Lecture Managerial economics - Chapter 5: Oligopoly

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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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Nội dung Text: Lecture Managerial economics - Chapter 5: Oligopoly

Week 5 Oligopoly 1
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 Industry 2
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 strategies 8
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 + 100 –e.g. If country A produces 50 barrels, unit cost is $150 for A choose the number of barrels (Qi) to produce. • You’ll collect the quantities from each member and calculate P • Each member’s profit = P * Qi – (Qi+100)*Qi 10
Summary Equilibrium: Outcome with no incentive to move • Not necessarily the optimal outcome • Sometimes, there could be more than one equilibrium 11
First Movers Advantage 12
Cases Wal-Mart’s Preemptive Strategy Super Jumbo Jet War between Airbus and Boeing 13
Wal-Mart’s Preemptive Strategy Background: • Sam Walton started in 1969 • During 70s and 80s, large discount chains went bankrupt. • Wal-Mart kept growing (153 stores in 1976 to 1009 in 1986). What is the key to Wal-Mart’s success in 1970s? 14
Wal-Mart’s Preemptive Strategy (70s) Wal-Mart realized that • A small town with population less than 100,000 can accommodate only 1 discount store Strategy: • Preempt the market by entering the market first – This is more subtle than you may think – Wal-Mart must commit to itself → Can’t bail out, if other company decides to enter 15
Wal-Mart’s Entry Deterrence Strategy Since 80s, many small towns expanded to accommodate more than 1 discount stores. To enjoy monopoly status in such market, Wal-Mart must prevent other stores from entering the market. What are the Wal-Mart’s Entry Deterrence Strategies in 90s? 16
Boeing vs. Airbus Background • Boeing is the incumbent monopoly of jumbo jet market –They enjoyed the first mover’s advantage for nearly 30 years. • In 2000, Boeing and Airbus were trying to decide whether to develop a double-decker Super Jumbo Jet. • It takes 6 years to design a new jet. • R&D cost is $10 billion Airbus announced they will develop the new super jumbo jet. (WSJ, Dec. 19, 2000 A380) 17
Entry Deterrence How to deter potential competitors’ entrance? • How to build a barrier to entry? • Wal-Mart’s entry deterrence example 18
Wal-Mart’s Entry Deterrence Strategy Situation • In 70s, Wal-Mart was the only discount store in a small size town. • Since 1980s, town has grown into a medium size and now can accommodate 2 discount stores. Market size increased from $2 mil to $4 mil K-mart • Potential Entrant: consider opening a store in that midsize town • Actions: Enter or Stay Out Wal-Mart: • Incumbent: the only discount store (monopoly) in the town • If K-mart enters, Wal-Mart has 2 actions – i) shares the market at monopoly price (cartel), or – ii) fights hard by lowering the price 19
Payoff Structure • K-mart stays out and Wal-Mart charges monopoly price, – Wal-Mart’s profit is $4 mil and K-mart earns $0. • K-mart enters by paying entry cost of $1.6 mil (K-mart moves first) i> If Wal-Mart shares the market with K-mart (monopoly price) → Wal-Mart’s profit is $2 mil (half), K-mart’s profit is $0.4 mil ( = $2 mil - $1.6 mil entry cost) ii> If Wal-Mart fights by charging low price and sell more, → revenue goes up by $0.3 mil but has to pay $1 mil (sunk cost) to increase the capacity • K-mart stays out and Wal-Mart charges low price (unlikely), iii> Wal-Mart suffers $1 mil sunk cost to increase capacity and $.5 revenue loss from low price with no gain in market share (silly case) 20