Transcription
Class, so now we are covering the last Market structure chapter of our textbook, and this is oligopoly. Uh, remember that this one is closer to the extreme side of Monopoly, where, uh, you have Monopoly, only one seller of a good. Uh, whereas now, oligopoly has few sellers of a good. And if you recall, a perfect competition has many buyers and sellers, and also for monopolistic competition, also many sellers of a similar good.
Anyway, so oligopoly, it's the last one, and it's going to look a little different in how we cover it because we're not going to be using the same marginal revenue, marginal cost curves and figuring out our profit-maximizing quantity and that method. Now, uh, we're looking at a few other issues that allow us to focus our, or, or I guess, forces us to focus on other issues in this market structure.
So, oligopoly, it's a few large firms comprising an entire industry, and each seller knows that the other sellers will react to its changes in prices and quantities. Now, the characteristics of an oligopoly is that primarily there's going to be a small number of firms, and therefore, because of the small number of firms, there's going to be interdependence. And we're really going to focus on more this concept of strategic dependence. If you recall, for perfect competition and monopolistic competition, there was a larger number of firms, and especially with perfect competition, the larger number of firms implied that there was no control and no effect on the marketplace. And all that the perfect competitor had to worry about was figuring out the quantity that they had to produce. They weren't even price searchers, they were just quantity searchers. And so, for that reason, uh, they, they just had no influence on the marketplace.
But now, with an oligopoly, there's going to be a small number of firms, and because of the small number of firms, what each one does matters, and, uh, the others will react to it. So, this concept of strategic dependence, it's one firm's actions, whether it be to price, quality, advertising, or etc., may be strategically countered by one or more other firms in an industry, and it exists only when there are a limited number of firms in an industry.
So, the reasons why an oligopoly situation occurs and forms up in a market, in, in, in a marketplace is that either because of economies of scale. Now, uh, that these are very, uh, similar or concepts that we've already covered, hopefully familiar to you. Economies of scale, ownership of the key input, government-imposed barriers such as patents, and then also mergers result in oligopoly.
Now, two types of mergers, uh, in, in, in this situation here. We're looking at vertical mergers, which is the joining of a firm with another to which it sells an output or from which it buys an input. And so, they call it a vertical merger because if you think about the market structure, uh, or organizational chart, rather, that looks something like this. And in this situation, let's just say that we're doing something like making chairs, for example. And, uh, that's supposed to be a chair where a person can sit. Um, so in a chair, might, there might be a situation where you have the, the raw wood here, and it might go to the manufacturer, and then you've got the distribution. And so, a vertical merger might be something like where these two might merge, or these two might merge, or all three of them might merge, and forming a larger portion, um, in terms of this, this, uh, product or good.
And then there's a horizontal merger. The horizontal merger is the joining of firms that are producing or selling a similar product. So, a structure chart might be something like this. And while this isn't exactly, it might be something like, uh, you might have, for example, Target, Walmart, and I don't know, I'm making up some, the CVS or whatever. And so, this horizontal merger means that the merger occurs in this way. So, it's really the structure, uh, chart that they're talking, I think, this vertical and horizontal mergers.
So, in understanding an oligopoly, uh, and trying to figure out these small number of firms that that interact with strategic interdependence, um, we're going to need to understand this concept of the concentration ratio. So, you're, this is where you're measuring industry concentration amongst a certain amount of firms. And the, and so, essentially, the concentration ratio is the percentage of all sales contributed by the leading four firms in an industry.
So, looking at computing the four-firm concentration ratio. If you look at here, we have on the left side, um, we have the firms over here, and so we have it ranging from one down through five, and then it goes through 25, and you have the annual sales here. And so, based on firm one and firm two, so these are the top four firms, and so the four-firm concentration ratio, out of this total of 450, 400 over 450, the four-firm, top four firms have 89% of, uh, the market, uh, ratio, I guess, within just them four.
And so, we can also get a look at some data here, which is the four-firm domestic concentration ratio for selected US industries. So, you can look at the share of total sales accounted for by the top four firms. And for the industries, cigarettes, they got to who, 98% of the top four, which is what is that, like Philip Morris and so forth. And then, um, breakfast cereals, 80, um, going down the line, you'll see soft drinks and commercial banking. Where a lot of people say commercial banking, the big banks, you know, a few of them have all the control. Actually, in commercial banking, there's only 32% share held by the top four firms. So, that's actually a relatively low concentration ratio.
Here's an international example with some numbers. The four-firm concentration ratio in the global tire industry. So, it shows here, recently, a few companies accounted for a significant share of total global, uh, total global dollar sales of tires, where you're looking at Bridgestone at 14.2, Michelin, Goodyear, and Continental with the top four. And so, the top four, four-firm concentration ratio for the industry was 45.2%.
Here's another industry method, uh, for looking at the concentration ratio. It's the Herfindahl-Hirschman Index, or HHI, and it's equal to the sum of the squared percentage sales shares of all firms in the industry. So, looking at Industry A and Industry B, you can see here the firms for Industry A, firms for Industry B, B here on the right. And so, essentially, what you have is the sales share for firm number one, and then you're going to square that value. That gives you 6601. Same thing here for firm one on for Industry B. Sales share percent 25, the squared value here. So, this sum of this column, top four, gives an HHI of 6718 versus 2500. So, for Industry A, which we saw was 6718, and Industry B, which was 2500, this difference reflects the fact that the distribution of firm sizes is more even in Industry B than in Industry A.
So, taking a look at the HHI for US airline industries. So, this is the percentage shares of sales for the top 10 US airline firms. You can see that, uh, 18.2, 18.1, and so forth. The resulting HHI is about 1272. And again, just to put it in perspective here, you can see the relative numbers of 671, 18.9 versus 2500. And this one, uh, for the industry is only 1272.
Okay, so now getting back to one of the main, uh, separating ideas and concepts in oligopolies that focuses the, uh, attention of economics classes, the concept of strategic behavior and game theory. So, game theory is pretty much, uh, tied into this oligopoly concept. And so, this is where you're going to see a lot of discussions, uh, coming from in the business world, or not just the business world, but any type of world where you have interactions between players and a small number of players where there's tends to be winners and losers based on how they interact with each other.
Explaining the prices and output behavior of oligopoly markets, we're looking at something called the reaction function, and that's simply referring to the manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry. Now, one thing to realize, as US firms face global competition, the less any current oligopoly will will be able to exercise market power because as we open up markets, the few firms in the US, uh, that might be forming an oligopoly now have new entrants into their marketplace from the global environment. And thereby, that's where it chips away from their ability to have influence in the marketplace because now it starts to resemble maybe monopolistic competition or perfect competition a little more, where you have a large number of sellers.
But anyway, uh, for going on to this strategic behavior concept and game theory. Game theory, it's a way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and they plan accordingly.
Now, the types of games that we can be looking at, uh, in game theory is the first one we're going to talk about is a cooperative game. And a cooperative game is pretty self-explanatory. It's the players explicitly cooperate to make themselves better off. Now, this situation of cooperative games, uh, in an industry is where firms collude, or they, they plan to and act and behave, uh, in, in conjunction and plan together for higher than competitive rates of return. In other words, these firms, which are not monopolies, they decide to restrict output in a coordinated effort. So, by restricting output, there's, they're essentially exercising monopoly-type power because when you restrict quantity, remember going on the horizontal axis of the demand curve, you restrict quantity, you move higher up on the demand curve, and you can charge a higher price. And that's what monopolists do with their marginal revenue equals marginal cost curve intersect. So, that's a cooperative game where the players, uh, collude to act to get monopoly power.
Then there's a non-cooperative game, which also is pretty self-explanatory. The players neither negotiate nor cooperate in any way, and relatively few firms with some ability to change price.
Now, we can talk about the different outcomes of games, whether it be a non-cooperative or cooperative game. Uh, the results of the games could be considered what we call a zero-sum game. And I'm sure you've heard this, uh, referred to in other situations. A zero-sum game is when any gains within the group are exactly offset by equal losses by the end of the game. So, within the group, it doesn't mean that nobody in the group loses. No, somebody in, one group within the group may lose, may be the losers, so to speak, maybe of a policy being implemented. Um, and but while some lose, and that will be a bummer for them, some will gain. And those that gain, gain by the amount that the others lose. So, as a group, as a whole, the group isn't worse off. Some lost, some got better off, but they're the same. So, that's a zero-sum game.
Then you can guess what a negative-sum game means, and that's when the players, as a group, lose at the end of the game. And again, it doesn't mean that within the group nobody wins. It's just that the wins within the group are offset by more than the wins, and therefore, as a group, there's a negative-sum outcome. And then there's the positive-sum game, which players, as the group, are better off at the end of the game. And likewise, it doesn't mean that nobody loses. It just means that while some lose in the group, overall, the group, uh, gains.
So, strategies in non-cooperative games. And when we consider what a strategy could be, a strategy is any rule that is used to make a choice. It could be some complicated algorithm, or it could be something as simple as always pick heads when you're flipping a coin, or never split tens when you're playing Blackjack. If you are a blackjack player, that you go to Vegas and you sit at a Vegas table, and let's just say you get dealt two tens. Maybe the dealer showing a nine or even a jack, whatever. Um, and you're thinking they might have 20, you have 20 because you have two tens, but you have an option to split them. Uh, if you do decide to split tens, essentially everybody at the table who knows how to play is going to look at you with angry looks, and quite possibly, if it turns out that somehow your action changed where the dealer wins and everybody loses, they're going to grab their chips and walk away from the table and not want to play with you. That's how splitting tens tends to work at a Vegas table, not always, but most of the time, in my opinion. But anyway, that's, uh, the concept of a strategy.
Now, we're going to talk about dominant strategies, which is a very important concept in this chapter. Dominant strategies are strategies that always yield the highest benefit, uh, and so therefore, you, it, it's very clear what action you're going to take because a dominant strategy exists. Now, dominant strategies don't always necessarily exist, so it's not necessarily clear what action to take in that situation. But the dominant strategy situation is something that we're going to build up on right, uh, right now, as we move forward, and it's going to be, uh, key to this concept of the prisoner's dilemma. And you've probably heard of the prisoner's dilemma somewhere before, but let's go over it again.
The prisoner's dilemma is a real-world example of game theory that occurs when two people involved in a bank robbery are caught. Now, the prisoner's dilemma, I, I've seen it just recently. I think I might have seen it in a Law and Order episode or, or, gosh, it might have been a, a spy type of, uh, action show. But anyway, the prisoner's dilemma is a very important concept and very, uh, widely spread in discussion, so it's good to understand what it is.
Now, here's the basics of the prisoner's dilemma. Two people are caught, uh, in a bank robbery, I guess, and, uh, they are separated. The two are interrogated separately, and their interrogator informs them that number one, if both of them confess, then they each get five years in jail for the crime. Now, if neither confesses, they will each get two years based on a lesser charge. And thirdly, if only one confesses, that person will go free, but the other receives 10 years. So, these are the outcomes that they have to choose from.
Now, this is what we call a payoff matrix, uh, and this is a typical prisoner's dilemma payoff matrix where they show two actors or two, uh, players in this game. In this game, we have Sam and we have Carol, and we have the actions that Sam can do. Sam can either confess or not confess. Carol can either confess or not confess. Now, these blue triangles here are the outcomes for Sam. Now, these outcomes for Sam will be based on whether or not Carol confesses. These are the outcomes: five or 10 years, or if Carol doesn't confess, these are the outcomes: go free or two years, whether it be confessed or don't confess. So, Sam has outcomes based on what Carol decides to do, and likewise, Carol has outcomes based on what Sam decides to do. If Sam chooses to confess, then Carol's outcomes fall in these green. Now, if Sam chooses not to confess, these are her outcomes based on her choices to confess or not confess.
So, this is a very important process right here. We want to figure out if there are going to be any dominant strategies for Sam and Carol. Now, a dominant strategy exists when, irrespective of what the other person does, one person has a clear decision of what they should do. That's a dominant strategy. So, let's break this down, uh, to figure out if a dominant strategy exists. And let's start off first to see if Sam has a dominant strategy. So, it's kind of going to be a two-step process. We're going to look at what Carol does. Let's just say that Carol chooses to confess. So, if, if she chooses to confess, then we are operating in this portion of the payoff matrix right here. And if she chooses to confess, which is the better action for Sam to do? Should he confess or not confess? Which is the better outcome? Where the better outcome, if Carol confesses here, he can have either five or 10 years served. Well, five years served is the best choice. So, right now, we're halfway to figuring it out because right now we see that, well, based on if she confesses, then he should confess, because five versus 10 years. But we're only halfway there. That's not a dominant strategy yet.
We're now, we're going to look at what happens if Carol doesn't confess. Now, we're operating in this bottom area. Now, his outcomes are to either go free or serve two years. Well, between the two, going free is the best option. So, irrespective of what Carol chooses, she can choose to confess, or she can choose to not confess. Five years versus 10 years, or go free versus two years. He clearly has the best activity choosing this first column here, which means that he should confess. So, Sam has a dominant strategy. Irrespective of what Carol chooses, his best outcome is to confess.
Next, we want to figure out, does Carol have a dominant strategy? Well, we're going to need to determine it based on what Sam does. So, if Sam chooses to confess, then we are in this column for Carol, and she needs to decide what to do. So, her outcomes are the pale green, uh, what is that, seafoam green, seafoam, uh, green triangles here, where she could either serve five years or 10 years. Five years is a more desirable outcome. So, confess is the action that she should do, should Sam confess. But we're only halfway there. We need to see if she has a clear outcome irrespective of what Sam chooses. So, if Sam chooses not to confess, we're going to be in this right side column. Her outcome in that case, if she confesses, she'll go free. If she doesn't confess, she'll serve two years. So, in that situation, her best action is to go free, and that falls in the confess range. So, in either situation, irrespective of what Sam does, whether he confesses or not confesses, her best action is to serve five years instead of 10 years, or to go free instead of two years. So, her dominant strategy is to confess.
So, both of them actually have a dominant strategy, and it is to confess. So, if both of them follow their dominant strategy, pursuing dominant strategy, they end up in here where they both serve five years. Okay. Could Sam have been better off? Certainly. Sam could have been better off instead of serving, uh, instead of serving those five years, Sam could have either gone free or served two years. Same thing with Carol. Instead of serving those five years, she could have gone free or served two years. So, either of those outcomes are better than the five years that they are serving. Kind of ironic, right? That pursuing your dominant strategy kept you away from this one, kept Sam, I mean, sorry, kept Carol away from this outcome, and kept Sam away from this outcome, leaving them five years each. So, that is in a, that is the prisoner's dilemma outcome. And let's sum that up.
So, the prisoner's dilemma, it's a game in which pursuing dominant strategies in non-cooperation that results in everyone being worse off. This is the prisoner's dilemma, pursuing dominant strategies, non-cooperative game, which leaves everyone worse off. Remember, one of the important aspects was that I'm moving backwards in the slide. Let's see. Oh, maybe it's not really clear yet. Um, okay, I, I need to make this, make this point is that the prisoner's dilemma is an outcome in a non-cooperative game. Okay.
Now, uh, we can talk about something called the Nash equilibrium in the prisoner's dilemma. A Nash equilibrium, a situation in which each firm chooses the best strategy given the strategies chosen by other firms. Pursuing their dominant strategy, and that is named after the Nobel Prize winner John Nash of Princeton University. You might have seen that movie with Russell Crowe, uh, called A Beautiful Mind. It was a Hollywoodized version of John Nash, the Princeton, uh, trained economist. Anyway, um, so, to me, one of the main points of the prisoner's dilemma is that it's a non-cooperative game, and that non-cooperative game leaving everyone to worse, to be worse off. Uh, and the idea, uh, that that was very groundbreaking in a sense, from John Nash, in, in how the Nash equilibrium and dominant strategies and outcomes and so forth, and how it contributed to his Nobel Prize, was that it's possible to escape the prisoner's dilemma. And one of the, the main ways to escape the prisoner's dilemma is, you've probably seen it in episodes of things like Law and Order or Criminal Minds or those type of crime shows, is that despite separating the criminals, the criminals act in a cooperative manner and thereby beat the system. So, you can escape the prisoner's dilemma by changing a non-cooperative game into a cooperative game.
Another method of escaping the prisoner's dilemma is a repeated game situation where people play the same, play, uh, similar or, or the same game over and over again, and through learning through the outcomes, they learn to, for example, cooperate because if they cooperate, then they each can, can, uh, achieve a better outcome than, for example, the five years served in prison.
So, looking at different behavior categories, uh, there's a, a strategic behavior called a tit-for-tat strategic behavior. And in game theory, it's cooperation that continues so long as the other players continue to cooperate. Now, I don't know if you've noticed, but the big box style retailers, whether it be Target or Walmart, for example, they all tend to sell a lot of very similar products, such as, for example, PlayStation 5s or the new Xboxes. And one of the things, if you're a gamer, you might notice that by going to those types of stores, you'll notice that the price is very by very little. So, there's not much change in them. If, if one system's going for $599, the other system in, I mean, the same system in another store will also be $599. Now, it kind of rests there for a reason. And a lot of it, this could be almost implicit collusion. What happens if one store, Walmart, for example, tries to gain market share over Target by lowering the price of one of the game systems? Well, the other, the competitor, Target, could match that low price. So, they'll drop their price as well to gain back the market they lost. But when the other firm lowered their market, lowered their price, now this can continue. One firm, the, could continue to lower the price of the product to gain more market share, but they're losing price per unit. Uh, they're losing revenue per unit by doing that. Now, the other firm can also match, and it can keep going down. It's, it's essentially a bit of a price war. Now, who wins in a price war? The, the consumers certainly do with the lower prices, but the firms all lost out because of this tit-for-tat strategic behavior, matching it. Now, they could have all been better off had they held prices higher.
So, this tit-for-tat strategic behavior could lead to something called implicit collusion, where, for example, after what I mentioned before, a repeated game scenario, Walmart and Target continually battling over these price cuts, to try to gain market share. In the end, they learned that all they do is lose out. So, by repeated game scenarios, they've learned that, hey, if I get into a price war and continue to cut prices, I'm made worse off, and so are they. So, let's just hold our prices steady and not get into a price war, and we'll both be better off. Now, that is also, in a way, how those price match situations that you see advertised, when you see online or in a newspaper, in a magazine, where we say, our firm will match the price of our competitors, the low price of our competitors. So, you can have confidence buying from us. That sounds like it's a situation that's really good for you, doesn't it, as the consumer? But if you kind of think of it for this tit-for-tat strategic behavior, it's essentially enforcing this implicit collusion, saying, hey, competitor, I'm going to match any price cut that you do, and we're both going to end up losing. But, but if you don't, then my price will stay high, your price will stay high, and we both can win. So, those low P, those low price matches that we've seen advertised, it sounds really good for us, but at the same time, it also is, in a way, a way for firms to collude to keep prices high, gain market, keep, get monopoly power type of profits, essentially.
So, some of these concepts lead us into, uh, a scenario in an oligopoly situation called a cartel. And a cartel is an association of producers in an industry that agree to set common prices and output quotas to prevent competition. So, again, if you recall, considering a demand curve where we have price and quantity and we have demand, what essentially they're trying to do, let's just say that this is the more competitive outcome right here at Q1 and P1. But if they collude to set common prices and output quotas, so an example, they might decide to set a quota at Q2. What happened to the price that they can charge based on the demand curve? They can charge a higher price and thereby getting, so for example, marginal cost, they get monopoly profits, right? If we have our, our situation where we have demand and marginal revenue, for example, marginal revenue curve and so forth here, they get monopoly profits. And that's one of the benefits of colluding to act together to gain monopoly profits in a cartel type situation.
Now, typical cartel discussion is OPEC, Organization of Petroleum Exporting Countries. And we're going to expand on that a little bit, uh, regarding this rationale for cartel to cooperate. The rationale for cartel is to cooperate to determine how much to produce to maximize their combined profits. They form a cartel and jointly act as a single producer. They collude and act together to attain the same outcome that a monopoly firm would aim to achieve. And cutting back on production maximizes economic profits by restraining its production to a rate below the competitive output rate. However, eventually, each individual member could theoretically increase its profits by charging, uh, by increasing production and lowering price. Is supposed to say, increase its profit by charging a lower price and increasing production, but that, that was edited incorrectly. So, essentially, though, cheating as a member of a cartel, uh, if they choose to cheat and not adhere to the fixed quota, they could increase output, allowing them to, uh, capture more market share and make more profits. And what happens is that tit-for-tat strategy starts to occur, where everybody says, okay, we have a cheater in our group. If they're going to cheat, I'm going to cheat. Everybody cheats. All the prices go down. Becomes more competitive situation where prices go down, output goes up. The firms lose, and the consumers win. Deadweight losses are minimized, and so forth.
So, why cartel agreements usually break down? Most cartel agreements do not last for more than 10 years. Economic profits that existing firms obtain from holding prices above competitive levels provide an incentive for new firms to enter the market. And variations in overall economic activity also tend to make cartels unsustainable. And, uh, regarding enforcing our cartel agreement, four conditions make it more likely that firms will collude as a cartel. And these are the conditions that make it, uh, higher probability of success: a small number of firms in the industry, of course, relatively undifferentiated products, easily observable prices for planning and, uh, so forth purposes, and little variation in prices, again, consistency and so forth. So, these are the conditions that make a cartel give it a greater chance for success to act like a monopoly and capture monopoly type profits.
Now, here is a brief summary of the market structures, uh, where you have on the first column, perfect competition, monopolistic competition, oligopoly, pure monopoly. You have the basic characteristics such as number of sellers, the entry and exit issue, ability to influence price, long-run profits, yes or no, product differentiation, non-price competition, and then type of examples for each market structure. So, this is a good thing to keep handy, uh, to try to recall, uh, some of the more technical aspects, and keep them in order in terms of thinking of about the marginal cost, marginal revenue curves and so forth. So, I hope this is helpful. There's some other concepts in the chapter, but I think a lot of that stuff is just suitable for reading. Again, these lecture videos are not meant to replace, uh, to replace the chapters, but readings, but rather augment it. So, please make sure you continue to do so, uh, reading the chapters. And, um, the next chapter we'll cover will be, uh, environmental economics in Chapter 30. I hope everyone's doing well. Stay healthy, uh, and, uh, stay focused as the term winds down, and I look forward to talking to you all soon. Aloha, take care.