Chapter 25 Oligopoly Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-1 Chapter Objectives • • • • • Concentration Ratios The Herfindahl-Hirschman index The competitive spectrum The kinked demand curve Administered prices Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-2 Oligopoly Defined • An oligopoly is an industry with just a few sellers • How few? So few that at least one firm is large enough to influence price Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-3 Oligopoly • Oligopoly is the prevalent type of industrial competition in the United States as well as in most of the noncommunist industrial west • In terms of production, the vast majority of our GDP is accounted for by firms in oligopolistic industries Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-4 Oligopoly • The crucial factor under oligopoly is the small number of firms • Because there are so few firms, every competitor must think continually about the actions of its rivals – What each does could make or break the others • Thus, there is a kind of interdependance among oligopolists Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-5 Oligopoly • When we talk about big business in the United States,we’re talking about oligopolies. Some examples are – GM, Ford, ExxonMobil, IBM, Boeing, CBS, NBC, Kellog, and General Mills – We can also include all the other industrial giants that have become household names Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-6 Oligopoly • The graph of the oligopolist is similar to that of the monopolist – The oligopolist is analyzed in the same manner as the monopolist with respect to price, output, profit, and efficiency – Price is higher than the minimum point of the ATC curve, therefore the oligopolist is not as efficient as the perfect competitor – The oligopolist has a higher price and a lower output than does the perfect competitor – The oligopolist, like the monopolist, makes a profit Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-7 Concentration Ratios • The concentration ration is the percentage share of industry sales of the four leading firms in the industry – Industries with high concentration ratios are very oligopolistic Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-8 Calculate the Concentration Ratio Firm Percent of sales A 14 % B 4 C D The concentration ratio is 23 + 17 + 15 + 14 = 69 23 5 E 2 F 8 G 17 H 10 I 2 J 15 Total 100 % Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-9 Concentration Ratio Shortcomings • Concentration ratios do not include imports – This ignores 2 million Japanese imports as well as the hundreds of thousands of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royces the United States imports • Concentration ratios tell us nothing about the competitive structure of the rest of the industry – Are all the firms relatively large or are they small? – When the remaining firms are large, they are not as easily dominated by the top four as are dozens of relatively small firms Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-10 Concentration Ratio Shortcomings • Concentration rations have become less meaningful as imports have increased – The United States gets 80% of its consumer electronics and 53% of its oil from abroad • Imports tend to make the automobile industry’s concentration ration less relevant – Transplants reduce this ratio – As a result, the American car buyers have reaped the benefits of lower prices and much higher quality Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-11 Herfindahl- Hirschman Index (HHI) • The HHI is the sum of the squares of the market shares of each firm in the industry – A monopoly has 100 percent of the market share 2 100 = (100 X 100) = 10,000 You can’t get a bigger HHI number than 10,000. Every monopoly would have an HHI of 10,000 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-12 Herfindahl- Hirschman Index (HHI) • The HHI is the sum of the squares of the market shares of each firm in the industry Find the HHI in an industry with just two firms Each firm has 50 percent of the market 2 2 50 + 50 = 2,500 + 2,500 = 5,000 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-13 Herfindahl- Hirschman Index (HHI) • The HHI is the sum of the squares of the market shares of each firm in the industry Find the HHI in an industry that has four firms Each firm has 25 percent of the market 2 2 2 2 25 + 25 + 25 + 25 625 + 625 + 625 + 625 2500 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-14 The Competitive Spectrum Cartel Open collusion Covert collusion Price leadership Weak Strong Cutthroat competition competition competition The possible degrees of competition in an oligopolistic market Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-15 Cartels • A cartel is a combination of firms that acts as if it were a monopoly – The leading firms in an industry band together to restrict output, share out markets and, consequently, increase prices and profits – If the demand is there, oligopolistic firms can openly collude to control supply and, to a large degree, market price – OPEC did this in 1973 when the price of oil quadrupled – A cartel is the most extreme case of oligopoly Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-16 Withholding Supply to Raise Price S2 P2 S1 P1 D Quantity When supply is lowered from S1 to S2, price rises from P1 to P2 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-17 Open Collusion • Open collusion operates like the alleged Mafia – This would be some type of territorial division of the market among the firms in the industry • This type of arrangement gives each firm in the market a regional monopoly • The firm may have only 15 or 20% of the market, but under this type of arrangement, its pricing behavior is that of the monopolist – Open collusion is slightly less extreme than a cartel Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-18 The Colluding Oligopolist 120 MC 105 90 ATC 75 60 D 40 35 MR 30 25 0 100 200 300 Output 400 500 600 This graph could also belong to the monopolist or the monopolistic competitor in the short run 25-19 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Covert Collusion • This usually involves price-fixing – In the late 1950s General Electric, Westinghouse, Allis-Chalmers and other leading electrical firms conspired to fix the price of electrical transformers, turbines, and other electrical equipment – They rigged government bids by taking turns making (high) low bids bilking the public of hundreds of millions of dollars • In 1961 the U.S. Supreme court found 7 high ranking corporate officials guilty of illegal price fixing and market sharing agreements • Their employers paid their fines • They got short jail sentences • Their employers paid their salaries while in jail, and they got their old job back after they got out Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-20 Other Cases of Collusion • In 1996 Archer Daniels Midland Company pleaded guilty and paid a $100 million criminal fine for its role in two international price-fixing conspiracies • In 1999 an arrangement was uncovered that fixed worldwide vitamin prices as much as 25% above the market level • A worldwide price-fixing conspiracy led by Swiss and German companies was prosecuted by the U.S Department of Justice Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-21 Price Leadership • Price leadership is playing follow the leader – One company raises prices and shortly after, the other companies in the same market do the same • The prime rate set by the big banks is a form of price leadership • Collusion is most likely to succeed when there are few firms and high barriers to entry Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-22 Cutthroat Competition • Cutthroat competition is an extreme case • The cutthroat competitor’s actions are based on assumptions about their rivals behavior • The cutthroat competitor assumes that if I raise my price my competitors won’t raise their price • The cutthroat competitor assumes that if I lower my price, my competitors will also lower their price • Therefore the cutthroat competitor keeps the price just where it is Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-23 The Cutthroat Oligopolist 48 MC 44 40 36 32 ATC 28 24 20 D 16 12 8 4 MR 0 1 2 3 4 Output 5 6 7 No cutthroat oligopolist will raise or lower price. It keeps the price just where it is and that is at the kink in the demand curve Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-24 The Cutthroat Oligopolist 48 MC 44 40 36 32 Price is $27 ATC 28 24 20 D 16 12 8 4 MR 0 1 2 3 4 Output 5 6 7 At an output of 4 MC=MR How much is the price and output for this firm? Output is 4 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-25 The Cutthroat Oligopolist 48 MC 44 40 36 32 Price is $27 ATC is $24 ATC 28 24 20 D 16 12 8 4 MR Total Profit = (Price – ATC) X Output = ($27 – 24) X 4 = 3 X 4 = 12 0 1 2 3 4 Output 5 6 7 At an output of 4 MC=MR Output is 4 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-26 Conclusion Cartel Open collusion Covert collusion Price leadership Weak Strong Cutthroat competition competition competition At one of the spectrum we have the cartel, which no longer operates within the American economy, although it may be found in world markets At the other end of the spectrum, we have the cutthroat competitor, the firm that will stop at nothing to beat out its rivals Near the middle are the mildly competing oligopolists and the occasionally cooperating oligopolists. Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-27 Conclusion Cartel Open collusion Covert collusion Price leadership Weak Strong Cutthroat competition competition competition Where is the spectrum in American industry? The answer is that there is no answer. First, there is no one place where American industry is located because different industries have different competitive situations. Second, there is widespread disagreement about the degree of competition in any given industry Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 25-28