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After reading the material in this chapter, you should be able to: Differentctiiate between interest-bearing and non-interest-bearing notes; calculate bank discount and proceeds for simple discount notes; calculate and compare the interest, maturity value, proceeds, and effeve rate of a simple interest note with a simple discount note; explain and calculate the effective rate for a Treasury bill;...
Chapter 11 Challenge To Market Effectiveness 2: Oligopolies McGrawHill/Irwin Copyright © 2009 by The McGrawHill Companies, Inc. All Rights Reserved Learning Objectives • What is oligopoly? • What is the Prisoners’ Dilemma? • How oligopolistic firms find themselves in the pricing Prisoners’ Dilemma? • How oligopolists escape the pricing Prisoners’ Dilemma? • How colluding oligopolists harm a society? • Why oligopolists have incentives to innovate? • How antitrust laws affect the society? 11-2 Oligopoly • Oligopolistic markets are in between a monopoly (where there is just one firm) and perfect competition (where there are a large number of firms) Industry % of U.S market controlled by four largest firms in the industry Breweries 90.5 Cigarette manufacturing 95.3 Electric lamp bulb and part manufacturing 89.6 Light truck and utility vehicle manufacturing 96.7 Guided missile and space vehicle manufacturing 95.3 11-3 In The Quest Of An Oligopoly • Antitrust laws prevent firms colluding on price as well as monopolies from forming • An implicit agreement to raise prices: sending a clear but legal signal through consecutive change of price • The challenge of maintaining high prices: each firm has an incentive to cheat by undercutting the implicit agreement • The challenge of international competition • The attempts of product differentiation and complicated pricing • Incompatibility and lock-in 11-4 Oligopoly • Economists are not sure when oligopolistic firms will compete and when they will cooperate • There is no reliable theory that tells when oligopolists will succeed cooperation • Prisoners’ Dilemma refers to forces that thwart oligopolists’ efforts at cooperation 11-5 Prisoners’ Dilemma • Two criminals are arrested • The only way to know they’re serious is to establish at least one of them has confessed • By separating them, the police create incentives for the prisoners to turn on each other 11-6 Prisoners’ Dilemma • Adam and Ben both simultaneously decide whether to confess or stay silent The two prisoners end up in the box corresponding to their choices Ben Confess Confess • In the Prisoners’ Dilemma game, each person is individually Adam better off confessing So if both Ben and Adam are rational Stay Silent and self-interested, they will both confess and spend their lives in prison Stay Silent Adam gets life in prison Adam goes free Ben gets life in prison Ben is executed Adam and Ben will end up here Adam is executed Ben goes free Adam gets one year in prison Ben gets one year in prison 11-7 Prisoners’ Dilemma • Prisoners’ Dilemma applies to many more groups • Generally, those stuck in the Prisoners’ Dilemma take an action that is either selfish or altruistic • Individually, each player is better off being selfish • Yet all players are better off if everyone is altruistic 11-8 Athlete's Steroid Dilemma If winning is more important than avoiding health problems then both athletes will individually always be better off using steroids Yet the athletes are in a Prisoners’ Dilemma game because they are both better off if neither uses steroids than if both use steroids Athlete Two Use Steroids Both athletes have an equal chance of winning Use Steroids Both athletes suffer health problems Don’t Use Steroids Athlete One wins Athlete One suffers health problems Athlete One Athlete Two wins Don’t Use Steroids Both athletes have an equal chance of winning Athlete Two suffers health problems 11-9 The Pricing Prisoners’ Dilemma • Oligopolists are often in a Prisoners' Dilemma with respect to pricing • Each firm’s pricing actions affect the other firm • If the two firms play the game just once, they each have an incentive to charge low prices 10 11-10 Using “Pro-Consumer” Policies to Promote Collusion “Most favored customer” promise: • Under this promise, the seller legally promises that the price the customer is paying is not higher than the price for any other customer Price matching: • The seller promises to match all its rival’s prices • “Most favored customer” and price matching can prevent firms from lowering prices 13 11-13 The Social Harm of Collusion • By the Law of Demand, when oligopolists maintain high prices, they reduce sales • When oligopolists collude, they raise prices above marginal costs • As a result, some consumers go without buying the good even when they value it higher than marginal costs • Colluding oligopolists reduce wealth of society 14 11-14 Escaping the Prisoners’ Dilemma Product differentiation: • Firms resort to product differentiation when they cannot escape a pricing Prisoners’ Dilemma through collusion • When consumers base their choice on more than just price, oligopolists not have the pressure to sell for the lowest price • Oligopolists sometimes use style rather than quality to differentiate their products Advertising and brand names: • Firms also have to inform consumers about the differences between their product and rivals’ products 15 11-15 Escaping the Prisoners’ Dilemma Using confusing prices: • Complication reduces the damage of price competition • With complicated pricing, customers cannot easily discern which firm is charging less • Complicated pricing reduces the incentive for firms to cut prices as well as the harm to one firm of its rival’s price cut, e.g long distance phone services, frequent-flyer programs of airlines 16 11-16 Oligopolies and Innovation • Oligopolies have greater incentives to innovate than any other type of firm • Firms in oligopoly face direct competition and so must innovate to survive • Oligopolies primarily engage in disruptive innovations 17 11-17 Disruptive Innovation in Oligopolies • Disruptive innovation reduces the value of existing products or services • Firms are willing to develop innovations that harm rival firms but not themselves • Though disruptive innovation can reduce the value of individual firms, it usually increases the wealth of society by giving it better products • Example firms are Bell Telephone, Black & Decker, Charles Schwab, Dell computer, eBay, Expedia, Kodak, Linux 18 11-18 Prisoners’ Dilemma and Disruptive Innovation • Oligopolists sometimes collude to avoid disruptive innovation • Oligopoly firms benefit from colluding to reduce innovation expenditure • However, colluding to suppress innovation is far more dangerous than colluding to set high prices 19 11-19 Antitrust Laws • Antitrust laws prohibit firms from colluding or attempting to acquire monopolies • They can reduce the deadweight loss caused by monopolies and oligopolies • However, antitrust laws are enacted and interpreted by imperfect government agent and hence can destroy society’s wealth 20 11-20 Antitrust Laws Beneficial antitrust enforcement: • The United States v Addyston Pipe and Steel Corporation,1899 • National Society of Professional Engineers v The United States,1978 • The courts ruled against eliminating price competition Harmful antitrust rulings: • The United States v IBM Corporation, 1969 : The government dropped the case in 1982 but IBM had spent valuable resources fighting the government that it soon lost its dominance of the computer market • Predatory pricing 21 11-21 Antitrust Laws and Predatory Pricing • Antitrust laws prevent predatory pricing • Predatory pricing litigation always seeks to punish firms when they charge low prices • According to predatory pricing theory, firms initially charge low prices to drive other firms out of their market Then, when the predatory firm becomes a monopolist it raises prices, thereby damaging consumers • However, economists have never found any successful examples of predatory pricing • Some firms can be expected to return to the market when the predatory firm starts charging high prices 22 11-22 Do You Know? • How both criminals confess in the Prisoners’ Dilemma? Each person is individually better off confessing regardless of what the person does So, each criminal confesses for his own good • How can oligopolistic collusion destroy wealth? When oligopolists collude, they maintain prices higher than marginal costs and reduce sales Since some consumers go without buying the good, it destroys society’s wealth 23 11-23 Do You Know? • Why oligopolistic firms often try to differentiate their products? When consumers base their choice on more than just price, oligopolists not have the pressure to sell for the lowest price Hence, oligopolists try to convince consumers that their product is different from their rivals • Why oligopolies have tremendous incentives to innovate? Oligopolistic firms face direct competition, so they must innovate to survive They have greater incentive to innovate to differentiate their products from their rivals 24 11-24 Summary • Oligopolistic markets are in between a monopoly and perfect competition • Through cooperation and collusion, oligopolists maintain high prices and increase profits • Oligopolists are often in a Prisoners' Dilemma with respect to pricing where each firm’s pricing actions affect the other firms • Generally, those stuck in Prisoners’ Dilemma take an action that is either selfish or altruistic • Though each player is individually better off being selfish, all players are better off if everyone is altruistic 25 11-25 Summary • Firms can cooperate and escape the pricing Prisoners' Dilemma by “most favored customer” and price matching • Product differentiation, advertising and brand names, and complicated pricing are the other ways to escape the pricing Prisoners' Dilemma • Colluding oligopolists reduce wealth of society • Oligopolies have greater incentives to innovate and primarily engage in disruptive innovations • Antitrust laws prohibit firms from colluding or attempting to acquire monopolies 26 11-26 Coming Up What are government imperfections? 27 11-27 ... • These are organizations of producers who explicitly collude to charge high prices • Organization of Petroleum Exporting Countries (OPEC) • Criminal cartels 11 11 -1 1 Antitrust Laws and Collusion... to cut prices as well as the harm to one firm of its rival’s price cut, e.g long distance phone services, frequent-flyer programs of airlines 16 1 1- 16 Oligopolies and Innovation • Oligopolies... selfish or altruistic • Individually, each player is better off being selfish • Yet all players are better off if everyone is altruistic 1 1- 8 Athlete's Steroid Dilemma If winning is more important