Chapter 25. Oligopoly

Chapter 25Oligopoly25-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesConcentration RatiosThe Herfindahl-Hirschman indexThe competitive spectrumThe kinked demand curveAdministered prices25-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Oligopoly DefinedAn oligopoly is an industry with just a few sellersHow few? So few that at least one firm is large enough to influence price25-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Oligopoly is the prevalent type of industrial competition in the United States as well as in most of the noncommunist industrial westIn terms of production, the vast majority of our GDP is accounted for by firms in oligopolistic industries25-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.OligopolyThe crucial factor under oligopoly is the small number of firmsBecause there are so few firms, every competitor must think continually about the actions of its rivalsWhat each does could make or break the othersThus, there is a kind of interdependance among oligopolists 25-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.OligopolyWhen we talk about big business in the United States,we’re talking about oligopolies. Some examples areGM, Ford, ExxonMobil, IBM, Boeing, CBS, NBC, Kellog, and General MillsWe can also include all the other industrial giants that have become household names 25-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.OligopolyThe graph of the oligopolist is similar to that of the monopolistThe oligopolist is analyzed in the same manner as the monopolist with respect to price, output, profit, and efficiencyPrice is higher than the minimum point of the ATC curve, therefore the oligopolist is not as efficient as the perfect competitorThe oligopolist has a higher price and a lower output than does the perfect competitorThe oligopolist, like the monopolist, makes a profit25-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.OligopolyConcentration RatiosThe concentration ration is the percentage share of industry sales of the four leading firms in the industryIndustries with high concentration ratios are very oligopolistic25-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Calculate the Concentration RatioFirm Percent of sales A 14 % B 4 C 23 D 5 E 2 F 8 G 17 H 10 I 2 J 15 Total 100 % 25-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The concentration ratio is 23 + 17 + 15 + 14 = 69Concentration Ratio ShortcomingsConcentration ratios do not include importsThis ignores 2 million Japanese imports as well as the hundreds of thousands of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royces the United States importsConcentration ratios tell us nothing about the competitive structure of the rest of the industryAre all the firms relatively large or are they small?When the remaining firms are large, they are not as easily dominated by the top four as are dozens of relatively small firms25-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Concentration Ratio ShortcomingsConcentration rations have become less meaningful as imports have increasedThe United States gets 80% of its consumer electronics and 53% of its oil from abroadImports tend to make the automobile industry’s concentration ration less relevantTransplants reduce this ratioAs a result, the American car buyers have reaped the benefits of lower prices and much higher quality 25-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The HHI is the sum of the squares of the market shares of each firm in the industryA monopoly has 100 percent of the market share25-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Herfindahl- Hirschman Index (HHI)100 = (100 X 100) = 10,0002You can’t get a bigger HHI number than 10,000. Every monopoly would have an HHI of 10,000The HHI is the sum of the squares of the market shares of each firm in the industry25-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Herfindahl- Hirschman Index (HHI)Find the HHI in an industry with just two firmsEach firm has 50 percent of the market50 + 50 = 2,500 + 2,500 = 5,00022The HHI is the sum of the squares of the market shares of each firm in the industry25-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Herfindahl- Hirschman Index (HHI)Find the HHI in an industry that has four firmsEach firm has 25 percent of the market25 + 25 + 25 + 25 2222625 + 625 + 625 + 6252500The Competitive Spectrum25-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The possible degrees of competition in an oligopolistic marketCartelsA cartel is a combination of firms that acts as if it were a monopolyThe leading firms in an industry band together to restrict output, share out markets and, consequently, increase prices and profitsIf the demand is there, oligopolistic firms can openly collude to control supply and, to a large degree, market priceOPEC did this in 1973 when the price of oil quadrupledA cartel is the most extreme case of oligopoly25-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Withholding Supply to Raise Price25-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When supply is lowered from S1 to S2, price rises from P1 to P2Open Collusion25-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Open collusion operates like the alleged MafiaThis would be some type of territorial division of the market among the firms in the industryThis type of arrangement gives each firm in the market a regional monopolyThe firm may have only 15 or 20% of the market, but under this type of arrangement, its pricing behavior is that of the monopolistOpen collusion is slightly less extreme than a cartelThe Colluding Oligopolist25-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.This graph could also belong to the monopolist or the monopolistic competitor in the short runCovert CollusionThis usually involves price-fixingIn the late 1950s General Electric, Westinghouse, Allis-Chalmers and other leading electrical firms conspired to fix the price of electrical transformers, turbines, and other electrical equipmentThey rigged government bids by taking turns making (high) low bids bilking the public of hundreds of millions of dollarsIn 1961 the U.S. Supreme court found 7 high ranking corporate officials guilty of illegal price fixing and market sharing agreementsTheir employers paid their finesThey got short jail sentencesTheir employers paid their salaries while in jail, and they got their old job back after they got out25-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Other Cases of CollusionIn 1996 Archer Daniels Midland Company pleaded guilty and paid a $100 million criminal fine for its role in two international price-fixing conspiraciesIn 1999 an arrangement was uncovered that fixed worldwide vitamin prices as much as 25% above the market levelA worldwide price-fixing conspiracy led by Swiss and German companies was prosecuted by the U.S Department of Justice25-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.25-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price LeadershipPrice leadership is playing follow the leaderOne company raises prices and shortly after, the other companies in the same market do the sameThe prime rate set by the big banks is a form of price leadershipCollusion is most likely to succeed when there are few firms and high barriers to entryCutthroat CompetitionCutthroat competition is an extreme caseThe cutthroat competitor’s actions are based on assumptions about their rivals behaviorThe cutthroat competitor assumes that if I raise my price my competitors won’t raise their priceThe cutthroat competitor assumes that if I lower my price, my competitors will also lower their priceTherefore the cutthroat competitor keeps the price just where it is25-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Cutthroat Oligopolist25-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.No cutthroat oligopolist will raise or lower price. It keeps the price just where it is and that is at the kink in the demand curveThe Cutthroat Oligopolist25-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How much is the price and output for this firm?Price is $27Output is 4At an output of 4 MC=MRThe Cutthroat Oligopolist25-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price is $27Output is 4At an output of 4 MC=MRATC is $24Total Profit = (Price – ATC) X Output = ($27 – 24) X 4 = 3 X 4 = 12Conclusion25-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.At one of the spectrum we have the cartel, which no longer operates within the American economy, although it may be found in world markets At the other end of the spectrum, we have the cutthroat competitor, the firm that will stop at nothing to beat out its rivalsNear the middle are the mildly competing oligopolists and the occasionally cooperating oligopolists. Conclusion25-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Where is the spectrum in American industry? The answer is that there is no answer.First, there is no one place where American industry is located because different industries have different competitive situations.Second, there is widespread disagreement about the degree of competition in any given industry