PRINCIPLES OF MICROECONOMICS Wajid Ali Qureshi
1
CHAPTER 14
Oligopoly and Strategic Behavior
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CHAPTER CONTENTS
Oligopoly
Oligopoly Behavior: A Game-Theory Overview
Three Oligopoly Models
Oligopoly and Advertising
Oligopoly and Efficiency
Game Theory and Strategic Behavior
14-3
OLIGOPOLY
A few large producers
Homogeneous oligopoly
Differentiated oligopoly
Limited control over price
Strategic behavior
Mutual interdependence
Entry barriers and mergers
14-4
LO14.1
OLIGOPOLISTIC INDUSTRIES
Four-firm concentration ratio: 40% or more to be an
oligopoly
Shortcomings
Localized markets
Interindustry competition
Import competition
Dominant firms
14-5
LO14.1
PERCENTAGE OF OUTPUT PRODUCED BY FIRMS IN SELECTED HIGH-
CONCENTRATION U.S. MANUFACTURING INDUSTRIES
(2) (2)
Percentage of (3) Percentage of (3)
Industry Output Herfindahl Industry Output Herfindahl
(1) Produced by the Index for the Top 50 (1) Produced by the Index for the
Industry Four Largest Firms Firms Industry Four Largest Firms Top 50 Firms
Household laundry equipment 100 ND︎ Primary aluminum 74 2,089
Household refrigerators and freezers 93 ND︎ Tires 73 1,531
Cigarettes 88 2,897 Bottled water 71 1,564
Beer 88 3,561 Gasoline pumps 70 1,611
Glass containers 86 ND Bar soaps 70 2,250
Phosphate fertilizers 85 3,152 Burial caskets 69 1,699
Small-arms ammunition 84 2,848 Printer toner cartridges 67 1,449
Electric light bulbs 84 3,395 Alcohol distilleries 65 1,394
Aircraft 80 3,287 Turbines and generators 61 1,263
Breakfast cereals 79 2,333 Motor vehicles 60 1,178
Aerosol cans 75 1,667 Primary copper 50 879
14-6
LO14.1
OLIGOPOLY BEHAVIOR
Game theory
Collusion
Incentive to cheat
Prisoner’s dilemma
14-7
LO14.2
PROFIT PAYOFF (IN MILLIONS) FOR A TWO-FIRM OLIGOPOLY (1 OF 2)
RareAir’s price strategy
•2 competitors High Low
•2 price strategies
Uptown’s price strategy
A B
•Each strategy has a $12 $15
payoff matrix. High
$12 $6
•Greatest combined
profit
•Independent actions C D
$6 $8
stimulate a response. Low
$15 $8
LO14.2 14-8
Profit Payoff (in Millions) for a Two-Firm Oligopoly (2 of 2)
RareAir’s price strategy
•Independently High Low
lowered prices in
Uptown’s price strategy
expectation of A $12
B
$15
greater profit leads High
to worst combined $12 $6
outcome.
•Eventually low C D
$6 $8
outcomes make firms Low
return to higher $15 $8
prices.
14-9
LO14.2
THREE OLIGOPOLY MODELS
Kinked-demand curve
Collusive pricing
Price leadership
Reasons for three models:
• Diversity of oligopolies
• Complications of interdependence
14-10
LO14.3
KINKED-DEMAND THEORY
Non-collusive oligopoly
Uncertainty about rivals’ reactions:
• Rivals match any price change.
• Rivals ignore any price change.
Assume combined strategy:
• Match price reductions.
• Ignore price increases.
14-11
LO14.3
KINKED-DEMAND
The CURVE
Kinked-Demand Curve
Rivals ignore
price increase
Price and costs
D2 MC1
e P0 MR2 e
Price
P0
f f MC2
D2
MR2 g
Rivals match g
price decrease D1 D1
0 Q0 MR1 0 Q0 MR1
Quantity Quantity
(a) (b)
14-12
LO14.3
KINKED-DEMAND CRITICISMS
Criticisms of this model
• Explains inflexibility, not price
• Prices are not that rigid
• Price war
14-13
LO14.3
COLLUSION AND THE TENDENCY TOWARD JOINT-PROFIT MAXIMIZATION
MC
Price and costs
ATC
P0
A0
MR = MC
Economic D
profit
MR
0 Q0
Quantity
14-14
LO14.3
OVERT COLLUSION
A cartel is a group of firms or nations that collude:
• Formally agreeing to the price.
• Sets output levels for members.
Collusion is illegal in the United States.
OPEC.
14-15
LO14.3
GLOBAL PERSPECTIVE 14.1: OPEC NATIONS
14-16
LO14.3
Source: BP Statistical Review of World Energy, BP p.l.c., 2018.
OBSTACLES TO COLLUSION
Demand and cost differences
Number of firms
Cheating
Recession
New entrants
Legal obstacles
14-17
LO14.3
PRICE LEADERSHIP MODEL
Price leadership
• Dominant firm initiates price changes.
• Other firms follow the leader.
Use limit pricing to block entry of new firms.
Possible price war.
14-18
LO14.3
OLIGOPOLY AND ADVERTISING
Oligopolies commonly compete through product
development and advertising.
• Less easily duplicated than a price change,
• Financially able to advertise.
14-19
LO14.4
POSITIVE EFFECTS OF ADVERTISING
Low-cost way of providing information to consumers.
Enhances competition.
Speeds up technological progress.
Can help firms obtain economies of scale.
14-20
LO14.4
THE LARGEST U.S. ADVERTISERS, 2018
Advertising Spending
Company Millions of $
Comcast $6,122
AT&T 5,362
Amazon 4,470
Proctor & Gamble 4,305
General Motors 3,139
Disney 3,132
Charter 3,042
Alphabet (Google) 2,960
American Express 2,798
Verizon 2,682
14-21
LO14.4
Source: Leading National Advertisers 2019 Fact Pack, Ad Age.
NEGATIVE EFFECTS OF ADVERTISING
Can be manipulative.
Contain misleading claims that confuse consumers.
Consumers may pay high prices for a good while
forgoing a better, lower priced, unadvertised version
of the product.
14-22
LO14.4
TOP TEN BRAND NAMES
14-23
LO14.4
Source: “Leading National Advertisers 2019 Fact Pack,” Ad Age
OLIGOPOLY AND EFFICIENCY
Oligopolies are inefficient:
• Productively inefficient because P > min ATC
• Allocatively inefficient because P > MC
Qualifications:
• Increased foreign competition
• Limit pricing
• Technological advance
14-24
LO14.5
A ONE-TIME GAME: STRATEGY
A one-time game
A simultaneous game
A positive-sum game
• Zero-sum game
• Negative-sum game
A firm’s dominant strategy
14-25
LO14.6
A ONE-TIME GAME: EQUILIBRIUM
Nash equilibrium
Outcome from which neither firm wants to deviate
Current strategy viewed as optimal
Stable and persistent outcome
14-26
LO14.6
A ONE-TIME GAME
Dramco’s strategies
•2 competitors International National
•2 price strategies A $11
B
$5
International
Chipco’s strategies
•Each strategy has a $11 $20
payoff matrix
•Independent actions C $20 D $17
National
stimulate a response
$17
$5
14-27
LO14.6
CREDIBLE AND EMPTY THREATS
Credible threats:
• Threat that is believable by the other firm.
• Can establish collusive agreements.
• A strong enforcer can prevent cheating.
• Can generate higher profits.
• May be countered with threat by rival.
Empty threats:
• A threat that is not believable by rival.
14-28
LO14.6
REPEATED GAMES
Repeated game is a game that recurs.
May cooperate and not compete strongly.
Rival reciprocates.
Examples:
• Coca-Cola and Pepsi
• Boeing and Airbus
• Walmart and Target
• Nike and Adidas
14-29
LO14.6
A REPEATED GAME WITH RECIPROCITY
ThirstQ’s advertising strategy ThirstQ’s advertising strategy
Promotional budget Normal budget Promotional budget Normal budget
Promotional budget
Promotional budget
2Cool’s advertising strategy
2Cool’s advertising strategy
A $10
B A $11
B
$8 $10
$10 $16 $11 $14
C D C D
Normal budget
Normal budget
$16 $12 $15 $13
$12 $13
$8 $10
(a) 2Cool introduces Cool Cola (b) ThirstQ introduces Quench It
14-30
LO14.6
A FIRST-MOVER ADVANTAGE AND THE PREEMPTION OF ENTRY
Big Box strategies
Build Don’t Build
A B
−$5 $0
Huge Box strategies
Build
−$5 $12
C $12 D $0
Don’t Build
$0
$0
14-31
LO14.6