Oligopoly: Strategic Decision Making and Interdependence

1
Oligopoly Strategic Decision Making and
Interdependence
2
Objectives of Discussion

• Discuss the managerial decision making process
  under Oligopoly
• Investigate possible strategies for oligopoly
  firms in different situations
• Discuss strategies and outcomes when oligopoly
  firms can compete and when they can cooperate
• Consider strategies to influence entry and exit
  in oligopoly markets

3
Oligopoly

• Small number of sellers, each with large capacity
  relative to total market demand
• Oligopolies may produce standardized (e.g. steel,
  aluminum, gasoline) or differentiated products
  (autos, cereals)
• Firms recognize interdependence between each
  others product, output and pricing decisions
• Barriers to entry in oligopolies
• economies of scale
• control of input markets

4
Strategic Decisions in Oligopoly

• Firms may decide on strategy without consulting
  with the other firms or by cooperating
• The outcome in the market is the result of the
  strategies chosen by all the firms
• The payoff to each firm is dependent on not
  just its strategy, but also the strategies chosen
  by competitors
• Two basic types of competition
• 1) Pricing ? Sweezy and Bertrand
• 2) Output ? Cournot and Stackelberg

5
Pricing Strategies in Oligopoly

• Since firms can compete on different levels and
  with respect to many choice variables no one
  model can fully capture oligopoly behavior. A
  common way for firms to compete is through
  pricing.
• Main difference between pricing strategy models
  is assumptions about type of product and
  cooperation between firms.

6
Sweezy Oligopoly and Rivals Reaction

• In a Sweezy oligopoly, a firms demand curve
  depends on how rivals match price changes for
  differentiated products.
• If rivals match, the demand curve is more
  inelastic (D1) because prices of substitutes are
  changing in same directions as firms prices
• If firms match price decreases but not increases,
  the demand curve is kinked ABD1 May lead to
  price rigidity because price increases penalize
  the firm and decreases are matched.
• Illustrates the importance of anticipating
  rivals reaction

7
Bertrand Oligopoly

• In a Bertrand oligopoly, firms set prices
  depending on the prices of their rivals for a
  homogeneous product. If firms cannot cooperate,
  would expect price cutting (price wars).
• Firms will cut prices so that P MC (same
  outcome as perfect competition).
• With pricing competition, output will be higher
  and profits lower than in any other type of
  oligopoly.
• With cooperation, firms could collude to set
  prices at monopoly level but face problems of
  maintaining agreement.

8
Output Competition and Reaction Functions

• A reaction function indicates the decision a
  firm would make based on the expected,
  simultaneous response from a rival no
  cooperation
• Reaction functions provide a schedule of actions
  that yield profit-maximizing decisions based on a
  rivals actions.
• In a Cournot oligopoly, changes in one firms
  output changes the marginal revenue for other
  firms. Increase in output by 1 firm lowers the
  profit maximizing level of others output
• QM1 monopoly profits for firm 1
• QM2 monopoly profits for firm 2
• Q1 and Q2 profit maximizing output assuming
  neither firm will change its output level
• E is a Cournot equilibrium neither firm expects
  to benefit from changing output

9
Cooperation and Collusion in Cournot Oligopoly

• Firms can benefit by agreeing to coordinate their
  output levels - output combinations along dotted
  line AB. Key issue is how to determine joint
  output and divide profits. Isoprofit lines
  indicate levels of profit (higher profits closer
  to monopoly output level)
• Output combinations E, D and F all yield higher
  levels of profits for both firms than at C. If
  they collude, both are better off. (In a duopoly
  with equal costs of production, firms split the
  market)
• Costs of collusion include organizational and
  bargaining costs as well as monitoring and
  enforcement (retaliation) costs.

10
Collusion and Cheating

• Every firm in a collusive agreement has an
  incentive to cheat and produce more output than
  the agreed level.
• If firm 1 produces at G rather than D, firm 1
  earns higher profits but firm 2 is worse off than
  at D (with collusion) or C (no cooperation).
• Cheating is easier if
• more firms
• detection and retaliation are difficult
• external sources of price fluctuations

11
A Dominant Firm with Followers (Stackelberg
Oligopoly)

• With a single firm that is a leader, the
  dominant firm selects its output level (makes a
  commitment) and other firms adjust based on their
  reaction functions.
• If the leader produces at S, the leader will earn
  higher profits than at the Cournot equilibrium C.
  Followers earn lower profits.

12
Other Strategies in Oligopoly (from Ch. 13, pp.
475 490)

• Other types of oligopoly strategies may be
  designed to deter entry and/or reduce
  competition.
• Limit Pricing Incumbent(s) prevents new
  entrants by committing to a price lower than the
  profit-maximizing (myopic) price. The residual
  demand for the entrant at the limit price would
  yield no profits.
• Expect same result if incumbent has cost
  advantage over rivals.
• Could also achieve same result with a
  credible threat to lower price.

13
Other Strategies in Oligopoly

• Predatory Pricing a firm commits to a price
  lower than its marginal cost to drive-out a rival
  or deter entry (e.g. grocery store chains). A
  similar result could occur with a credible threat
  to lower price. Illegal under Sherman Antitrust
  Act.
• Penetration Pricing entrant charges an initial
  price that is lower than incumbent(s) to gain
  market share effective in overcoming network
  effects (e.g. Yahoo! and eBay)
• Capacity Expansion incumbent firm increases
  production capacity to lower its own costs,
  reduce prices and increase market share.
• Raising Rivals Costs actions that raise the
  fixed and/or marginal costs of rivals through
  control or influence over input markets higher
  cost lowers rivals output. Strategy often
  occurs through regulations that benefit some
  firms over others (e.g. pollution controls for
  new firms Wal-Marts concern about the minimum
  wage).

14
Examples of Oligopoly Behavior

• National Football League McMillan, Ch. 6
• Japanese dango McMillan, Ch. 11

15
Summary

• Oligopoly
• Products can be homogeneous, or differentiated
• Interdependence and choice of decision variables
  make it difficult to capture behavior
• Manager must consider strategies of other firms
• Consider actions of firms (managers) in
  non-cooperative and cooperative settings
• In a non-cooperative setting, firms cannot fully
  exercise market power. Firms will compete and
  zero economic profits could result in the long
  run.
• Potential for economic profits suggests that
  firms will seek cooperative solutions but
  cheating always limits extent of cooperation.
• Different output and pricing strategies can be
  used to influence entry and exit of rivals

16

• Selected Problems
• Ch. 9, 1, 5, 6, 13 and 14