C hapter 12 Price and Output Determination Under Oligopoly © 2002 South-Western

CChapter 12hapter 12

Price and Output Determination Under

Oligopoly

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• The concentration ratio and the Herfindahl-Hirschman Index (HHI)

• Balanced and unbalanced oligopoly

• Horizontal, vertical and conglomerate mergers

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Economic PrinciplesEconomic Principles

• Cartels

• Game theory

• Price leadership

• Kinked demand

• Brand multiplication

• Price discrimination

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Oligopoly and Oligopoly and Concentration RatiosConcentration Ratios

For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few – oligopoly.

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An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic.

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Concentration ratio

A measure of market power. It is the ratio of total sales of the leading firms in an industry (usually four) to the industry’s total sales.

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A criterion for determining whether an industry is an oligopoly:

If the leading four firms in an industry account for 40 percent or more of total industry sales, then an industry is likely to be an oligopoly.

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Herfindahl-Hirschman index

A measure of industry concentration, calculated as the sum of the squares of the market shares held by each of the firms in the industry.

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EXHIBIT 1 CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI

Source: U.S. Bureau of the Census, 1992 Concentration Ratios in Manufacturing, 1996.

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Exhibit 1: Concentration Ratios Exhibit 1: Concentration Ratios – Percentage of Total Industry – Percentage of Total Industry Sales Produced by the Leading Sales Produced by the Leading

Four Firms, and HHI: 1992Four Firms, and HHI: 1992

How many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level?

• Eleven of the fifteen industries.

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EXHIBIT 2 DISTRIBUTION OF MANUFACTURING INDUSTRIES BY FOUR-FIRM SALES CONCENTRATION

Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission. Data refer to 1982.

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Exhibit 2: Distribution of Exhibit 2: Distribution of Manufacturing Industries by Manufacturing Industries by

Four-Firm Sales Four-Firm Sales Concentration: 1982Concentration: 1982

How many industries had four-firms controlling 40-59 percent of the industry sales in 1982?

• 120 out of 448 total industries had four firms controlling 40-59 percent of the total industry sales.

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Contrary to many people’s intuition, there is no convincing evidence that the share of industry sales controlled by the four leading firms in the US manufacturing economy is growing.

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EXHIBIT 3 PERCENTAGE OF TOTAL INDUSTRIAL SALES PRODUCED BY INDUSTRIES WITH FOUR-FIRM SALES CONCENTRATION RATIOS OF 50 PERCENT OR MORE: 1895–1982

Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission.

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Exhibit 3: Percentage of Total Exhibit 3: Percentage of Total Industrial Sales Produced by Industrial Sales Produced by

Industries with Four-Firm Sales Industries with Four-Firm Sales Concentration Ratios of 50 Concentration Ratios of 50

Percent or More: 1895-1982Percent or More: 1895-1982What is the trend in the percentage of industrial sales produced by the largest four firms since 1963? • There is a downward trend in the percentage of industrial sales by the largest four firms from 1963 to 1982.

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Market power

A firm’s ability to select and control market price and output.

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Unbalanced oligopoly

An oligopoly in which the sales of the leading firms are distributed unevenly among them.

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Balanced oligopoly

An oligopoly in which the sales of the leading firms are distributed fairly evenly among them.

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EXHIBIT 4 BALANCED AND UNBALANCED OLIGOPOLY

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Exhibit 4: Balanced Exhibit 4: Balanced and Unbalanced and Unbalanced

OligopolyOligopoly1. What percentage of their industry’s total sales do the leading four firms in Industry A and B control? • The leading four firms in both industry A and B control 80 percent of their industry’s sales.

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Exhibit 4: Balanced Exhibit 4: Balanced and Unbalanced and Unbalanced

OligopolyOligopoly2. Why is industry B considered an unbalanced oligopoly?

• The largest firm in industry B controls 50 percent of the industry’s sales. It’s market share is greater than the other three leading industries combined and more than four times greater than the next largest firm’s sales share.

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Oligopoly and Oligopoly and Concentration Ratios Concentration Ratios

• The dominance of oligopolies in industry is not unique to the US.

• The concentration ratios for US industries are similar to other modern industrialized economies.

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EXHIBIT 5 PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS: 1991

Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano Memorial Society, p. 162.

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Exhibit 5: Production Exhibit 5: Production Concentration Ratios in Japanese Concentration Ratios in Japanese

Manufacturing Industries by Manufacturing Industries by Leading and Five Leading Firms: Leading and Five Leading Firms:

19911991In how many Japanese industries do the five leading firms have greater than a 90 percent production concentration ratio? • Four industries – beer, nylon, glass, and tires and tubes – are controlled by the five leading firms at a concentration of 90 percent or greater.

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Concentrating the Concentrating the ConcentrationConcentration

An oligopoly can build market power in two ways:

• Reinvesting its profit and painstakingly expanding its production capacity.

• Merging with and/or acquiring other firms.

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There are three reasons why firms merge:

1. To exercise greater market control.

2. To increase control over the supplies of their inputs or the buyers of their goods.

3. To expand and diversify their asset holdings.

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There are three types of mergers:

1. Horizontal merger.

2. Vertical merger.

3. Conglomerate merger.

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EXHIBIT 6 THE GROWTH OF MERGERS

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Exhibit 6: The Growth Exhibit 6: The Growth of Mergersof Mergers

Complete this sentence: On the whole, the number of mergers per year in the US has ____ between 1890 and 1990.

i. Increased.

ii. Remained the same.

iii. Decreased.

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Exhibit 6: The Growth Exhibit 6: The Growth of Mergersof Mergers

Complete this sentence: On the whole, the number of mergers per year in the US has ____ between 1890 and 1990.

i. Increased.

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Horizontal merger

A merger between firms producing the same good in the same industry.

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A number of high-profile horizontal mergers occurred in the 1990s.

• Boeing and McDonnell Douglas in the aircraft industry.

• Staples and Office Depot in the office supply industry.

• Union Pacific and Southern Pacific Rail in the railroad industry.

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Vertical merger

A merger between firms that have a supplier-purchaser relationship.

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An example of vertical merging is that of Anheuser-Busch.

The firm has acquired malt plants, yeast plants, a corn-processing plant, beer can factories, and a railway that ships freight by rail and truck.

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Conglomerate merger

A merger between firms in unrelated industries.

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The conglomerate merger is the most common type of merger.

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• One reason for conglomerate mergers is the desire to diversify operations.

• While horizontal and vertical mergers strengthen the firm’s position within the industry, the fate of the firm rests on the health of the industry.

• Acquiring unrelated firms insures the conglomerate against catastrophe if one industry faces severe problems.

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Cartel

A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares.

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Collusion

The practice of firms to negotiate price and market share decision that limit competition in a market.

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Cartels are an example of a merger in which firms don’t have to actually buy each other’s assets, yet they enjoy the benefits of having market power.

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• While cartels are illegal in the United States, it is difficult to prove collusion.

• Some cartels are disguised. Agricultural cooperatives in regions of the US behave like cartels.

• Some governments encourage cartels to form in their countries. OPEC is one example.

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Many studies support the contention that price and concentration ratios move in the same direction – an increase in one is associated with an increase in the other.

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EXHIBIT 7 RELATIONSHIP BETWEEN THE CONCENTRATION RATIO AND PRICE

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Exhibit 7: Exhibit 7: Relationship Between Relationship Between

the Concentration the Concentration Ratio and PriceRatio and Price

Where on the curve in Exhibit 7 does the concentration ratio have the strongest effect on price?

• The effect is the strongest in the middle of the S-shaped curve.

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Theories of Oligopoly Theories of Oligopoly PricingPricing

Game theory

A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent.

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In monopoly, monopolistic competition and perfect competition, firms react only to the demand and cost structures they face. Prices tend toward equilibrium.

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In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change.

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EXHIBIT 8 FIRM PROFIT, GENERATED BY HIGH AND LOW PRICING

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EXHIBIT 9 PAYOFF MATRIX

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Exhibit 9: Firm Profit, Exhibit 9: Firm Profit, Generated by High and Generated by High and

Low PricingLow PricingHow does total profit change as Dell and Compaq change their prices?

• When both firms price high, total profit is 20. When one firm prices high and the other prices low, total profit is 18. When both firms price low, total profit is 12.

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Price leadership

A firm whose price decisions are tacitly accepted and followed by other firms in the industry. The theory explains pricing in unbalanced oligopolies.

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EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF GODFATHER OLIGOPOLY

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Exhibit 10: Price and Exhibit 10: Price and Output Under Output Under

Conditions of Godfather Conditions of Godfather OligopolyOligopoly

How is the price of chocolate determined in Exhibit 9?• Hershey is the “godfather” in the chocolate business. Hershey produces where its MR=MC. That is, 5 tons of chocolate at $5 per pound. The other firms in the chocolate industry accept the $5 per pound price.

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Kinked demand curve

The demand curve facing a firm in oligopoly; the curve is more elastic when the firm raises price than when it lowers price.

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EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND CURVE

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Exhibit 11: Exhibit 11: Constructing an Constructing an

Oligopolist’s Demand Oligopolist’s Demand CurveCurve

1. If Lipton were to raise its price above $0.80 per box, what would its competitors do, according to the curve in panel b?• Lipton’s competitors would not follow suit. Lipton’s demand curve above $0.80 (NK) is relatively elastic.

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Exhibit 11: Exhibit 11: Constructing an Constructing an

Oligopolist’s Demand Oligopolist’s Demand CurveCurve

2. If Lipton were to lower its price below $0.80 per box, then what would its competitors do?

• Lipton’s competitors would feel compelled to follow suit. Lipton’s demand curve below $0.80 (YK) is relatively inelastic.

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EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH KINKED DEMAND CURVES

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Exhibit 12: Price Exhibit 12: Price Rigidity in Oligopolies Rigidity in Oligopolies with Kinked Demand with Kinked Demand

CurvesCurvesThe marginal revenue curve associated with a kinked demand curve is:

i. Continuous.

ii. Discontinuous.

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CurvesCurvesThe marginal revenue curve associated with a kinked demand curve is:

ii. Discontinuous.

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CurvesCurvesAs long as the MC curve crosses the gap created by the discontinuity in the MR curve, price will remain unchanged, as shown in panel b.

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CurvesCurvesIf the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c.

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Oligopoly and Brand Oligopoly and Brand MultiplicationMultiplication

Brand multiplication

Variations on essentially one good that a firm produces in order to increase its market share.

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Oligopoly and Brand Oligopoly and Brand MultiplicationMultiplication

• A firm’s market share =

(number of brands) x (brand market share).

• As the number of brands in the industry increases, market share per brand diminishes.

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Why Oligopolists Why Oligopolists Sometimes Sometimes

DiscriminateDiscriminate

Price discrimination

The practice of offering a specific good or service at different prices to different segments of the market.

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DiscriminateDiscriminate• Oligopolists sometimes segment the market in order to charge consumers what they are willing to pay for a good or service.

• Differences in airline ticket prices are a good example.

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EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK

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Exhibit 13: Demand Exhibit 13: Demand Schedule for a United Schedule for a United

Airlines Round-Trip Flight Airlines Round-Trip Flight Between LA and NYBetween LA and NY

If United chose not to segment its market in Exhibit 12, what would be its total revenue?

• The maximum total revenue for United would be achieved at a ticket price of $318 each, for a total of $119,250.

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EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK

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Exhibit 14: Demand by Exhibit 14: Demand by Market Segment for a Market Segment for a United Airlines Round-United Airlines Round-Trip Flight Between LA Trip Flight Between LA

and NYand NYWhat is United’s total revenue when it segments its market into a multiple-fare system?

• United’s total revenue is $210,635. This is an increase of $91,385 over the unsegmented market.

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DiscriminateDiscriminate• Price discrimination exists in virtually every market.

• Some differences in price are not clear cases of price discrimination, however.

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DiscriminateDiscriminate• For example, many would argue that upper balcony seats are not the same as front row seats at a concert. If the goods are different, then it is not necessarily price discrimination to charge more for the front row seats.

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Cartel PricingCartel Pricing

• A cartel determines price by acting as if it is a monopoly.

• Price and quantity are determined using the MR=MC rule.

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EXHIBIT 15 CARTEL PRICING AND OUTPUT ALLOCATIONS

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Exhibit 15: Cartel Exhibit 15: Cartel Pricing and Output Pricing and Output

AllocationsAllocationsWhy is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?

• The price and output decisions made by the cartel are determined by the MR=MC rule.

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AllocationsAllocationsWhy is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?• The price and quantity assigned to individual firms within the cartel may not coincide with where the firm would maximize profit using its own MR and MC curves.

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AllocationsAllocationsWhy is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?

• There is an incentive for the firm to try to secretly increase quantity and thereby increase its own profit.

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C hapter 12 Price and Output Determination Under Oligopoly © 2002 South-Western