1 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 • π = 0 • p = AC • usually products differentiated 2 Strategies and games • oligopolistic or monopolistically competitive firm use a • strategy: • battle plan of actions (such as setting a price or quantity) it will take to compete with other firms • oligopolies engage in a • game: • any competition between players (such as firms) in which strategic behavior plays a major role Game theory • set of tools used by economists, political scientists, military analysts, and others to analyze decision making by players (such as firms) who use strategies • these analytic tools can be used to analyze • oligopolistic games • poker • coin-matching games • tic-tac-toe • elections • nuclear war Firm's objective • obtain largest possible profit (or payoff) at game’s end • typically, one firm's gain comes at expense of other firms • each firm's profit depends on actions taken by all firms 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 3 Notation • Q = total number of passengers flown by both firms; sum of: • q A = passengers on American Airlines • q U = 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 Dominant strategy • a strategy that strictly dominates all other strategies regardless of which actions rivals’ chose • in this Table 13.2 game, each firm has a dominant strategy • firm chooses its dominant strategy • where a firm has a dominant strategy, its belief about its rival's behavior is irrelevant Noncooperative game • firms do not cooperate in a single-period game • In Nash equilibrium (q A = q U = 64), each firm earns $4.1 million (< $4.6 million it would make if firms restricted their outputs to q A = q U = 48) • sum of firms' profits is not maximized in this simultaneous choice, one-period game Why don't firms cooperate? • don't cooperate due to a lack of trust: • each firm can profitably use low-output strategy only if it trusts other firm! • each firm has a substantial profit incentive to cheat on a collusive agreement 4 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" 5 Why cartels form • cartel can raise profits by raising price • limit entry • demand elasticity not too large • low expectation of severe punishment • low organization costs • few firms • national association Why can cartels raise profits? • if a competitive firm is maximizing its profit, why should joining a cartel increase its profit? • competitive firm is already choosing output to maximize its profit • however, it ignores effect that changing its output level has on other firms' profits • cartel takes into account how changes in one firm's output affect cartel profits Historic cartels in late nineteenth century, cartels (trusts) were legal and common in the United States • oil • railroads • sugar • tobacco • steel 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 6 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) Auctions (cont.) • DOJ started investigating in 1997, but gained the necessary evidence in 2000, when Christie’s approached both DOJ and European Commission with proof that it had conspired with Sotheby’s to fix prices • Christie’s applied for leniency under the U.S. antitrust laws, effectively “shopping” its rival Auctions (cont.) • DOJ charged that the pair • held meetings between top-level executives • exchanged confidential lists of super-rich clients • agreed to limit which customers received lower commissions • charged identical commission rates (a sliding scale up to 20%) to other sellers who had little negotiation power • Sotheby’s paid a $45 million fine • the two auction houses agreed to pay more than $512 million to former clients to settle lawsuits Auctions (cont.) • A. Alfred Taubman, Sotheby’s former chairman and who still held a 21% share of stock and controlled 63% of its voting rights, was sentenced for price fixing to a year in prison and fined $7.5 million in 2002 • Christie’s former chairman, Sir Anthony Tennant, lives in England has refused to come to the United States to face trial • however, days before Taubman’s conviction, the European Commission brought charges against both auction houses 7 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 • governments forbid them 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 c q*q m Quantity, q, Units per year S MR Market demand AC MC p m MC m p c p m e m e c MC m p c Price, p, $ per unit (b) Market Q m Q c 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? 8 Maintaining cartels to maintain a cartel, firms must • detect cheating • punish violators • keep its illegal behavior hidden from governments Detection and enforcement • inspect each other's books (e.g., most-favored nation clauses) • governments report bids on government contracts • divide market by region or by customers mercury cartel (1928-1972) allocated U.S. to Spain and Europe to Italy • use industry organizations to detect cheating • offer "low price" guarantees Government created cartels • U.S., European, & other governments established a cartel in 1944 that fixed prices for international airline flights and prevented competition • baseball teams exempted from some U.S. antitrust laws since 1922 Bud Selig, baseball's commissioner: “[The baseball] antitrust exemption is protection for the fans.” 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 1963-1972 • 48% involved 6 or fewer firms • average number of firms: 7.25 • only 6.5% involved 50 or more conspirators • cartels often fall apart after entry (mercury) 9 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 648New Haven 543Norwalk 7810Bridgeport 982Meriden, New London 991Plainville, Stamford, Wallingford % of maximum allowed fee # of active firms Town 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 market • share of global production of 4 largest manufacturers of lysine in early 1990s • > 97% in U.S. • > 95% world • CR4 of buyers < 30% • large infrequent purchases • cost of a new plant $150+ million (over 3 years to build) • perfectly homogeneous product Lysine fines • 5 corporate fines • U.S. corporate fines: $92.5 million • EU: $97.9 million • Canada: $11.5 million • lysine cartel U.S. fine was 7x previous highest fine • 7 personal fines • in 1999, 3 people got prison sentences of 99 months total (indiv. max 36 months) Individual fines Michael D. Andreas (U.S.), Vice Chairman, ADM, $350,000 fine, 36 months of jail Terrance Wilson (U.S.), Pres., Corn Products Div., ADM, $350,000, 33 months Mark Whitacre (U.S.), Pres., Bioproducts Div., ADM, $350,000, 30 months Kanji Mimoto (J), Div. Mgr., Ajinomoto, $75,000 Hirozaku Ikeda (J), Div. Mgr., Ajinomoto $0 Kaztoshi Yamada (J), Mng. Dir., Ajinomoto, Fugitive Masaru Yamamoto (J), Div. Mgr., Kyowa, $50,000 Jhom Su Kim (SK), Pres., Sewon America, 75,000 10 Lysine buyers • individual U.S. buyers received compensation ≈ their losses • that is, they did not get treble damages • total U.S. corporate settlements: about $85 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 1985-1988 • 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" [...]... are playing noncooperative game of imperfect information Noncooperative oligopoly • many models of noncooperative oligopoly behavior • firms choose quantities • Cournot model • Stackelberg model • firms set prices: Bertrand model Basic model • duopoly: 2 firms (no other firms can enter) • firms sell identical products • market that lasts only 1 period (product or service cannot be stored and sold later)... Monopolistically Competitive Equilibrium Monopolistic competition • market structure in which firms • have market power • are price setters • firms enter if there is a profit opportunity (π = 0) p, $ per unit p = AC p • monopolistically competitive equilibrium: MR = MC p = AC (demand curve tangent to AC curve) MR r = MC MR r Dr q Figure 13.9a Monopolistic Competition Among Airlines (a) Two Firms in the Market... other routes • a single firm is the only carrier or the dominate carrier on 58% of all U.S domestic routes • although nearly two-thirds of all routes have three or more carriers, one or two firms dominate virtually all routes • monopoly serves 18% of all routes • dominant firm: has at least 60% of ticket sales by value but is not a monopoly • dominant pair if they collectively have at least 60% of the market... simultaneously, • why doesn't AA announce it will produce Stackelberg-leader output, • so as to induce UA to produce the Stackelberg follower's output level? when firms move simultaneously, UA doesn't view AA's warning that it will produce a large quantity as a credible threat: • not in AA’s best interest to produce large quantity • because AA cannot be sure that UA believes threat and reduce its output,... less than Coke offered) • Seven-Up Co sold for $240 million to another investment group ($140 million less than Pepsico's bid) • lower values to others than to Coke and Pepsi is consistent with FTC's view that Coke and Pepsi would have gained market power through these mergers Eventually • Dr Pepper and Seven-Up merged • by 1995: Dr Pepper/Seven-Up: 11.5% of carbonated beverages market • Cadbury: 5.5%... MR = MC p = AC (demand curve tangent to AC curve) MR r = MC MR r Dr q Figure 13.9a Monopolistic Competition Among Airlines (a) Two Firms in the Market AC MC q, Units per year Figure 13.9b Monopolistic Competition Among Airlines (b) Three Firms in the Market p, $ per passenger if F = $2.3 million 300 p, $ per passenger 300 275 π = $1.8 million 243 211 183 195 AC MC 147 AC MC 147 r D for 2 firms MR r... structure • all firms maximize profit by setting MR = MC • oligopolies and monopolistically competitive firms are price setters: face downward-sloping demand curves • oligopoly: entry blocked • monopolistic competition: free entry 25 pp , Price of Pepsi, $ per unit 17 2 Game theory • set of tools used to analyze conflict and cooperation between firms • each firm forms a strategy or battle plan of the actions... Nash equilibrium if, • holding the strategies of all other firms constant, 3 Cooperative oligopoly models • with collusion, firms collectively produce monopoly output and earn monopoly profit • each individual firm has an incentive to cheat on a cartel arrangement so as to raise its own profit even higher • no firm can obtain a higher profit by choosing a different strategy 4 Cournot model of noncooperative... noncooperative oligopoly • Stackelberg leader chooses its output first • then its rivals - Stackelberg followers – choose outputs • leader produces more and earns a higher profit than followers 6 Monopolistic competition • monopolistically competitive firms are price setters: MR= MC, so p > MC • there's free entry: p = AC 18 . fine was 7x previous highest fine • 7 personal fines • in 1999, 3 people got prison sentences of 99 months total (indiv. max 36 months) Individual fines Michael D. Andreas (U.S.), Vice Chairman,. compete with other firms • oligopolies engage in a • game: • any competition between players (such as firms) in which strategic behavior plays a major role Game theory • set of tools used by economists,. firm will do • firms are playing • a noncooperative game of imperfect information: • each firm must choose an action before observing rivals’ simultaneous actions Dominant strategy • a strategy