Lecture Managerial economics - Chapter 5: Oligopoly

We’ve modeled 2 ends of the market structure: Competitive market and monopoly. Now we look at cases in between ( N = small ). Oligopoly is market or industry dominated by a small number of firms, whose decisions (price, output, marketing) are interdependent. In chapter 5, we will discuss this problem.
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Lecture Managerial economics - Chapter 5: Oligopoly Week 5 Oligopoly1 Introduction We’ve modeled 2 ends of the market structure • Competitive market ( N = ∞ ) • Monopoly ( N = 1) Now we look at cases in between ( N = small ) Oligopoly: Market or industry dominated by a small number of firms, whose decisions (price, output, marketing) are interdependent. • More than 1 firm, but industry is highly concentrated. • Examples – Coke vs Pepsi – Boeing vs Airbus – Auto Industry2 Concentration Concentration ratio: One measure of industry concentration. CR4=% of Total Industry Sales accounted for by the four largest firms CR20=% of Total Industry Sales accounted for by the twenty largest firms  The higher the CR, the greater the degree of market power by a small number of firms. Benchmarks:  Effective Monopoly: CR1 > 90% (only 2-3% of GDP)  Effectively Competitive: CR4 < 40% (top four firms have individual markets shares averaging less than 10%). 75% of GDP  Loose Oligopoly: 40% < CR4 < 60% (monopolistic competition) 12% of GDP  Tight Oligopoly: CR4 > 60% (10% of GDP)3 Concentration and Prices  Department of Justice is concerned with how mergers affect consumers because of the following possible outcome:  Ceteris paribus, the higher the concentration the higher the prices and the higher the profits.  High prices could be because of collusion or just because of reduced competition.  The fewer the firms, the less the intense, cutthroat competition, and the more likely that prices will be high.  The higher the entry barriers, the higher the expected prices.  More formally, we have P = f (Cost, Demand, and Seller Concentration).4 Game Theory Game theory is a way to model strategic interactions • Developed by John Nash, watch “Beautiful Mind” The Prisoners’ Dilemma Game: A Classic Example • Two prisoners suspected of committing a crime are in custody • They are put into 2 separate interrogation rooms (no communication between prisoners) • If they both keep silence, then both will only get 1 year time in jail. • If both confess, they will both get 3 years. • If A confesses and B keeps silence, A gets out of jail and B gets 5 years and vice versa. What will be the outcome?5 The Prisoners’ Dilemma Game Convention rules • 2 players, 2 actions : Draw a 2 by 2 matrix • Write first player’s actions (confess / silence) in left of matrix (above & below) • Write second player’s actions (confess / silence) on top (left & right) • Write the payoffs in each cell. First player’s payoff first.6 What is the Equilibrium Outcome? Equilibrium: No one has incentive to move from the outcome • (confess, confess) : If any deviates, he will get 5 years instead of 3 years. • The optimal outcome (silence, silence) is not an equilibrium. Principle : Equilibrium outcome is not always optimal.7 Dominant Strategies No matter what Prisoner 2 chooses, Prisoner 1 always finds it better to confess • Confessing is also always Prisoner 2’s best strategy … try it yourself Dominant Strategy: an action that is best no matter what strategy a rival adopts • Prisoner 1’s dominant strategy is to confess • Prisoner 2’s dominant strategy is also to confess • Equilibrium is (confess, confess). • Lesson: if you have a dominant strategy, always play it Not all games have dominant strategy. • it is not always the case that a player has a dominant strategy • it is not always the case that a game has any dominant strategies8 Perspective on Game Theory The basic question • if my rivals act to maximize their objective, how should I take their behavior into account when making my own decisions? Applications • Any situation where there are a small number (2, 3, 4) of players with small number of actions –Business Strategy » OPEC game: How much to produce? –Sports Game » In football, Pass or Run? » In baseball, Throw a Strike or Ball?9 OPEC Game Suppose OPEC has 12 members (Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela). • They all produce identical oil. • Each county decides how many barrels to produce • Price will be determined by P = $(1400 – Total Quantity). –If total number of barrels > 1400, then P = 0. • Unit cost for each country = Qi ...