Chapter 12 Price and Output Determination Under Oligopoly

Chapter 12 Price and Output Determination Under Oligopoly © 2005

Economic Principles The concentration ratio and the Herfindahl-Hirschman Index (HHI) Balanced and unbalanced oligopoly Horizontal, vertical and conglomerate mergers © 2005 Gottheil - Principles of Economics, 4 e 2

Economic Principles Cartels Game theory Price leadership Kinked demand Brand multiplication Price discrimination © 2005 Gottheil - Principles of Economics, 4 e 3

Concentration Ratios For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few—oligopoly. © 2005 Gottheil - Principles of Economics, 4 e 4

Concentration Ratios An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic. © 2005 Gottheil - Principles of Economics, 4 e 5

Concentration Ratios 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. © 2005 Gottheil - Principles of Economics, 4 e 6

Concentration Ratios 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. © 2005 Gottheil - Principles of Economics, 4 e 7

Concentration Ratios 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. © 2005 Gottheil - Principles of Economics, 4 e 8

EXHIBIT 1 CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI Source: U. S. Bureau of the Census, 1997 Concentration Ratios in Manufacturing, 2001. © 2005 Gottheil - Principles of Economics, 4 e 9

Exhibit 1: Concentration Ratios— Percentage of Total Industry Sales Produced by the Leading Four Firms, and HHI How many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level? • 12 of the 15 industries. © 2005 Gottheil - Principles of Economics, 4 e 10

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. © 2005 Gottheil - Principles of Economics, 4 e 11

Exhibit 2: Distribution of Manufacturing Industries by Four -Firm Sales Concentration How many industries had fourfirms 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. © 2005 Gottheil - Principles of Economics, 4 e 12

Oligopoly and Concentration Ratios 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. © 2005 Gottheil - Principles of Economics, 4 e 13

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. © 2005 Gottheil - Principles of Economics, 4 e 14

Exhibit 3: Percentage of Total Industrial Sales Produced by Industries with Four-Firm Sales Concentration Ratios of 50 Percent or More: 1895 -1982 What 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. © 2005 Gottheil - Principles of Economics, 4 e 15

Oligopoly and Concentration Ratios Market power • A firm’s ability to select and control market price and output. © 2005 Gottheil - Principles of Economics, 4 e 16

Oligopoly and Concentration Ratios Unbalanced oligopoly • An oligopoly in which the sales of the leading firms are distributed unevenly among them. © 2005 Gottheil - Principles of Economics, 4 e 17

Oligopoly and Concentration Ratios Balanced oligopoly • An oligopoly in which the sales of the leading firms are distributed fairly evenly among them. © 2005 Gottheil - Principles of Economics, 4 e 18

EXHIBIT 4 © 2005 BALANCED AND UNBALANCED OLIGOPOLY Gottheil - Principles of Economics, 4 e 19

Exhibit 4: Balanced and Unbalanced Oligopoly 1. 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. © 2005 Gottheil - Principles of Economics, 4 e 20

Exhibit 4: Balanced and Unbalanced Oligopoly 2. 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. 21 Gottheil - Principles of Economics, © 2005 4 e

Oligopoly and Concentration Ratios • The dominance of oligopolies in industry is not unique to the U. S. • The concentration ratios for U. S. industries are similar to other modern industrialized economies. © 2005 Gottheil - Principles of Economics, 4 e 22

EXHIBIT 5 PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I. , ed. , The Tsuneta Yano Memorial Society, p. 162. © 2005 Gottheil - Principles of Economics, 4 e 23

Exhibit 5: Production Concentration Ratios in Japanese Manufacturing Industries by Leading and Five Leading Firms In 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. 24 © 2005

Concentrating the Concentration 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. © 2005 Gottheil - Principles of Economics, 4 e 25

Concentrating the Concentration 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 diversify their asset holdings. © 2005 Gottheil - Principles of Economics, 4 e 26

Concentrating the Concentration There are three types of mergers: 1. Horizontal merger 2. Vertical merger 3. Conglomerate merger © 2005 Gottheil - Principles of Economics, 4 e 27

EXHIBIT 6 © 2005 A CENTURY OF HIGH MERGER ACTIVITY Gottheil - Principles of Economics, 4 e 28

Exhibit 6: A Century of High Merger Activity Complete this sentence: On the whole, the number of mergers per year in the U. S. has ____ between 1890 and 1990. i. Increased ii. Remained the same iii. Decreased © 2005 Gottheil - Principles of Economics, 4 e 29

Exhibit 6: A Century of High Merger Activity Complete this sentence: On the whole, the number of mergers per year in the U. S. has ____ between 1890 and 1990. i. Increased ii. Remained the same iii. Decreased © 2005 Gottheil - Principles of Economics, 4 e 30

Concentrating the Concentration Horizontal merger • A merger between firms producing the same good in the same industry. © 2005 Gottheil - Principles of Economics, 4 e 31

Concentrating the Concentration A number of high-profile horizontal mergers occurred in the 1990 s. • Boeing and Mc. Donnell Douglas in the aircraft industry. • Staples and Office Depot in the office supply industry. • Union Pacific and Southern Pacific Rail in the railroad industry. © 2005 Gottheil - Principles of Economics, 4 e 32

Concentrating the Concentration Vertical merger • A merger between firms that have a supplier-purchaser relationship. © 2005 Gottheil - Principles of Economics, 4 e 33

Concentrating the Concentration An example of vertical merging is that of Anheuser-Busch. The firm has acquired malt plants, yeast plants, a cornprocessing plant, beer can factories, and a railway that ships freight by rail and truck. © 2005 Gottheil - Principles of Economics, 4 e 34

Concentrating the Concentration Conglomerate merger • A merger between firms in unrelated industries. © 2005 Gottheil - Principles of Economics, 4 e 35

Concentrating the Concentration The conglomerate merger is the most common type of merger. © 2005 Gottheil - Principles of Economics, 4 e 36

Concentrating the Concentration • 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. © 2005 Gottheil - Principles of Economics, 4 e 37

Concentrating the Concentration Cartel • A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares. © 2005 Gottheil - Principles of Economics, 4 e 38

Concentrating the Concentration Collusion • The practice of firms to negotiate price and market share decision that limit competition in a market. © 2005 Gottheil - Principles of Economics, 4 e 39

Concentrating the Concentration 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. © 2005 Gottheil - Principles of Economics, 4 e 40

Concentrating the Concentration • 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. © 2005 Gottheil - Principles of Economics, 4 e 41

Concentrating the Concentration 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. © 2005 Gottheil - Principles of Economics, 4 e 42

EXHIBIT 7 © 2005 RELATIONSHIP BETWEEN THE CONCENTRATION RATIO AND PRICE Gottheil - Principles of Economics, 4 e 43

Exhibit 7: Relationship Between the Concentration Ratio 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. © 2005 Gottheil - Principles of Economics, 4 e 44

Theories of Oligopoly Pricing Game theory • A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent. © 2005 Gottheil - Principles of Economics, 4 e 45

Theories of Oligopoly Pricing In monopoly, monopolistic competition and perfect competition, firms react only to the demand cost structures they face. Prices tend toward equilibrium. © 2005 Gottheil - Principles of Economics, 4 e 46

Theories of Oligopoly Pricing In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change. © 2005 Gottheil - Principles of Economics, 4 e 47

EXHIBIT 8 © 2005 FIRM PROFIT, GENERATED BY HIGH AND LOW PRICING Gottheil - Principles of Economics, 4 e 48

EXHIBIT 9 © 2005 PAYOFF MATRIX Gottheil - Principles of Economics, 4 e 49

Exhibit 9: Firm Profit, Generated by High and Low Pricing How 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. © 2005 Gottheil - Principles of Economics, 4 e 50

Theories of Oligopoly Pricing 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. © 2005 Gottheil - Principles of Economics, 4 e 51

EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF GODFATHER OLIGOPOLY 52 © 2005

Exhibit 10: Price and Output Under Conditions of Godfather Oligopoly 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. Gottheil - Principles of Economics, 53 © 2005 4 e

Theories of Oligopoly Pricing 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. © 2005 Gottheil - Principles of Economics, 4 e 54

EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND CURVE © 2005 Gottheil - Principles of Economics, 4 e 55

Exhibit 11: Constructing an Oligopolist’s Demand Curve 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. © 2005 Gottheil - Principles of Economics, 4 e 56

Exhibit 11: Constructing an Oligopolist’s Demand Curve 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. © 2005 Gottheil - Principles of Economics, 4 e 57

EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH KINKED DEMAND CURVES © 2005 Gottheil - Principles of Economics, 4 e 58

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves The marginal revenue curve associated with a kinked demand curve is: i. Continuous ii. Discontinuous © 2005 Gottheil - Principles of Economics, 4 e 59

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves The marginal revenue curve associated with a kinked demand curve is: i. Continuous ii. Discontinuous © 2005 Gottheil - Principles of Economics, 4 e 60

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves As 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. © 2005 Gottheil - Principles of Economics, 4 e 61

Exhibit 12: Price Rigidity in Oligopolies with Kinked Demand Curves If the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c. © 2005 Gottheil - Principles of Economics, 4 e 62

Brand Multiplication Brand multiplication • Variations on essentially one good that a firm produces in order to increase its market share. © 2005 Gottheil - Principles of Economics, 4 e 63

Brand Multiplication • A firm’s market share = (number of brands) × (brand market share). • As the number of brands in the industry increases, market share per brand diminishes. © 2005 Gottheil - Principles of Economics, 4 e 64

Price Discrimination Price discrimination • The practice of offering a specific good or service at different prices to different segments of the market. © 2005 Gottheil - Principles of Economics, 4 e 65

Price Discrimination • 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. © 2005 Gottheil - Principles of Economics, 4 e 66

EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK © 2005 Gottheil - Principles of Economics, 4 e 67

Exhibit 13: Demand Schedule for a United Airlines Round-Trip Flight Between 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. © 2005 Gottheil - Principles of Economics, 4 e 68

EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK © 2005 Gottheil - Principles of Economics, 4 e 69

Exhibit 14: Demand by Market Segment for a United Airlines Round-Trip Flight Between LA and NY What 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. © 2005 Gottheil - Principles of Economics, 4 e 70

Price Discrimination • Price discrimination exists in virtually every market. • Some differences in price are not clear cases of price discrimination, however. © 2005 Gottheil - Principles of Economics, 4 e 71

Why Oligopolists Sometimes Discriminate • 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. © 2005 Gottheil - Principles of Economics, 4 e 72

Cartel Pricing • A cartel determines price by acting as if it is a monopoly. • Price and quantity are determined using the MR = MC rule. © 2005 Gottheil - Principles of Economics, 4 e 73

EXHIBIT 15 CARTEL PRICING AND OUTPUT ALLOCATIONS © 2005 Gottheil - Principles of Economics, 4 e 74

Exhibit 15: Cartel Pricing and Output Allocations Why 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. © 2005 Gottheil - Principles of Economics, 4 e 75

Exhibit 15: Cartel Pricing and Output Allocations Why 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. 76 Gottheil - Principles of Economics, © 2005 4 e

Exhibit 15: Cartel Pricing and Output Allocations Why 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. © 2005 Gottheil - Principles of Economics, 4 e 77