The Theory of the Firm Oligopoly Open/formal collusion

Presentation on theme: "The Theory of the Firm Oligopoly Open/formal collusion"— Presentation transcript:

1 The Theory of the Firm Oligopoly Open/formal collusion
Tacit/informal collusion Non-collusive oligopoly Most info from Blink & Dorton or Tragakes

2 RECAP: Intro to Oligopoly: Assumptions
Large proportion of industry’s output is shared by a small number of firms. Industry may or may not have many firms. But only a few DOMINATE! What is a small #? Varies. Key indicator: Concentration Ratio Shows % of market share held by x # of firms Most common: CR4 and the CR8 How many firms in each example?

3 CONCENTRATION RATIOS AND MARKET STRUCTURES

4 CONCENTRATION RATIOS REAL LIFE-EXAMPLES
In the US malt beverages industry, there are 160 firms and the CR4 is 90%. Is this an oligopoly? YES! (It’s the # of firms that dominate that is important, not the # of firms that exist in the industry.) What if one company controls 75% and 3 control 5% of the industry. Is it still a CR4 of 90%? YES! That’s one of the problems with the CR measurement. In the US frozen fish and seafood industry, there are 600 firms and the CR4 is 19%. Is this an oligopoly? NO! (This is monopolistic competition, albeit not “pure” monopolistic competition. The top 4 firms should be approx. 40% or more to be considered an oligopoly.

5 RECAP: Intro to Duopoly:
2 firms dominate an industry This is still part of oligopoly theory!

6 RECAP: Intro to Oligopoly: Assumptions
Dominance by small # of firms Importance of interdependence (new): One firm’s profits depend on (strategies adopted by) other firms Leads to dilemma: COMPETE or COLLUDE? Differentiated (e.g. automobiles) or homogeneous (e.g. petroleum) products (new): Most have high barriers to entry (but not impossible)

7 RECAP: Game Theory Game Theory:
A mathematical technique analysing the behavior of decision-makers who are dependent on each other, and who use strategic behavior as they try to anticipate the behaviour of their rivals.  Individuals that act the most rationally may be left with the worst outcome (Nash equilibrium: There is sometimes a conflict between the individual pursuit and collective interest)

8 The Prisoner’s Dilemma

9 The Prisoner’s Dilemma

10 Types of Oligopolies COLLUSIVE NON-COLLUSIVE
COLLUSION: An agreement between firms to limit competition, increase monopoly, & increase profits Note: Illegal in most countries (Why?) 2 TYPES OF COLLUSION Open/formal: Formal agreement occurs in the form of a CARTEL PRIMARY GOAL: Limit competition between member firms and to maximize joint profits as if the firms were collectively a monopoly Tacit/informal: Cooperation (w/same objectives) but w/o a formal agreement. Often involves PRICE LEADERSHIP by a dominant firm When oligopolistic firms do not agree, whether formally or informally, to fix prices or collaborate in some way COLLUSION RESTRICTS COMPETITION! Why illegal? It limits competition. Anti-trust authorities will investigate.

11 OPEC: The #1 Cartel Example
Also, Ecuador (1973) and Angola (2007)

12 OPEC: The #1 Cartel Example
The Organization of Petroleum Exporting Countries Sets production quotas. Each member is assigned an output level (quota) it is permitted to produce How has OPEC been effective? How has it not?

13 OPEC: The #1 Cartel Example

14 What about drug cartels?

15 PROBLEMS WITH CARTELS (formal collusion) (Why are they difficult to maintain? Brainstorm!!!)
#1. INCENTIVE TO CHEAT Cheating by (a) lowering the price for some buyers or (b) making other secret/special deals to sell more. Incentives increase during recessions (Think of incentives for OPEC nations right now!) #2. COST DIFFERENCES Ex.: Qatar—much easier (cheaper) to produce oil than Iran. MC = different price points for both! #3. DEMAND CURVE DIFFERENCES Partly b/c of diff. market shares & partly b/c of product differentiation #4. # OF FIRMS Larger # of firms = harder to agree on price/output levels #5. POTENTIAL ENTRY INTO INDUSTRY A successful cartel (w/large economic profits) encourages new firms (e.g. U.S. & oil). Long-run survival of cartel depends on high barriers to entry. #6. INDUSTRY LACKS DOMINANT FIRM A dominant firm (e.g. Saudi Arabia) helps make consensus easier to reach

16 2012-2013 Break-Even Oil Prices for OPEC

17 Tacit Collusion NO!!! Do tacit colluders OFFICIALLY agree to collude?
One type of t.c.: PRICE LEADERSHIP Where a dominant firm sets a price & initiates any price changes Remaining firms become price-takers but they can engage in non-price competition Examples: R.J. Reynolds (cigarettes), Kellogg’s (breakfast cereals) Types of dominance: Largest firm AND/OR one with lowest per unit costs

18 Formal + Tacit collusion firms behave like a monopolist by:
OLIGOPOLISTS ACTING AS A MONOPOLIST Formal + Tacit collusion firms behave like a monopolist by: 1. Charging monopoly price 2. Making monopoly profits

19 Are prices in oligopolies (esp. non-collusive ones) flexible or rigid?

20 Price RIGIDITY in Oligopolies
If firm RAISES price from current level, demand is quite elastic or inelastic. Why? ELASTIC b/c consumers will then buy more from other firms that did not change their price. Raising price will greatly decrease Qd If firm LOWERS price from current level, demand is quite elastic or inelastic. Why? INELASTIC b/c other firms will lower their price in what is called “a price war.” All firms will lose revenue but market share for each will stay similar. Lowering price will barely change Qd How is this graphed? A KINKED DEMAND CURVE!

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22 Price RIGIDITY in Oligopolies
At what price should the oligopolistic firm with the MC1 curve sell its product? P (b/c MC = MR) What about the firm with the MC2 curve? MAIN IDEA: LOWERING THE PRICE DOES NOT ALWAYS INCREASE THE Q DEMANDED! ANOTHER IDEA: COST CHANGES DON’T ALWAYS AFFECT PROFIT-MAXIMIZING PT

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24 Through NON-PRICE COMPETITION!
So…if the price usually stays the same, then how do oligopolies compete? Through NON-PRICE COMPETITION!

25 RECAP: Types of monopolistic competition
PRICE COMPETITION NON-PRICE COMPETITION Rivalry between producers based solely on price, usually when selling identical or extremely similar products Examples? Competition between producers based on all except the price by focusing on product differentiation. Examples? Advertising Packaging Product Development/Quality Quality/Amount of Service Branding

26 Is the need for advertising allocatively efficient?
No! Not bad b/c it leads to increased competition among oligopolies and, therefore, hopefully better products for consumers. But…is this always a bad thing for consumers?

27 The World’s Leading Oligopolies
Examples include: Coke/Pepsi Adidas/Nike Unilever/Proctor & Gamble Both produce a vast # of brands in a variety of industries such as home care products, personal hygiene, health care and beauty products.

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29 Formal collusion Tacit collusion Non-collusive
Pepsi & Coca-Cola are examples of firms inside of which oligopolistic structure? Formal collusion Tacit collusion Non-collusive Not “formal collusion.” How might the behavior of each be ‘strategic?’