Chapter 9 Market Structure: Oligopoly

1 Economics for Managersby Paul FarnhamyChapter 9 Market Structure: 2005 Prentice Hall, Market structure characterized byA Market structure characterized by competition among a small number of large firms that have gmarket power, but that must take their rivals actions into idtihdliconsideration when developing their competitive 2005 Prentice Hall, Olilof an Oligopoly Firms have Market power derived from barriers to entryy However, a small number of firms compete with each othercompete with each other Each firm doesn t have to consider the actions of otherconsider the actions of other firms, thus, behavior is 2005 Prentice Hall, Olil M d lOligopoly ModelsAssumes that firms pursue profit-maximizing strategies based on ggassumptions about rivals behavior and the impact of this behavior on thifi t tithe given firm s strategies demand curve theory models3 Strategic entr 2005 Prentice Hall, entry deterrenceKinked Demand C MdlCurve Model Assumes that a firm is faced with two demand curves, assuming fthat other firms will not match price increases but will match price decreasesprice decreases If the firm considers raising the price above P1, its quantity demanded will depend upon the beha ior of ri al 2005 Prentice Hall.

2 Of rival firmsKinked Demand C MdlCurve Model Assumes that managers will inflict maximum damage on other firmsg Implies Oligopoly prices tend to be sticky and not change asbe sticky and not change as they would in other Market structures Does not explain why price P1exists 2005 Prentice Hall, initiallyKinked Demand CurveKinked Demand CurveFigure Rivals don t followQ0QD1= rivals 2005 Prentice Hall, Theory ModelsGame Theory Models Mathematically analyzes situations in which players make various strategic moves and have different outcomes ormoves and have different outcomes or payoffs associated with those moves Dominant strategy: results in best oatstategyesu tsbestoutcome to a given 2005 Prentice Hall, EquilibriumNash Equilibrium Strategies for which all players are choosing their best strategy, ggy,given actions of other players Proves useful when there is onlyProves useful when there is only one unique equilibrium in the gameg There may be multiple Nash 2005 Prentice Hall, Entry DtDeterrencePolicies that prevent rivals from entering the marketg Limit pricing: charging a price lower than the profit-maximizinglower than the profitmaximizing price Predatory pricing: lowering pricesPredatory pricing.

3 Lowering prices below cost to drive out existing competitors and scare off 2005 Prentice Hall, entrantsLimit Pricing ModelLimit Pricing ModelFigure EntrantATCE stablished FirmMCATCEN 2005 Prentice Hall, Pricing ModelLimit Pricing Model Assumes existing firms have lower costs Attracts other firms into the industryindustry Established firms can thwart entry by charging the limit price (or aby charging the limit price (or a lower price) rather than profit-maximization 2005 Prentice Hall, pricePredatory PricingPredatory PricingFigure = 2005 Prentice Hall, of Successful Pdt PiiPredatory Pricing How far the predatory price is below cost Period of time in which the predatory price is in effectRate of return used for judging the Rate of return used for judging the investment in predatory pricing How many rivals enter the industry How many rivals enter the industry after predation ends Time over which recouping of profits 2005 Prentice Hall, poccursCooperative Oligopoly MdlModels Focus on cooperative behavior among rivalsg Two typesCtl Cartels Tacit 2005 Prentice Hall.)

4 Firms that get together and agree to coordinate behavior regarding pricing and output decisionsand output decisions Joint profit maximization: strategy that maximizes profits for a cartel but may aesp o ts o aca te but aycreate incentives for individual members to cheatHi tlti fi l t Horizontal summation of marginal cost curve: calculated from marginal cost curve for the 2005 Prentice Hall, Rule for Joint P fit M i i tiProfit MaximizationMC1= MC2= MC3whereMCFi#1 iltMC2=Firm #2 s marginal costMC1= Firm #1 s marginal costMC2 Firm #2 s marginal costMCC= Cartel s marginal 2005 Prentice Hall, a Carteli Sf lis Successful It can raise Market price without inducing significant competition ftlbfrom non-cartel members The expected punishment from fith tlil ltiforming the cartel is low relative to the expected gainsThtft bli hid The costs of establishing and enforcing agreement are low relative to the 2005 Prentice Hall, to the gains Tacit CollusionTacit Collusion Tacit collusion.

5 Coordinated behavior that is an achieved without a formal agreementagreement Tacit collusion practices:Uniform prices Uniform prices Penalty for price discountsAdvantage notice of price changes Advantage notice of price changes Information exchangesSwaps and 2005 Prentice Hall, Inc. Swaps and exchangesManagerial Rule of Thumb: didiCoordinated ActionsManagers must Coordinate efforts, but withinCoordinate efforts, but within constraints of antitrust legislation Recognize incentives for cheating ggin coordinated behavior Remember that even coordinated fffliihefforts are fleeting, given the dynamic and competitive nature of a Market 2005 Prentice Hall, Market environment Summary of Key TermsSummary of Key TermsCtl Cartel Cooperative Oligopoly models Dominant strategy Game theory Game theory Horizontal summation of marginal cost curvescost curves Joint profit 2005 Prentice Hall, Inc.

6 Kinked demand curve modelSummary of Key TermsSummary of Key TermsLimit pricing Limit pricing Nash equilibrium Noncooperative Oligopoly models Oligopolygy Predatory pricing Strategicentry deterrenceStrategic entry deterrence Tacit 2005 Prentice Hall, you haveany questions? 2005 Prentice Hall, Inc.