Economics for Managers

by
y Paul Farnham

Chapter 9
Market Structure: Oligopoly

2005 Prentice Hall, Inc.

9.1

Oligopoly

A market structure characterized by

competition among a small
number of large
g firms that have
market power, but that must take
their rivals actions into
consideration
id
ti when
h developing
d
l i
their competitive strategies
2005 Prentice Hall, Inc.

9.2

Characteristics
off an Oli
Oligopoly
l
Firms have market power derived

from barriers to entry

y
However, a small number of firms
compete with each other
Each firm doesnt have to
consider the actions of other
firms, thus, behavior is
interdependent
2005 Prentice Hall, Inc.

9.3

Noncooperative
Oli
Oligopoly
l Models
M d l
Assumes that firms pursue profitmaximizing
g strategies
g
based on
assumptions about rivals behavior
and the impact of this behavior on
th given
the
i
firms
fi strategies
t t i
1. Kinked demand curve model
2. Game theory models
3 Strategic entr
3.
entry deterrence
2005 Prentice Hall, Inc.

9.4

Kinked Demand
C
Curve
Model
M d l
Assumes that a firm is faced with

two demand curves, assuming

that other firms
f
will not match
price increases but will match
price decreases
If the firm considers raising the
price above P1, its quantity
demanded will depend upon the
beha ior of rival
behavior
ri al firms
2005 Prentice Hall, Inc.

9.5

Kinked Demand
C
Curve
Model
M d l
Assumes that managers will inflict

maximum damage
g on other firms
Implies oligopoly prices tend to
be sticky
sticky and not change as
they would in other market
structures
Does not explain why price P1
exists initially
2005 Prentice Hall, Inc.

9.6

Kinked Demand Curve

Figure
g
9.1

MC
P1

MR2
D2 = Rivals
dont follow

MR1
0
2005 Prentice Hall, Inc.

Q1

D1 = rivals follow

Q
9.7

Game Theory Models

Mathematically analyzes situations in

which players make various strategic

moves and have different outcomes or
payoffs associated with those moves
Dominant
o
a t strategy:
st ategy results
esu ts in best
outcome to a given player

2005 Prentice Hall, Inc.

9.8

Nash Equilibrium
Strategies for which all players

are choosing
g their best strategy,
gy,
given actions of other players
Proves useful when there is only
one unique equilibrium in the
g
game
There may be multiple Nash
equilibrium
2005 Prentice Hall, Inc.

9.9

Strategic Entry
D t
Deterrence
Policies that prevent rivals from
entering
g the market
Limit pricing: charging a price

lower than the profit-maximizing

profit maximizing
price
Predatory pricing: lowering prices

below cost to drive out existing

competitors and scare off
potential entrants
2005 Prentice Hall, Inc.

9.10

Limit Pricing Model

Figure 9.2

Potential Entrant

Established Firm
MC

ATCEN
PM
PL

0
2005 Prentice Hall, Inc.

A C

PL
ATCM
ATCL
0

ATC

B
F
Q1

Q2

Q
9.11

Limit Pricing Model

Assumes existing firms have

lower costs
Attracts other firms into the
industry
Established firms can thwart entry
by charging the limit price (or a
lower price) rather than profitmaximization price
2005 Prentice Hall, Inc.

9.12

Predatory Pricing
Figure 9.3

PUS
PJ
PC
PP

T
R S
N

L
J

LRAC = LRMC
M
Demand
MR

QUS QPP QC QP

2005 Prentice Hall, Inc.

Q
9.13

Determinates of Successful
P d t
Predatory
Pricing
P i i
How far the predatory price is below

cost
Period of time in which the predatory
price is in effect
Rate of return used for judging the
investment in predatory pricing
How many rivals enter the industry
after predation ends
Time over which recouping
p g of profits
p
occurs
2005 Prentice Hall, Inc.

9.14

Cooperative Oligopoly
M d l
Models
Focus on cooperative behavior

among
g rivals
Two types
Cartels
C t l
Tacit collusion

2005 Prentice Hall, Inc.

9.15

Cartels
Firms that get together and agree to

coordinate behavior regarding pricing

and output decisions
Joint profit maximization: strategy that
maximizes
a
es p
profits
o ts for
o a ca
cartel
te but may
ay
create incentives for individual
members to cheat
Horizontal
H i
t l summation
ti
off marginal
i l costt
curve: calculated from marginal cost
curve for the cartel
2005 Prentice Hall, Inc.

9.16

Allocation Rule for Joint

P fit M
Profit
Maximization
i i ti
MC1 = MC2 = MC3
where
MC1 = Firm
Fi
#1s
#1 marginal
i l costt
MC2 = Firm #2
#2s
s marginal cost
MCC = Cartels marginal cost
2005 Prentice Hall, Inc.

9.17

When a Cartel
i Successful
is
S
f l
It can raise market price without

inducing significant competition

f
from
non-cartel
t l members
b
The expected punishment from
f
forming
i the
th cartel
t l is
i low
l
relative
l ti
to the expected gains
The
Th costs
t off establishing
t bli hi and
d
enforcing agreement are low
relative to the gains
2005 Prentice Hall, Inc.

9.18

Tacit Collusion
Tacit collusion: coordinated behavior

that is an achieved without a formal

agreement
Tacit collusion practices:
Uniform prices
Penalty for price discounts
Advantage notice of price changes
Information exchanges
Swaps and exchanges
2005 Prentice Hall, Inc.

9.19

Managerial Rule of Thumb:

Coordinated
di
d Actions
i
Managers must
Coordinate efforts, but within

constraints of antitrust legislation

Recognize
g
incentives for cheating
g
in coordinated behavior
Remember that even coordinated
efforts
ff
are fl
fleeting,
i
given
i
the
h
dynamic and competitive nature of
a market environment
2005 Prentice Hall, Inc.

9.20

Summary of Key Terms

Cartel
C t l
Cooperative oligopoly models
Dominant strategy
Game theory
Horizontal summation of marginal

cost curves
Joint profit maximization
Kinked demand curve model
2005 Prentice Hall, Inc.

9.21

Summary of Key Terms

Limit pricing
Nash equilibrium
Noncooperative oligopoly models
Oligopoly
g
y
Predatory pricing
Strategic entry deterrence
Tacit collusion

2005 Prentice Hall, Inc.

9.22

Do you have
any questions?

2005 Prentice Hall, Inc.

9.23