1

BSc(Econ) Financial EconomicsBSc Statistics and Economics

Introduction to Economics

Lecture 8 Oligopoly and Policy

Chapter 14 & 15

2

When Are Industries Oligopolistic?

• Common feature of developed economies

• Few firms

• Large barriers to entry– Development costs– Importance of reputation

• Highly differentiated, complex products

• Strategic interactions between firms

3

Some Industries

• Retail Banking – UK Big Four

• Pharmaceuticals – Glaxo Smith Kline, etc

• Civilian Aircraft – Boeing, Airbus

• Grocery – Tesco, Sainsbury, Asda, Waitrose, etc

4

Collusion• Example: OPEC – 1973, 1979.

• Joint effort to restrict supply of oil and raise prices.

• Agreed production levels of OPEC members.

• Firms attempt to limit their joint output to keep up prices and maximise joint profits

• 1994 – 16 European steel companies heavily fined by the EC for operating a cartel to raise steel prices.

5

Keeping out new competition

• High profits may attract newcomers – e.g., Branson – Virgin Atlantic

• Potential competition

• Contestable markets

6

Restrictive Practices• Attempts to limit competition • Vertical restrictions

– producers/wholesalers/retailers– dealership arrangements– exclusive dealing

• filling stations• pubs

– Tie-ins: banks; computer games• Resale Price Maintenance

– abolished in UK in 1976

7

Coordination among oligopolists• Explicit collusion generally illegal

• Tacit collusion – implicit understanding that the oligopoly’s interests are best served if its members do not compete too vigorously.– Price leadership– “never knowingly undersold”– Exclusion from information sharing etc –

punishment for deviation

8

Enforcement problem

• The cartel restricts total production to maximise total profits of members

• Each individual member finds it profitable to raise its own production – providing others keep theirs unchanged

• How to share out the profits? – Disputes over quotas

• FREE RIDING

9

Incentive to Cheat

10

Playing Monopoly for Real

• Actually OLIGOPOLY, not MONOPOLY

• Example: two firms: DUOPOLY

• Strategies: high price, low price

• Collusion: each firm sets high price– problem: each firm would like to undercut the

other– benefit: high profits from high price strategy

11

Playing Monopoly Games (II)

• Competition: both firms set low price– problem: each makes low profits– advantage: no temptation to cheat by

undercutting

• Can these firms sustain collusion?

12

Game Theory

• Payoff matrix

Profits offirms Firm A

HighPrice

LowPrice

HighPrice

100, 100 150, 50

Firm B LowPrice

50, 150 70, 70

13

Game Theory II• (Low, low) – Nash Equilibrium

• John Nash, Princeton, Nobel Prize 1994

(Russell Crowe – “A Beautiful Mind”)

• Each player’s action is a best response to the action of the other player.

• High price is a dominated strategy.– Whatever your opponent has chosen, choosing

low brings higher profits

14

Game Theory III

• Good things about game theory– applicable in many areas of economics and

politics and sociology etc– can explain almost anything

• Bad things about game theory – can explain almost anything

15

Alternative Competitions• Price or output?• Examples

– Output: COURNOT competition• Assume that the rivals’ outputs are fixed and maximise

your profit by choosing your optimal output• E.g. Manufacturing industry where capital cannot be

easily adjusted.

– Price: BERTRAND competition• Assume that the rivals’ prices are fixed and maximise

your profit by choosing your optimal price• E.g. Airlines where products are imperfect substitutes.

16

Cournot Competition (1838)• Augustin Cournot

• Firms produce perfectly substitutable goods– cement– aluminium

• Each firm decides how much to produce, assuming others have made their choice

• Each faces a RESIDUAL DEMAND CURVE

17

Residual Demand Curve

18

Reaction Function• What is your optimal output given your rival’s

output?• Downward-sloping.

19

Cournot Nash Equilibrium• Where the two reaction curves intersect.

20

Cournot Outcome• Production ends up below competitive

industry production and above monopoly.

• Prices higher than perfect competition, lower than monopoly.

• More firms means lower prices and higher production.

• With many firms, you end up with pure competition.

21

Bertrand Competition (1883)• Firms produce imperfectly substitutable

goods– E.g. The Sun vs. The Mirror

• They compete on price.

• Reaction function: the price that maximises your profit given the rival’s price.

• The higher the price set by the competition, the higher I want to set my own price – upward-sloping.

22

Bertrand Equilibrium• Again the intersect of the reaction functions.

23

Bertrand Outcome• Production ends up below competitive

industry production and above monopoly.

• Prices higher than perfect competition, lower than monopoly.

• But if the goods are perfectly substitutable (i.e. the demand is perfectly elastic), then get the perfectly competitive outcome (more or less).

24

Oligopoly: Conclusion

• Strategic interactions dominate– each firm responds to its rivals’ actions

• Many dimensions of competition and possible strategies

• Many theories and models

• Firms try to limit competition, restrict production, raise prices, and raise profits

25

Economic Costs of Monopoly• Production too low

• Prices too high: price exceeds marginal cost

• Economy does not have an efficient product-mix: too little of monopoly produced goods

• Inefficient allocation – dead-weight loss

• Transfer of income from consumers to monopolist

26

Restricted Output• Cost of monopoly -- welfare triangle

• Competitive Price PC, Output QC

• Monopoly Price PM, Output QM

• Deadweight Loss = (PM -PC)(QC-QM )/2

• Loss of consumers’ surplus

• How big for the economy as a whole? May be 2-3% of national income

27

Harberger Triangle (1954)

28

More Economic Costs of Monopoly

• Innovation – reduced R&D– Eastern Europe

• Efficiency– privatisation – water companies, telecoms– “managerial slack”

• Rent-seeking– Attempts to acquire or maintain rents by a

monopoly position: advertising, lobbying, bribery

29

Natural Monopoly

• Gas, electricity and water distribution

• Local phone networks

• Network externatilities

• Increasing returns to scale

• Socially efficient pricing: P = MC – firms make a loss

30

Natural Monopoly• The fixed cost is so large that the firm still exhibits

IRS even for the whole market.

31

Policies for Natural Monopolies• Nationalisation

– Labour government 1945-51: railways, telephones, electricity, water, gas.

– Problems• Managerial slack, innovation• Vehicle to control unemployment• Lack of investment to keep public sector borrowing

down• Cross-subsidisation (universal service)

• Introduce Competition– railway operators, gas and electricity producers

and sellers, telecoms, post

32

Problem with Competition• IRS firms can undercut potential entrants with the

downward-sloping AC curve.

33

Regulation II• Regulation

– OFCOM, OFGEM, OFWAT, ORR, CAA etc.

– limit rate of profit (base prices on costs)

– RPI minus X, X = estimated rate of productivity growth in excess of economy-wide rate

• Criticisms:– Problem of Incentives

• fixing rate of profit induces excess investment

• RPI formula allows firms to keep efficiency gains

– Regulatory Capture• Regulators are frequently pulled into the camps of those they

regulate (bribery, corruption, but also personal relationship)

34

Monopolies and Mergers• UK institutions

– Office of Fair Trading (1973)• Investigates cases

• Monopoly defined to be 25% or more of the share of the market

• May impose fines and other sanctions

• Apply EU as well as UK laws

– Competition Commission• May prevent mergers or impose conditions

• Recent cases: supermarkets; BAA; store credit cards

• Problems of market definition– Geography: UK / EU / global?

– Product differentiation: 4x4 / vans / luxury cars?

35

Restrictive Trade Practices (RTP)• In UK also handled by OFT

• The British policy does not outlaw the mere existence of a monopoly or a RTP.

• They have to operate against the public interest to be outlawed.

• The structure of industry is not enough to justify intervention, but the conduct and the performance.

36

EU Policy• Articles 81 and 82 of Treaty of the

European Union

• Economic effects of monopoly or restrictive agreements, not form.– Does not define the market share, but looks at

the abuse of market power.

• Penalties: greater than UK– In UK firms are not required to pay back the

monopoly rent earned.

37

Some recent EU Cases

• Microsoft (OK – not news)• Nov 2007. Fine of €486.9 million on flat glass

producers for operating price-fixing cartel• Dec 2007. Fine of €250 million on rubber

companies for price fixing between 1993 and 2002 (Eni, Bayer (let off as the whistleblower), DuPont (US), Dow Chemicals (US), Denka (Japan), Tosoh (Japan)

38

US Anti-Trust Policies• Date from late 19th Century• Cases may be brought by aggrieved competitors

– Rather than just by the government administration as in the UK

• Courts may impose punitive damages– Up to 3 times the value of losses they have imposed on

competing firms.

• US Dept of Justice Anti-Trust Division– Web site: http://www.usdoj.gov/atr/index.html

39

US Laws

• Sherman Act 1890– Prohibits all contracts, combinations and

conspiracies that unreasonably restrain inter-state and foreign trade

– Makes it a crime to monopolize any part of inter-state commerce, by suppressing competition, rather than by producing a superior product or service

40

US Laws: 2

• Clayton Act 1914 (amended 1950) prohibits mergers or acquisitions likely to lessen competition

• The Federal Trade Commission Act 1914 prohibits unfair methods of competition in interstate competition. Carries no criminal penalties. Created the FTC