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Oligopoly
• Characteristics of oligopoly– Small number of firms– Interdependence
• Strategic dependence
• Whatever you do, I shall do –the zero percent financing
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Oligopoly
• Strategic Dependence– A situation in which one firm’s actions
with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry
– LIKE PLAYING CHESS
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Oligopoly
• Why oligopoly occurs– Economies of scale– Barriers to entry– Mergers
• Vertical mergers• Horizontal mergers
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Oligopoly
• Vertical Merger– The joining of a firm with another to which it
sells an output or from which it buys an input
• Horizontal Merger– The joining of firms that are producing
or selling a similar product
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Oligopoly
• Measuring industry concentration– Concentration Ratio
• The percentage of all sales contributed by the leading four or leading eight firms in an industry
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Computing the Four-Firm Concentration Ratio
Annual SalesFirm ($ Millions)
1 1502 1003 804 705 through 25 50
Total 450
Total numberof firms inIndustry = 25
Four-firm concentration ratio =450
40088.9%
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Computing the Four-Firm Concentration Ratio
Percentage of Value of TotalDomestic Shipments Accounted
Industry For By the Top Four Firms %
Domestic motor vehicles 84
Breakfast cereals 85
Soft drinks 69
Tobacco products 93
Primary aluminum 59
Household vacuum cleaners 59
Electronic computers 45
Printing and publishing 23
Source: U.S. Bureau of the Census
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Models of Oligopoly
• Game Theory– A way of describing the various possible
outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly
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Game Theory
• Cooperative Game– A game in which the players explicitly cooperate to make
themselves better off• Noncooperative Game
– A game in which the players neither negotiate nor cooperate in any way
• Zero-Sum Game– A game in which any gains
within the group are exactly offset by equal losses by the end of the game
• Negative-Sum Game– A game in which players as a group
lose at the end of the game
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Strategic Behaviorand Game Theory
• Positive-Sum Game– A game in which players as a group
are better off at the end of the game
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Strategic Behaviorand Game Theory
• Strategies in noncooperative games– Strategy
• Any rule that is used to make a choice• Any potential choice that can be made
by players in a game
– Dominant Strategies• Strategies that always yield the highest benefit
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Prisoner’s Dilemma
• You and your partner rob a bank and get caught.
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Prisoner’s Dilemma
• You are separated and given these options:– Both confess and get 5 years in jail– Neither confess and get 2 years– One confess and the other does not
• Confessor goes free• One who does not confess get 10 years
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The Prisoners’ Dilemma Payoff Matrix
Figure 25-3
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Strategic Behaviorand Game Theory
• Applying game theory to pricing strategies– Would you choose a high price
or a low price?• Remember
– No collusion
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Strategic Behaviorand Game Theory
Figure 25-4
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Strategic Behaviorand Game Theory
• Opportunistic Behavior– Actions that ignore the possible long-run
benefits of cooperation and focus solely on short-run gains
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Strategic Behaviorand Game Theory
• Opportunistic behavior– Implies a noncooperative game– Not realistic
• We make repeat transactions
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Strategic Behaviorand Game Theory
• Tit-for-Tat Strategic Behavior– In game theory, cooperation that continues
so long as the other players continue to cooperate
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• Pakistan agreed to certain conditions for an IMF loan– In 1999, the IMF discovered that Pakistan
had spent much of this loan on the development of nuclear weapons
– Soon, Pakistan had to default on its debt
• Why would Pakistan engage in this behavior with the IMF?
International Example:Strategically Relating Subsidies to Nuclear
Weapons
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d1 is relatively elastic• if one firm raises itsprice the others will notand it will lose marketshare
d2 is relatively inelastic• if one firm lowers itsprice the others lowertheir price so gain in salesis small
Price Rigidity and the Kinked Demand Curve
Figure 25-5, Panel (a)
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The kinked demand curve indicates the possibility of price rigidity
Price Rigidity and the Kinked Demand Curve
Figure 25-5, Panel (b)
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Price Rigidity and theKinked Demand Curve
Figure 25-6
Changes in cost donot impact outputand prices as long as MC remains in thevertical portion of MR
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d1
d2
MR2
P0
q0
Criticisms of theKinked Demand Curve
Quantity per Time Period
Pri
ce a
nd
Mar
gin
al R
even
ue
per
Un
it
MR1
• Cannot determine P0
• Empirical evidence does not confirm the kinked demand theory
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Strategic Behavior
• Do pet products have nine lives?– H.J. Heinz’s Pet Products Company
• Dropped its price of 9-Lives cat food by 22% to meet increased competition from Nestle, Quaker, Grand Metropolitan, and Mars
• Heinz then decided to raise prices• Its competition did not and Heinz’s market share
dropped from 23 to 15 percent
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• Price Leadership– A practice in many oligopolistic industries in
which the largest firm publishes its price list ahead of its competitors, who then match those announced prices
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
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• Price War– A pricing campaign designed to drive
competing firms out of a market by repeatedly cutting prices
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
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• Markets where price wars are common– Cigarettes– Long-distance telephone companies– Airlines
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
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• Markets where price wars are common– Diapers– Frozen foods– PC hardware and software
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
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• Cigarette price wars– Philip Morris cut Marlboro
by 40 cents a pack– RJR Nabisco matched the cut for Camel– Marlboro’s market share rose
from 22.1% to 27.3%– Profits and stock prices fell
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
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• Cigarette price wars– Phillip Morris reduced prices by 18%
and sales went up by only 12.5% • Profits fell by 25%
Strategic Behavior with Implicit Collusion: A Model of Price Leadership
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• Entry Deterrence Strategy– Any strategy undertaken by firms in an
industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm
Deterring Entry Into an Industry
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• Increasing entry cost– Threat of price wars– Government regulations
• Environmental regulation• Safety standards
Deterring Entry Into an Industry
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• Limit-Pricing Strategies– A model that hypothesizes that a group
of colluding sellers will set the highest common price that they believe they can charge without new firms seeking to enter that industry in search of relatively high profits
Deterring Entry Into an Industry
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• Raising customer’s switching cost– Examples
• Non-compatible software• Non-transferability of college courses
Deterring Entry Into an Industry