Chapter 27 Oligopoly and Strategic Behavior Overview In this chapter the oligopoly model is presented and its major characteristics are discussed. The reason why oligopoly occurs is discussed, and the concept of the concentration ratio is introduced. Strategic Strategic behavior under oligopolistic conditions along with game theory is presented. The model of price leadership as a form of strategic behavior with implicit collusion is developed. The ways oligopolists deter entry by potential competitors is analyzed. The nature and significance of network effects is then examined. inally, inally, the various market structures are compared. Outline I. !ligo !ligopol poly" y" #n #n oligop oligopoly oly is is a market market str struct ucture ure in in which which there there are are very very few few seller sellers. s. $ach $ach sell seller er knows knows the the other other sel seller lerss will will react to its changes in prices and %uantities. #n #n oligopoly market structure can exist for either a homogeneous or a differentiated product.
#. &haracteristics of of !l !ligopoly '. Small Small (umb (umber er of ir irms" ms" #n olig oligopo opoly ly exist existss when when the few few top top firms firms accou account nt for for an overw overwhel helmin ming g percen percentag tagee of total total industry output. ). Inter Interdep depend endenc ence" e" This This is also also calle called d strate strategic gic depen dependen dence, ce, whic which h is a situat situation ion in in which which one firm firm*s *s acti actions ons with with resp respect ect to to output, price, %uality, advertising, advertising, and related changes may be strategically strategically countered by one or more other firms in the industry. Such dependence can only exist when there are a few major firms in an industry. industry. +. hy !ligopoly !ccurs '. $cono $conomie miess of Scale Scale"" The The strong strongest est reas reason on that that has been been off offere ered d for the the exist existenc encee of oligo oligopol poly y is econo economie miess of scale scale.. $conomies of scale are defined as a production situation in which a doubling of output results in less that a doubling of total costs. The firm*s firm*s average total cost curve will slope downward as it produces more and more output. #verage #verage total cost can be reduced by continuing to expand the scale of operation. ). +arri +arrier erss to $ntry $ntry"" These These barrie barriers rs includ includee legal legal barrie barriers, rs, such such as as patents patents,, and contr control ol and owne ownersh rship ip over over critic critical al suppl supplies ies.. -. !ligo !ligopol poly y by erg erger" er" # merg merger er is the the joini joining ng of two two of more more firm firmss under under a singl singlee owners ownership hip or or contro control. l. Ther Theree are two two types types of mergers. # horizontal merger involves firms producing or selling a similar product. # vertical merger occurs when one firm merges with another from which it purchases an input or to which it sells an output. &. easuring Industry &o &oncentration '. &oncen &oncentr trati ation on /atio /atio"" The The percen percentag tagee of all all sales sales contr contribu ibuted ted by by the lead leading ing four four or or leadin leading g eight eight firms firms in in an indus industry try"" sometimes called the industry concentration ratio. 0See Table )12'.3 ). 4.S. &oncentra &oncentration tion /atios" /atios" The concept concept of an an industr industry y is necessar necessarily ily arbitrary arbitrary.. #s a conse% conse%uence uence,, concen concentrati tration on ratio ratioss rise rise as we narrow the definition of an industry and fall as we broaden it. 0See Table Table )12).3 5. !ligopoly !ligopoly,, $ffici $fficiency ency,, and /esource /esource #llocat #llocation" ion" Some oligopoli oligopolists sts charg chargee prices prices that that are are greater greater than than margi marginal nal cost. cost. There There is no definite evidence of serious resource allocation in the 4nited States. The more 4.S. firms face competition from the rest of the world, the less any oligopoly will be able to exercise market power. III. III. Strategi Strategicc +ehavior +ehavior and 6ame 6ame Theory Theory"" hen hen there there are are relative relatively ly few few firms firms in an industr industry, y, each reacts reacts to the price price,, %uantity %uantity,, %uality, %uality, and new product innovations that the others undertake. $ach oligopolist has a reaction function which is the manner in which one oligopolist reacts to a change in price 0or output or %uality3 of another oligopolist. 6ame 6ame theory is the analytical framework framework in which two or more individuals, companies, or nations compete for certain payoffs that depend on the strategy that the others employ. The plans made by these individuals are known as game strategies. #. Some +asic +asic (otions (otions #bout #bout 6ame Theory" Theory" 6ames 6ames can can be cooperati cooperative ve or non7cooper non7cooperativ ative. e. They They are are classi classified fied by wheth whether er the the payoffs are negative, zero, or positive. # cooperative game game is one in which which players explicitly explicitly collude to make themselves themselves better off. off. ith firms, it involves companies colluding in order to make higher than competitive rates of return. # non7cooperative game is a game in which players neither collude nor negotiate in any way. #pplied #pplied to firms, it is a situation in which there are few firms and each firm has some ability to change price. # zero sum game is a game in which one player*s losses are exactly offset by the other player*s gains. gains. # negative7sum game game is a game game in which both players are worse worse off at the the end of the game. game. # positive7sum game game is a game in which both players are better off at the end of the game. '. Strate Strategie giess in (onco (oncoope operat rative ive 6ame 6ames" s" # strate strategy gy is any any rule rule that that is used used to to make make a choice choice,, e.g., e.g., alway alwayss pick pick heads. heads. The The goal goal is to devise a dominant strategy. strategy. # dominant strategy will yield the highest benefit for the player using it. These strategies are generally successful no matter what actions other players take. +. #pply #pplying ing 6am 6amee Theor Theory y to 8rici 8ricing ng Stra Strateg tegies ies"" #n #n exampl examplee of the the use of of game game theory theory is is presen presented ted.. 0See 0See igur iguree )12).3 )12).3 &. !pportuni !pportunistic stic +ehavior +ehavior"" #ction #ctionss that that ignore ignore possibl possiblee long7r long7run un benefi benefits ts of of coopera cooperation tion and focus focus solely solely on short7 short7run run gains. gains. This kind of behavior can be contrasted to tit7for7tat strategic behavior when repeat transactions are likely. 9ere a player will behave well as long as others do likewise.
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I:. 8rice /igidity and the ;inked 5emand &urve" #ssume that rivals will match all price decreases 0in order not to be undersold3 but not price increases 0because they want to capture more business3. There is no collusion. The implications of this reaction function are rigid prices and a kinked demand curve. #. (ature of the ;inked 5emand &urve" #n oligopoly firm will assume that if it lowers price, rivals will react by matching that reduction to avoid losing their respective shares of the market. The oligopolist lowering the price will not greatly increase its %uantity demanded and total revenues will fall. If it increases price, rivals will not follow. Thus, a higher price will cause %uantity demanded to decease rapidly and total revenues will fall. There is a kink in the demand curve. The resulting marginal revenue curve has a discontinuous portion. 0See igure )12-.3 +. 8rice /igidity" The kinked demand curve analysis may help explain why price changes might be infre%uent in an oligopolistic industry without collusion. $ach oligopolist can only expect lower revenues if it changes price. 0See igure )12-.3 '. # +reak in the arginal /evenue &urve" # theoretical reason for price inflexibility under the kinked demand curve model has to do with the discontinuous portion of the marginal revenue curve. #s long as the marginal cost curve passes through the discontinuity, the firm will not change price. 0See igure )12<.3 ). # Theory of 8rice /igidity" #s long as the marginal cost curve is in the discontinuous portion of the firm*s marginal revenue curve neither price nor %uantity will change since the price and %uantity are at the profit maximizing level. 0See igure )12<.3 &. &riticisms of the ;inked 5emand &urve" If every oligopolistic firm faced a kinked demand curve, it would not pay to change prices. The problem is that the kinked demand curve does not show us how supply and demand originally determined the going price of an oligopolist*s product. !ligopoly prices do not appear to be as rigid, particularly in the upward direction, as the kinked demand curve theory implies. :. Strategic +ehavior with Implicit &ollusion" # odel of 8rice =eadership" 8rice leadership is a model of a pricing practice in many oligopolistic industries and is a form of tacit collusion. #. The Theory of 8rice =eadership" The largest firm publishes its price list ahead of its competitors, who then follow those prices. This is also called parallel pricing. +y definition, price leadership re%uires one firm to be the leader. +ecause of laws against collusion, firms in an industry cannot communicate who the price leader will be directly. That is why the largest firm often becomes the price leader. +. 8rice ars" 8rice leadership may not always work. If the price leader ends up much better off than those firms that follow, they may not set prices according to the dominant firm. # price war may result. # price war is a pricing campaign designed to capture additional market share by repeatedly cutting prices. :I. 5eterring $ntry into an Industry" #n important part of game playing has to do with how potential competitors might react to a decision. $xisting firms in an industry devise strategies to deter entrance into that industry. +y getting a local, state, or federal government to restrict entry, or by adopting certain pricing and investment strategies they may deter the entrance of new firms. #. Increasing $ntry &osts" #ny strategy undertaken by firms in an industry with the intent or effect of raising the cost of entry into the industry by a new firm. To sustain a long price war, existing firms might invest in excess capacity so that they may expand output during the price war, thus signaling potential competitors that they will engage in a price war. $xisting domestic firms can also raise the cost of entry by foreign firms by getting the 4.S. government to pass stringent environmental or health and safety standards. +. =imit78ricing Strategies" The existing firms may lower their market price until they sell the same %uantity as before a new firm entered the industry. $xisting firms limit their price to be above competitive prices, but if there is a new entrant, the new limit price will be below the one at which a new firm can make a profit. The limit7pricing model is a model that hypothesizes a group of colluding sellers who together set the highest common price they believe they can charge without new firms seeking to enter the industry. &. /aising &ustomers* Switching &osts" If an existing firm can make it more costly for customers to switch from its product or service to a competitor*s, the existing firm can deter entry. In the computer industry switching costs were high because computer operating systems were not compatible across computer operating systems. :II. (etwork $ffects" This is a situation in which a consumer*s willingness to purchase a good or service is influenced by how many others also buy the item. #.
(etwork $ffects and arket eedback 2
'. 8ositive arket eedback" # tendency for a good or service to come into favor with additional consumers because other consumers have chosen to buy the item. ). (egative arket eedback" # tendency for a good or service to fall out of favor with more consumers because other consumers have stopped purchasing the item. +. (etwork $ffects and Industry &oncentration" In some industries a few firms can reap the benefits of positive market feedback. These firms can then capture the bulk of the sales in the market. :III.
&omparing arket Structures" arket structures are compared in Table )12-.
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