Microeconomics
ECON 2302
Summer I, 2011
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 13
CHAPTER
13
Oligopoly:
Firms in Less
Competitive Markets
Today, in the software and
computer industries, fewer
than 10 firms account for
the great majority of sales.
CHAPTER
13
Oligopoly: Firms in Less Competitive Markets
Chapter Outline and Learning Objectives
13.1 Oligopoly and Barriers to Entry
Show how barriers to entry explain the existence of
oligopolies.
13.2 Using Game Theory to Analyze Oligopoly
Use game theory to analyze the strategies of oligopolistic
firms.
13.3 Sequential Games and Business Strategy
Use sequential games to analyze business strategies.
13.4 The Five Competitive Forces Model
Use the five competitive forces model to analyze
competition in an industry.
Oligopoly: Firms in Less Competitive Markets
Oligopoly A market structure in which a small number
of interdependent firms compete.
13.1 LEARNING OBJECTIVE
Show how barriers to entry explain the existence of oligopolies.
Oligopoly and Barriers to Entry
Table 13-1 Examples of Oligopolies in Retail Trade and Manufacturing
RETAIL TRADE
MANUFACTURING
FOUR-FIRM
CONCENTRATION
RATIO
INDUSTRY
FOUR-FIRM
CONCENTRATION
RATIO
INDUSTRY
Discount department stores
95%
Cigarettes
95%
Warehouse clubs and
supercenters
92%
Beer
91%
72%
Aircraft
81%
Athletic footwear stores
71%
Breakfast cereal
78%
College bookstores
70%
Automobiles
76%
Radio, television, and other
electronic stores
69%
Pharmacies and drugstores
53%
Hobby, toy, and game stores
75%
Computers
Dog and cat food
64%
Oligopoly and Barriers to Entry
Barrier to entry Anything that keeps new firms from
entering an industry in which firms are earning economic
profits.
Barriers to Entry: 1. Economies of Scale
An industry will be
competitive if the
minimum point on
the typical firm’s
long-run average cost
curve (LRAC1) occurs
at a level of output
that is a small
fraction of total
industry sales, such
as Q1.
The industry will be
an oligopoly if the
minimum point
comes at a level of
output that is a large
fraction of industry
sales, such as Q2.
FIGURE 13-1 Economies of Scale Help Determine the Extent of Competition in an Industry
Barriers to Entry, cont.
1. Economies of scale The situation when a firm’s long-run
average costs fall as it increases output.
2. Ownership of a Key Input
If production of a good requires a particular input,
then control of that input can be a barrier to entry.
3. Government-Imposed Barriers
Patent The exclusive right to a product for a period of
20 years from the date the product is invented.
Other government-imposed barriers?
13.2 LEARNING OBJECTIVE
Use game theory to analyze the strategies of oligopolistic firms.
Using Game Theory to Analyze Oligopoly
Game theory The study of how people make decisions
in situations in which attaining their goals depends on
their interactions with others; in economics, the study of
the decisions of firms in industries where the profits of
each firm depend on its interactions with other firms.
Using Game Theory to Analyze Oligopoly
All games share three key characteristics:
1. Rules that determine what actions are allowable
2. Strategies that players employ to attain their
objectives in the game
3. Payoffs that are the results of the interaction among
the players’ strategies
Business strategy Actions taken by a firm to achieve a goal,
such as maximizing profits.
Game Theory to Analyze Oligopoly
HP’s profits are in
blue, and Apple’s
profits are in red.
HP and Apple
would each make
profits of $10
million per month
on sales of desktop
computers if they
both charged
$1,200.
However, each firm
has an incentive to
undercut the other
by charging a lower
price.
If both firms charge
$1,000, they would
each make a profit
of only $7.5 million
per month.
A Duopoly Game:
Price Competition between Two Firms
FIGURE 13-2
A Duopoly Game
Using Game Theory to Analyze Oligopoly
Duopoly Game: Price Competition between 2 Firms
Payoff matrix A table that shows the payoffs that each firm
earns from every combination of strategies by the firms.
Collusion An agreement among firms to charge the same
price or otherwise not to compete.
Dominant strategy A strategy that is the best for a firm,
no matter what strategies other firms use.
Nash equilibrium A situation in which each firm chooses
the best strategy, given the strategies chosen by other
firms.
Using Game Theory to Analyze Oligopoly
Firm Behavior and the Prisoner’s Dilemma
Cooperative equilibrium An equilibrium in a game
in which players cooperate to increase their mutual
payoff.
Noncooperative equilibrium An equilibrium in a game
in which players do not cooperate but pursue their own
self-interest.
Prisoner’s dilemma A game in which pursuing dominant
strategies results in noncooperation that leaves everyone
worse off.
Solved Problem
13-2
Is Advertising a Prisoner’s Dilemma
for Coca-Cola and Pepsi?
Given that Coca-Cola is advertising, Pepsi’s best strategy is to advertise.
Therefore, advertising is the optimal decision for both firms, given the
decision by the other firm.
Making
Is There a Dominant Strategy
Connection for Bidding on eBay?
the
On eBay, bidding the maximum value you place
on an item is a dominant strategy.
Using Game Theory to Analyze Oligopoly
Can Firms Escape the Prisoner’s Dilemma?
Wal-Mart and Target can change
the payoff matrix for selling
PlayStation 3 game consoles by
advertising that they will match
their competitor’s P. This retaliation
strategy provides a signal that one
store charging a lower P will be
met automatically by the other
store charging a lower P.
In the payoff matrix in panel (a),
there is no matching offer, and each
store benefits if it charges $300
when the other charges $500.
In the payoff matrix in panel (b),
with the matching offer, the
companies have only 2 choices:
They can charge $500 and receive a
p of $10,000/month, or they can
charge $300 and receive a p of
$7,500/month. The equilibrium
shifts from the prisoner’s dilemma
result of both stores charging the
low P and receiving low p to both
stores charging the high P and
receiving high p.
FIGURE 13-3 Changing the Payoff Matrix in a Repeated Game
Using Game Theory to Analyze Oligopoly
Can Firms Escape the Prisoner’s Dilemma?
Yes, by engaging in cooperative strategies
Price leadership A form of implicit collusion in which
one firm in an oligopoly announces a price change and
the other firms in the industry match the change.
Tit for tat A form of implicit collusion in which all firms
in an oligopoly cooperate – on price or territory or
warranty or some other aspect of the product or service,
instead of competing If any one firm makes a
competitive move, then other firms reciprocate to
undercut the one who competes.
Making
American Airlines and Northwest Airlines
Connection Fail to Cooperate on a Price Increase
the
Airlines therefore
continually adjust their
prices while at the same time
monitoring their rivals’
prices and retaliating against
them either for cutting prices
or failing to go along with
price increases.
The airlines have trouble raising
the price that this business
traveler pays for a ticket.
Using Game Theory to Analyze Oligopoly
Cartels: The Case of OPEC
The blue line shows the
P of a barrel of oil in
each year.
The red line measures
the P of a barrel of oil in
terms of the purchasing
power of the $ in 2009.
By reducing oil
production, OPEC was
able to raise the world P
of oil in the mid-1970s
and early 1980s.
Sustaining high Ps has
been difficult over the
long run, however,
because members often
exceed their output
quotas.
Cartel A group of firms that collude
by agreeing to restrict output to
increase prices and profits.
FIGURE 13-4 Oil Prices, 1972 to mid–2009
Because Saudi Arabia
can produce much
more oil than Nigeria,
its output decisions
have a much larger
effect on the P of oil.
In the figure, Low
Output corresponds to
cooperating with the
OPEC-assigned output
quota, and High Output
corresponds to
producing at maximum
capacity.
Saudi Arabia has a
dominant strategy to
cooperate and produce
a low output.
Game Theory to Analyze Oligopoly
Cartels: The Case of OPEC
FIGURE 13-5
The OPEC Cartel with Unequal Members
Nigeria, however, has a dominant strategy not
to cooperate and instead produce a high output.
Therefore, the equilibrium of this game will
occur with Saudi Arabia producing a low output
and Nigeria producing a high output.
13.3 LEARNING OBJECTIVE
Use sequential games to analyze business strategies.
Sequential Games and Business Strategy
Deterring Entry
HP earns its highest
return if it charges
$600 for its netbook
and Apple does not
enter the market.
But at that P, Apple
will enter the market,
and HP will earn
only 16%.
If HP charges $275,
Apple will not enter
because Apple will
suffer an economic
loss by receiving
only a 5% return on
its investment.
Therefore, HP’s best
decision is to deter
Apple’s entry by
charging $275.
FIGURE 13-6
The Decision Tree for an Entry Game
HP will earn an economic profit by receiving a 20% return on its
investment. Note that the dashes indicate the situation where
Apple does not enter the market, and so makes no investment and
receives no return.
Solved Problem
13-3
Is Deterring Entry Always a Good Idea?
Deterrence is worth pursuing only if the payoff is higher than
for other strategies. In this case, expanding the market for
netbooks by charging a lower price has a higher payoff, even
given that Apple will enter the market.
Dell earns the
highest p if it
offers a contract
price of
$20/copy and
TruImage
accepts the
contract.
TruImage earns
the highest p if
Dell offers it a
contract of
$30/copy and it
accepts the
contract.
TruImage may
attempt to
bargain by
threatening to
reject a $20/copy
contract. But
Game Theory to Analyze Oligopoly
Bargaining
FIGURE 13-7
The Decision Tree for a Bargaining Game
Dell knows this threat is not credible because once Dell has offered a $20/copy contract,
TruImage’s profits are higher if it accepts the contract than if it rejects it.
13.4 LEARNING OBJECTIVE
Use the five competitive forces model to analyze competition in an industry.
The Five Competitive Forces Model
Michael Porter’s
model identifies 5
forces that
determine the
level of
competition in an
industry:
1. competition
from existing
firms,
2. the threat from
new entrants,
3. competition
from substitute
goods or services,
4. the bargaining
power of buyers,
and
5. the bargaining
power of
suppliers.
FIGURE 13-8
The Five Competitive Forces Model
The Five Competitive Forces Model
1. Competition from Existing Firms
Competition among firms in an industry can lower prices
and profits.
Competition in the form of advertising, better customer
service, or longer warranties can also reduce profits by
raising costs.
2. The Threat from Potential Entrants
Firms face competition from companies that currently are
not in the market but might enter. We have already seen
how actions taken to deter entry can reduce profits.
The Five Competitive Forces Model
3. Competition from Substitute Goods or Services
Firms are always vulnerable to competitors introducing
a new product that fills a consumer need better than
their current product does.
4. The Bargaining Power of Buyers
If buyers have enough bargaining power, they can insist
on lower prices, higher-quality products, or additional
services.
The Five Competitive Forces Model
5. The Bargaining Power of Suppliers
If many firms can supply an input and the input is
not specialized, the suppliers are unlikely to have
the bargaining power to limit a firm’s profits.
Making
Can We Predict Which Firms
Connection Will Continue to Be Successful?
the
Is it possible to draw
general conclusions
about which business
strategies are likely
to be successful in
the future?
Unfortunately, Circuit City’s
excellence as a company didn’t last.
AN INSIDE
LOOK
>> Hewlett-Packard Uses New Technology to Boost
Sales of Personal Computers
Dell decides whether to sell touch-sensitive personal computers.
KEY TERMS
Barrier to entry
Business strategy
Cartel
Collusion
Cooperative equilibrium
Dominant strategy
Economies of scale
Game theory
Nash equilibrium
Non-cooperative equilibrium
Oligopoly
Patent
Payoff matrix
Price leadership
Prisoner’s dilemma