheat by undercutting the monopoly price – no firms cheat by producing more than its quota 32 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 • Not a cartel and it’s legal • Examples: Gas Stations 33 What Makes a Cartel or Tacit Collusion Easier? key elements of a cartel / tacit collusion • It should detect whether a member is cheating or not • If found a member cheats, then punish him heavily Conditions • repeated interactions • homogeneous product • relatively few firms • stable cost & demand • few choice variables with strategic implications 34 “Cartels Come in Many Shapes and Sizes” Why couldn’t Brazil and Columbia form a coffee cartel? 35 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 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 b) decreases cross-price elasticity (%Qx / %Py) 36 Advertising within oligopoly (cont.) 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, etc.? 37 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 38 ... – 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... 20 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? 21 Wal-Mart’s Threat Fails 22 • Wal-Mart... 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