Strategic Interdependence

Interdependence occurs because what one firm does has a noticeable affect on the profits of other firms in oligopolies Each firm will choose a course of action (strategy) depending upon what it believes the other firms in the industry will do. A dominant strategy is one that is best under all circumstances -- regardless of what others do. Firms will follow their dominant strategy. Even if a firm does not have a dominant strategy, it may be able to assess whether the other firms do. If so, it assumes the others will follow their dominant strategy and then chooses according to what maximizes its profits given this assumption. If a firm lacks information to assess others' likely reactions, they will assume the worst; leading firms may assume that smaller firms will follow their lead or that they will not change their output and/or price.

Example

In Thursday's simulation, the dominant strategy for each firm was to charge the low price. If other firms charged the low price, this firm made $17 if it chose a low price but lost $40 if it charged the high price. If the other firms both charged a high price, this firm made $105 by charging a low price instead of the $35 it would have made by charging the high price. If the other firms followed different pricing (one H, one L), then this firm could gain $45 by charging a low price but lose $25 by charging a high price. The low price is best under all circumstances -- it is the dominant strategy.

Prisoner's Dilemma
Each firm follows its dominant strategy Each gets less profit that it would if they could jointly agree to follow some other strategy. Example: each firm charges the low price but both would be better off if they could agree to charge a higher price. Firms will look for ways to coordinate actions to reach the alternative that provides them both with higher prices.

Means of Coordination
Collusion (price fixing) and the formation of cartels. Guaranteed price matching -- a firm guarantees that it will match a lower price by a competitor. Price leadership and the use of "trial ballons" released to the media. Retaliation strategies -- firms punish those who undercut the established price.

Collusion
Firms agree to all charge the same price. They act as a monopoly. Firms sets price that maximizes the industry profits (gives them the largest total to divide). The price is the same as what a monopolist would charge. The firms also agree to output quotas or a dividing of the market (who sells to which customers) to avoid over-production and downward pressure on prices.

Optimal conditions for collusion

Collusion is more likely when The firms have similar costs and products (not highly differentiated) The number of firms is not too large or small. Larger numbers make agreement difficult and cheating hard to detect. Firms in very strong oligopolies have alternative ways of coordination actions an don't need formal collusion. Median number = 8. Collusions is allowed by the government. Although it may be legal in some places, in the US, price fixing and other forms of collusion are illegal. Demand is stable.

Cheating under collusion
Once firms have established a price through collusion, each firm has an incentive to cheat. It can sell more and earn more profits if it cuts the price a bit to at least some customers. Firms try to avoid detection by keeping their list prices the same and giving secret discounts to some customers. Most price fixing agreements eventually disintegrate due to cheating or prosecution.

Guaranteed price matching

A firm guarantees that it will match its competitor's price by advertising that if consumers find the product available eslewhere for a lower price, it will refund the difference. The firm can charge the higher price. If competitors also charge the higher price, all will earn $35. If, however, the other firm were to charge a lower price, the first firm's price automatically falls too and both earn only $17. Because the second firm knows from the ads that price cuts will be matched, it choses the better alternative -- it keeps its price high too.

Informal Coordination

If the number of firms is very small, they they do not need to collude. Over several time periods, firms learn that a certain pattern of responses works to coordinate prices. One firm, understood to be the price leader, issues a press release announcing future price increases. This is an easily-rescinded trial ballon to see if others will follow. If the change is initiated due to increased costs or other market changes that affect all firms, the initiator expects, and usually finds, that soon others announce similar price changes. Firms are more likely to follow the leader if they have similar costs and products.

Retaliation

Firms maintain coordinated prices by punishing those who don't "follow the rules," especially if they believe the firm cut its prices to gain market share. If someone else cuts price, the other firms also cut theirs and keep them low until the price-cutter raises its price. Then after a time to recoup the loses, the others will again raise theirs, (tit for tat strategy) Many times the other firms punish the price cutter by cutting their prices even more, driving down the offending firm's profits to zero or below. (grim trigger) Further price cuts (a price war) may occur until the offending firm raises its prices to a level the others can accept. Repetition of these patterns will make firms reluctant to devaite from the established pattern.

Concentration and Coordination

Informal coordination works best if the number of firms is small (highly concentrated industry). Firms are more likely to estimate others' costs and revenues and anticipate how they will respond. As the number of firms increases, these assessments are more difficult. As the number increases, firms are more likely to be in different situations in terms of costs and product lines and therefore not willing to go along. As the number of firms increases, cheating is harder to detect and punish. Informal coordination works better when demand is increasing than when demand is decreasing.

Maximin Strategies

As the number of firms increases, it becomes more difficult to assess whether other firms have a dominant strategy. Because it is difficult to assess what others will do, firms assume the worst. They assume that competitors will not match price increases. The initiator's sales will decrease substantially as will profits. They assume that competitors will match price decreases; the initiator gains little in sales and profits. Estimating demand under those assumptions, firms chose the price and quantity which maximize profits. Firms can try to coordinate prices but the lack of information about the others makes this difficult.

Uncertainty and sticky prices

Price change infrequently in most oligopolies. Most firms change them only months after changes in market conditions. Most change prices no more than once per year. Prices are sticky (slow to change) because firms are uncertainty about competitors' reactions and willingness to coordinate their prices. When costs rise, firms are reluctant to raise prices for fear others won't follow their lead but will ue th opportunity to gains sales and profits. Even if the firms agree to raise prices, some might cheat. When demand falls, firms are reluctant to cut prices for fear the others will relatiate and that a price way will develop, hurting everyone's profits. Consequently, prices remain high.

Price discrimination

Is the practice of selling a product to different consumers at different prices when the cost of serving those customers is the same. Practiced by all types of imperfectly competitive firms (monopoly, oligopoly, monopolistic comepetition). Examples: student or senior citizen discounts, coupons Quantity discounts are not a form of price discrimination if they reflect the lower cost of handling large orders. Works only if consumers can not resell the product, different groups of consumers have different price elasticities of demadn and can be distinguished from each other at low cost.

Setting different prices

The firm should produce and sell so that MR = MC for each group of customers. The group with the more inelastic demadnw ill be chared a high price as that will increase revenue without losing many sales. The group with the more elastic demand will be charged a lower price to sell additional units. Price discrimination allows the firm to sell additional units. Revenues and profits will increase as a result. It may also be a way of cutting the price without provoking retaliation if done in secret.

Example
Price 13 12 11 10 9 8 Demand 1 0 2 4 6 8 10 MR 1 - 12 10 8 6 4 Demand 2 3 4 5 6 7 8 MR 2 13 9 7 5 3 1 Total Dd 3 6 9 12 15 18 MR 13 11 9 7 5 3 If MC = 8 for all units in this range of outputs, what price should the firm set in each market?

Non-price competition

Because price competition is often detrimental to the firms, oligopolists will usually compete on non-price terms: by advertising, or on the basis of product characteristics or service. Advertising or styling strategies: If others advertize, you sell much less unless you advertize too. If they don;t advertize you cen sell more and increase profits if MR > MC of ads. Advertising dominates. All advertize, cost rise, revenues do not increase much, profits decline.

Advantages of non-price competition
Although product differentiation can also be subject to the prisoner's dilemma, there are advantages to using it as a basis for competition. Product differentiation changes take longer to match. The innovator earns economic profits for longer. Advertising and product characteristics are more difficult to match exactly. Product differentiation creates barriers to entry.

Product Differentiation in Monopolistic Competition

Monopolistically competitive firms also compete in terms of product characteristics. Firms which are successful in introducing appealing new varieties will find that demand for their product or service is a bit less elastic and that they firm can raise price while retaining more customers. Advertising in monopolistic competition tends to be a bit more informative and less image-creating than advertising under oligopoly.

The long run under monopolistic competition
Barriers to entry are low: short-run economic profits lead to entry. New brands will attract some buyers; the older firms will find demand for their product has decreased and become more elastic. Revenues and profits have fallen. Entry continues until the typical firm makes zero economic profit. This aspect of the industry is similar to perfect competition.

Long-run Equilibrium - Monopolistic Competition

In the long run, the firm is maximizing profits (MR =MC) and entry has led to zero profits (TR = TC; p = LAC). The firm's demand curve is tangent to its long-run average cost curve on the downward-sloping section. The firm is not operating at the minimum point on its long-run average cost curve. There is excess capacity. The economy could produce the same output with fewer resources if the each firm were a bit bigger (produced a bit more). That doesn't happen because people don't want more of any one variety. The extra cost is a result of the product differentiation. Is variety of products worth the extra cost?

Oligopoly in the long run

Coordination (collusion or by informal means) leads to higher prices and higher profits. If barriers to entry are high, few enter and the industry remains concentrated. Firms continue to restrict output, charge high prices, and earn economic profit. If barriers to entry are low to moderate, short-run economic profits will attract in new firms, leading to a fall in price and profits in the long run. The threat of this entry will moderate firm behavior -- they will keep prices lower and output higher to forestall entry. They will also try to erect additional barriers. Other things being equal, economic profits will be greater than more concentrated the industry and the higher the barriers to entry.

Entry limiting strategies
Firms can exploit cost advantages by limit pricing (pricing to deter entry). The firm expands output and lowers price until it is just below the average cost of a potential entrant. Even though the established firms make a profit, a new entrant, having higher cost, would not. Entry is deterrred. Established firms make smaller economic profits in the short run but gain in the long run.

Creation of barriers

Firms have an incentive (long-run profits) to create barriers to entry. Product differentiation (brand names, style changes, image-creating advertising) makes it less likely consumers will switch to a new entrant's product. Control of key raw materials on control of distribution channels through internal investment, vertical mergers or agreements with corporate buyers (exclusive dealing). Multiple patents.