CH 26 Oligopolies PDF

CH 26: Oligopolies An oligopoly is a market structure that consists of a small number of interdependent sellers. Each firm in the industry knows that other firms will react to its changes in prices, quantities and qualities. **Characteristics:** - **Small number of firms:** An oligopoly exists...

CH 26: Oligopolies An oligopoly is a market structure that consists of a small number of interdependent sellers. Each firm in the industry knows that other firms will react to its changes in prices, quantities and qualities. **Characteristics:** - **Small number of firms:** An oligopoly exists when the top few firms in the industry account for an overwhelming percentage of total industry output. - **Interdependence:** There is a strategic dependence of one on the other's actions. This is when any one firm changes its output, its price or its quality for their product, other firms notice the effects of its decision, and act based on that. - In Contrast: Recall that in a perfect competition market, each firm ignores the behavior of others, because they can sell all they want at the going market price. A pure monopolist doesn't worry about the reaction of its competitors because there isn't any. **Why do They Occur:** - **Economies of Scale:** Recall that economies of scale happen when a doubling of output results in less than a doubling of total costs. When this happens, the firms long-run average total costs will slope downward as they produce more output. Smaller firms in this situation will be at disadvantage compared to larger firms, eventually going out of business. - **Barriers to Entry:** Include legal barriers (such as patents), and control and ownership of critical supplies. - **Mergers:** A merger is joining two or more firms under single ownership or control. The merged firm naturally enjoys greater economies of scale as output increases and ultimately have a greater influence over the market price. The types of mergers: - Vertical Merger: When one firm merges with either a firm from which it purchases an input or a firm to which it sells its output. Ex: When a coal-using electrical utility buys a coal-mining firm. - Horizontal Merger: The joining of firms that are producing or selling a similar product. Ex: If a group of firms, all producing steel, merge into one. **Concentration Ratio:** The percentage of all sales contributed by the leading four or the leading eight firms in an industry. It indicates the degree of competition in an industry. - Low concentration ratio indicates greater competition in an industry, compared to one with a ratio nearing 100%, which would be a monopoly. - **Herfindahl-Hirschman Index:** - **Reaction Function:** Which is the manner in which one oligopolist reacts to a change in price, output or quality made by another oligopolist in the industry. - **Game Theory:** Because they have to be weary about their competitors actions in the oligopoly, they develop certain strategies for this, such as the game theory. - **Game Theory:** A way of describing the various possible outcomes in any situation involving two or more interacting individuals, firms or nations, when those actors involved are aware of the interactive nature of their situation and plan accordingly. The plans made by these individuals are called game strategies. - **Notions about Game Theory:** - Cooperative Game: If firms work together to obtain a jointly shared objective, such as maximizing profits for the industry as a whole. - Noncooperative Game: If its too costly for firms to coordinate their actions to obtain cooperative outcomes, they are in a noncooperative game situation. Neither negotiate nor cooperate in any way. - Zero-Sum Games: When one player's losses are offset by another player's gains. For example, if two retailer have an absolutely fixed number of customer, the customers that one retailer gains are exactly equal to the customers that the other retailer loses. - Negative-Sum Game: A game in which players as a group lose during the process of the game. - Positive-Sum Game: Players as a group end up better off. A voluntary exchange is an example, since the seller and the buyer are supposed to be better off after the exchange. - **Strategies in Noncooperative Games:** - The Dominant Strategy: Whenever a firm's decision maker can come up with certain strategies that are generally successful no matter what actions competitors take, these are called dominant strategies. A dominant strategy will yield the most benefit for the player using it. - **Applying Game Theory to Pricing Strategies:** Example: Having two firms determining their prices. Unless they collude, they will both charge low prices, because it's the dominant strategy. If they collude, they'd charge high prices, since its what yields the most profits, but, if its noncooperative game, and each firm has no idea what they other one will choose, charging low prices it's the smartest. - If we look at this from Firm 1's perspective, charging low prices it's the best move. That way, if Firm 2 decides to charge high prices, firm one will take most of the profits, but if Firm 2 decides to go low, firm 1 will make \$4 million (which is best than making \$2 million if firm one had charged high). And vice versa. - **The Cooperative Game: A Collusive Cartel:** - **Cartel:** A cartel is an association of producers in an industry that agree to set common prices and output quotas to prevent competition. 1. They first need to determine how much each producer will restrain its output to start charging higher prices. 2. Enforcing the cartel agreement - **Enforcing the Cartel Agreement:** There are four conditions that make it more likely that firms will be able to coordinate their efforts to restrain output and detect cheating: 1. A small number of firms in the industry: If it's a few firms only, it is easier to assess how much each firm should produce and to monitor each one of them. 2. Relatively Undifferentiated Products: If each firm sells a highly differentiated product, then some members can reasonably claim that the prices of their products should reflect differences in costs of production. Therefore if the product is nearly homogenous, its easier for all to agree on production quotas and prices. 3. Easily Observable Prices 4. Little Variation In Prices - Cartels can also prevent cheating while using consumers as their police. For example, all members of a cartel can agree to offer buyers "deals" that permit a buyer to switch to another seller if that seller offers the product at a lower price. That way, the customer will be providing evidence that another firm participating on the cartel is offering lower prices, which is cheating. This is a price-matching example.