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Chapter 13
Oligopoly and Monopolistic
Competition
Key issues
1. market structure
2. game theory
3. cartels
4. Cournot model of oligopoly
5. Stackelberg model of oligopoly
6. monopolistic competition
7. Bertrand model of oligopoly
Market structures
markets differ according to
- number of firms in market
- ease of entry and exit
- ability of firms to differentiate their
products
Oligopoly
- small group of firms in a market with substantial barriers to entry
- because relatively few firms compete in such a market, - each firm faces a downward-sloping demand curve - each firm can set its price: p > MC - market failure: inefficient (too little) consumption - each affects rival firms
- typical oligopolists differentiate their products
Monopolistic competition
- small or moderate number of firms
- free entry
- usually products differentiated
Nash equilibrium
- set of strategies is a Nash equilibrium if,
- holding strategies of all other players (firms) constant,
- no player (firm) can obtain a higher payoff (profit) by choosing a different strategy
- in a Nash equilibrium, no firm wants to change its strategy because each firm is using its - best response : - strategy that maximizes its profit given its beliefs about its rivals' strategies
Duopoly
- consider single-period, duopoly, quantity-
setting game
- duopoly : an oligopoly with two ("duo")
firms
Airlines Example
- American Airlines and United Airlines
- compete for customers on flights between
Chicago and Los Angeles
Notation
- Q = total number of passengers flown by
both firms; sum of:
- qA = passengers on American Airlines
- qU = passengers on United Airlines
Firms act simultaneously
- each firm selects a strategy that
- maximizes its profit
- given what it believes other firm will do
- firms are playing
- a noncooperative game of imperfect information:
- each firm must choose an action before observing rivals’ simultaneous actions
Prisoners' dilemma game
all players have dominant strategies that
lead to a profit (or other payoff) that is
inferior to what they could achieve if they
cooperated and played alternative strategies
Collusion in repeated games
- in a single-period prisoners' dilemma game,
firms produce more than they would if they
colluded
- why, then, are cartels frequently observed?
- collusion is more likely in a multiperiod
game: single-period game played repeatedly
- punishment: not possible in a single-period
game but possible in a multiperiod game
Supergame
- if a single-period game is played repeatedly, firms engage in a - supergame : - players’ strategies in this period may depend on rivals' actions in previous periods
- in a repeated game, firm can influence its rival's behavior by - signaling - threatening to punish
Threat
- suppose American announces to United that
it will use the following two-part strategy:
- American produces smaller quantity each period as long as United does the same
- if United produces larger quantity in period t , then American will produce larger quantity in period t + 1and all subsequent periods
- thus, if firms play same game indefinitely,
they should find it easier to collude
Know number of periods
- suppose firms know that they are going to play game for T periods
- period T is like a single-period game, and all firms cheat
- hence T -1 period is last interesting period
- by same reasoning, they cheat in that period, etc.
- cheating is less likely to occur if end period is unknown or there is no end
Cartels
Adam Smith:
"People of the same trade seldom meet
together, even for merriment and diversion,
but the conversation ends in a conspiracy
against the public, or some contrivance to
raise prices"
Laws against cartels
- in response to trusts' high prices, Congress passed
- Sherman Antitrust Act in 1890
- Federal Trade Commission Act of 1914
- these laws prohibit firms from explicitly agreeing to take actions that reduce competition, such as jointly setting price
- these anti-cartel laws are called
- antitrust laws in U.S.
- competition policies in most other countries
Effectiveness of Antitrust Laws
- at first they had no bite because the
language was vague and full of loopholes
- mocked as “the Swiss Cheese Act”
Supreme Court
- In 1902, Teddy Roosevelt had DOJ sue
Northern Securities Company (railroad—
part of J.P. Morgan empire) under the
Sherman Act
- 1906 sued to dissolve Rockefeller’s
Standard Oil
- 1911: Supreme Court breaks up oil trust—
Sherman Act gains teeth
Europe
- over the last dozen years, the European Commission has been pursuing competition cases under laws that are similar to U.S. antitrust laws
- recently the EC, the DOJ, and the FTC have become increasingly aggressive, prosecuting many more cases
- following the U.S., which uses both civil and criminal penalties, the British government introduced legislation in 2002 to criminalize certain cartel-related conduct
- EU uses only civil penalties, but its fines have increased dramatically, as have U.S. fines
Corporate Leniency Program
- in 1993, DOJ introduced a new Corporate Leniency Program that guarantees that participants in cartels who blow the whistle will receive immunity from federal prosecution
- as a consequence, DOJ has caught, prosecuted, and fined several gigantic cartels (e.g. Vitamins)
- on Valentine’s Day, 2002, EC adopted a similar policy
Sotheby’s and Christie’s
- Sotheby’s (established in 1744) and Christie’s (1776) are the two largest and most prestigious auction houses in the world
- they control 90% of the $4 billion worldwide auction market
- for most of the last two and a half centuries, they thrived
- starting at least by 1993, when faced with poor business conditions, they started to collude, according to the U.S. Department of Justice (DOJ)
Why some cartels persist
1. tacit collusion
2. international cartels (OPEC) and cartels
within certain countries operate legally
3. illegal cartel believes it can avoid detection
or punishment will be small
Cartels fail
luckily for consumers, cartels often fail
because
- each firm in a cartel has an incentive to
cheat on the cartel agreement by producing
extra output
Why cartels fail
- cartels fail if noncartel members can supply
consumers with large quantities of goods
(example: copper)
- each member of a cartel has an incentive to
cheat on cartel agreement
Figure 13.1 Competition Versus Cartel
Price, p , $ per unit
(a) Firm
q (^) m q (^) c q * Quantity, q , Units per year
S
MR
Market demand
AC
MC p (^) m
MC (^) m
p (^) c
p (^) m em
e (^) c MCm
pc
Price, p , $ per unit
(b) Market
Q (^) m Qc Quantity, Q , Units per year
Solved problem
- initially, all identical firms in a market
collude
- if some of these firms leave the cartel and
act like price takers, how are consumers
affected?
Automobile cartel
- Reagan admin. negotiated 1981 voluntary export restraints (VER): Japanese auto manufacturers would reduce their auto exports to U.S.
- Why would Japanese manufacturers “voluntarily” reduce their exports? - to avoid government quotas - to act like a cartel: reducing sales to collusive level
- when U.S. allowed VER agreements to lapse in 1985, Japanese government wanted to continue to restrict exports
Auto cartel effects
- stock market value of Japanese auto industry increased during VER period by $6.6 billion
- VERs raised price of American cars by 5.4% between 1981 and 1983
- U.S. consumers lost $6.9 billion ($1984) due to these export restrictions
- using VER is foolish
- foreign and domestic auto manufacturers capture “cartel” profits from higher prices
- tariffs better for U.S.
Entry and cartel success
- barriers to entry help cartel: limit competition
- cartels with large number of firms rare (except professional associations)
- Dept. of Justice price-fixing cases 1963-
- 48% involved 6 or fewer firms
- average number of firms: 7.
- only 6.5% involved 50 or more conspirators
- cartels often fall apart after entry (mercury)
Bail bonds
- Connecticut sets a maximum fee bail-bond
businesses can charge for posting a given-
size bond
- how close a city’s price is to legal
maximum depends on number
of firms
New Haven 8 64
Norwalk 3 54
Bridgeport 10 78
Meriden, New London 2 98
Plainville, Stamford, 1 99 Wallingford
% of maximum allowed fee
# of active
Town firms
Lysine cartel
- 1996: Archer Daniels Midland (ADM)
pleaded guilty to price fixing
- ADM admitted to price fixing in lysine
(used in livestock feed) and citric acid (used
in soft drinks and detergents)
- source of following: Connor (1993)
Lysine buyers
- individual U.S. buyers received
compensation ≈ their losses
- that is, they did not get treble damages
- total U.S. corporate settlements: about $
million
Mergers
- if antitrust or competition laws prevent
firms from colluding, they may try to merge
- U.S. laws restrict ability of firms to merge if
effect would be anticompetitive
Some mergers raise efficiency
- efficiency due to greater scale
- sharing trade secrets
- closing duplicative retail outlets
Chase and Chemical banks merged in 1995: closed or combined 7 branches in Manhattan located within 2 blocks of another branch
Airline mergers
- government did not contest most airline
mergers 1985-
- prices increased on routes served by firms
that merged relative to those on routes
without mergers
Soft drinks 1986 merger
proposals
- Coke, largest carbonated soft drinks producer (38.6% of sales), tried to buy 3rd largest, Dr Pepper (7.1%)
- Pepsi, 2nd largest producer (27.4%), tried to acquire 4th largest firm, Seven-Up Co. (6.3%)
- had these proposed mergers taken place, Coke's market share would have risen to 45.7% and Pepsi's to 33.7%
- combined share would have risen from 66.0% to 79.4%
FTC intervenes
Federal Trade Commission (FTC) opposed
mergers, arguing that merger
- would increase market shares of big firms
- make entry of new firms more difficult
- raise costs of other companies doing
business in this market
- ease "collusion among participants in the
relevant markets"
