Oligopoly Pricing: A Game Theory Overview

   Oligopoly pricing behavior has characteristics of a specific game of strategy. Like chess or poker. The best way to play such a game depends on the way opponent play. Oligopolists (in our case players) must pattern their action according to actions and reactions of rivals. The study of oligopolists behave in this strategic situations is called game theory. We will use game theory model to analyze and explain the pricing behavior of oligopolists. Let’s assume that in our oligopolistic market system are only two firms that produce CDs simply called “A” and “B”. Each firms- “A” and “B”- has a choice of two pricing strategies: increase the price or lower it. The profit of each firm depends on what strategy it chooses and what strategy its rival chooses.
   There are four combinations of strategies possible for these two firms, and letter cells in the table below express them. For example, cell W represents low-price strategy of firm “B” and high-price strategy of firm “A”. This table is called payoff matrix because its cells represent the profit(payoff) each firm makes that result from combination of strategies of firms “A” and “B”. Cell W represents that after firm “A” chooses to adopt high-price strategy and firm “B” chooses to adopt low-price strategy, then firm “B” will make 4 million dollars and firm “A” will make only 1 million.

Mutual Interdependence
   The Data in the payoff matrix are just hypothetical one, but relationship is very realistic. Remind the fact that oligopolistic firms can increase their revenues, and influence rival’s profits, by changing its price strategies. Each firm’s payoff depends on its own pricing policy and that of its rival. This mutual interdependence in economics is very well demonstrated by figure above. If both firm “A” and firm “B” adopt a high-price strategy then revenue of each one will be 3 million of dollars. If firm “A” uses a low-price strategy while firm “B” uses a high-price strategy then firm “A” will increase its market share and profit from 3 to 4 million of dollars, however firm “B” will lose 1 million of dollars, since its revenues will decrease from 2 million to 1 million of dollars. So, firm “B” high-price policy will be efficient only if firm “A” will also choose to employ a high-price strategy.
Collusive Tendency
   The figure above suggests that oligopolists will benefit from collusion, or better said cooperation with rivals. An example of benefit can be when both firms are following high-price strategies, so each firm will get a profit of 3 million of dollars (cell X).
   Note that either firm “A” or firm “B” can increase its profit by switching from high-price to lo-price policy. So, the profit can become 4 million of dollars, but the firm that keeps high-price policy will get only 1 million of dollars as revenue. If the firm that right now employs high-price strategy switches to low-price strategy will increase its revenues by 1 million so it will be able to collect 2 million (cell Z). The effect of all this will be switching the profits from 3 million (cell X) to ones which worth 2 million (cell Z).
   In real situation, however independent actions of oligopolists may lead to competitive low-price strategies, which clearly will be beneficial to consumers but not also to oligopolists whose profits will decrease.
   How can oligopolists avoid low-profit outcome of cell Z? They may collude, rather that installing independent and competitive price. Each firm will increase its profits from 2 to 3 million dollars (from cell Z to cell X).
Cheating
   The payoff matrix explains why oligoplists may be tempted to cheat on a collusive agreement. Suppose that our firms “A” and “B” agree to maintain high-price policy, both of them earning 3 million of dollars (cell X). Both firms are tempted to cheat so that they will be able to increase their revenues to 4 million of dollars. If firm “A” cheats and diminishes its prices then it will increase its revenues from 3 to 4 million of dollars (cell Y), while if firm “B” cheats secretly and moves to low-price policy while firm “A” keeps high-price policy then firm “B” will increase its revenues by 1 million of dollars moving from cell X to cell W.

Advertisement

Technological advance: invention, innovation, and diffusion.

       In economics technological advantage is new and better goods and services and new and better ways of producing or spreading them. This process occurs over a theoretical time called very long run, than can be as short as few weeks or as long as many years. Let’s recall that in all our market systems (pure competition, monopolistic competition, oligopoly and pure monopoly), the short run is a period in which technology, plant are fixed, however in the long run , technology is constant but the firms can change their plant size and are free to enter and exit the industry. In contrast, very long run is a period in which technology can change and firm can develop and supply totally new products.
   It’s known that technological advantage shifts product possibility curve upward, enabling economy to achieve more goods and more services. Technological advantage can be is made up of three parts: invention, innovation, and diffusion.
 Invention
   The first step to technological advantage is invention: the discovery of product or process of producing by using imagination, thinking and experimenting. Invention is a process and the result of it is also called invention. Invention is based in scientific knowledge and it is the result of work of individuals who work on their own or as members of Research and Development (R&D) departments in firms. Government encourages invention by providing patents, right to sell any innovative process of production, machines or products in a set time.
Innovation
Innovation is directly related to invention. While invention is “discovery and proof of workability”, innovation is the successful introduction of new product (invention) in the market, the first use of a new method of producing, or the creation of new form of business firm. There are two types of innovation: product innovation, improving products and services, and process innovation, which is improved ways of production and spreading of these inventions in the market.
In contrast to invention, innovations cannot be patented. Innovation needs not to weaken or destroy the existing firms. Because new products and processes threaten firms’ survival, existing firms have a high incentive to engage into research and development (R&D) process continuously. These innovative products and processes enable firm to earn higher revenue or to maintain the present ones. Innovation can strengthen or weaken market power.
 Diffusion
   Diffusion is the process of spreading of inventions through imitating or copying. To take the advantage of new profits or to slow down disappearing of others, all firms try to implement the innovations. In most of the cases innovation leads to widespread imitation (that’s diffusion) of inventions. For example, soon after McDonald’s introduced the fast-food hamburger, Burger Kings also started to produce it, since it offered high revenues for the firms that supplied this good.
Research and Development (R&D) Expenditures
When it’s related to business research and development means the efforts towards inventions, innovations and diffusion. Many countries engage in R&D of national defense, so that annually they spend thousands of billions of dollars.
Importance of Technological Advantage
   Technological advances for many centuries were viewed ad external to economies, like a force to which economies adjust. Periodically new advances in scientific and technological knowledge occurred. Firms and industries, incorporated new technology into their products and production process to increase or to maintain their revenues. After making some adjustments, they continue to settle into long-run equilibrium position. Economists believe that technological advantage is related to advance of science, which is very important for market system. Some of economists see capitalism is the as driving force of technological advantage. Technological advantage arises from rivalry among individuals and firms that motivates them to seek and exploit new opportunities of profit and of expanding. This rivalry occurs between new firms and existing ones. Entrepreneurs and innovators are viewed as heart of technological advantage.

Measurement of Industry Concentration

      There are several methods used to measure the degree to which oligopolistic industries are concentrated by largest firms. The most often used ways to measure are concentration ratios and the Herfindahl index.

Concentration Ratio
   Concentration Ration shoes the percentage of total output produced and sold by industry’s largest firms. For example, three largest U.S producers of iron, supply almost 100% of all iron resource in this country.
   When the largest three-four firms in an industry control 40% or more of the market, that industry is said to be oligopolistic. Although concentration ratios offer useful ideas about competitiveness and monopoly power of diverse industries, there are three shortcomings.

• Local Markets

   Concentration ratios relate to nations as a whole, where the markets for some goods are highly localized because of expensive transport. For example, the four-firm concentration ratio for tobacco products is just 37% in China, suggesting that this industry is a competitive one. But, when we relate this product to some specific market or town in this country, we may often find that four firms produce about 80% of the total output in that area.

• Inter-industry Competition

   Inter-industry competition is competition between the products of one industry and the products of another industry. An example to this kind of competition may serve primary metals in some industries aluminum and copper, since aluminum competes with copper in many applications. (Electric devices, robots, machineries)

• World Trade

   The data for products produced in one country only may overstate concentration ratio since in most of cases they don’t account for import competition of foreign suppliers. Although some figures show that domestic firms produce over 90% of the total output for some good, they ignore the fact that some large quantities of that good may be imported. Many of the world’s largest corporations are foreign, so many of them are spread in diverse countries.

Herfindahl Index
   The shortcomings of concentration ratio from above apply to many measures of concentration, but one of these can be eliminated: Let’s say in industry “A” one firm produces all market output, but in industry “B” five firms produce 20% of the market. The concentration ratio is 100% in both cases. But industry “A” is pure monopoly, while industry “B” is an oligopoly. Economically, monopoly power is greater in industry “A” is greater than that from industry “B”, this fact isn’t shown by identical 100% concentration ratio.
   Herfindahl index solves this problem. This index is the sum of the squared percentage market shares all firms in the industry have. In equation from:

   Where %S₁ is the percentage share of firm 1, %S₂ is the percentage share of firm 2, and so on for each firm in the industry. By squaring percentages this index give more power to firms that have larger market shares, than to smaller ones. In case that a single firm has 100% then the Herfindahl index gives its highest value- 10000. In our industry “B”, Herfinahl index will be 20²+20²+20²+20²+20² which results in 2000, which is much more less that 10000 showing less market power.(In a purely competitive industry this index will approach to zero). More market power-higher Herfindahl index.

Oligopoly Market System

   Oligopoly is a market system that is dominated by few big suppliers of homogeneous or differentiated products. Because there are few firms, oligopolists have great control over prices, but they should consider reaction of rivals after they change price of goods, output quantity and amount of money spent on advertising.
Producers
   The phrase “few large producers” is one necessary to describe this kind of market system. Some examples of oligopoly can be two or three zinc producers in Sweden, or five or six producers of auto parts in U.K. When you will read in some magazines at economics about Big Three, Big Four or Big Five, you may be sure that there is described an oligopoly.
 Homogeneous or Differentiated Products
   An oligopoly may be either homogeneous or differentiated one, since the firms in this kind of market system produce a standardized or differentiated product. Many industrial goods( aluminum, lead, cement) are standardized products that are supplied in oligopolies. However, other goods (like cigarettes, automobiles, breakfast cereals) are produced in differentiated oligopolies. Last kind of oligopoly engages in non-price competition by heavy advertising.
   Price and mutual interdependence
   Since in oligopolies there are few firms, each one is a price-maker, like monopolists the y may set the price and output level for their goods, so that these firms control the revenue. However, unlike monopolists (since there are no competitors), oligopolists should consider the reaction of rivals to this changes in price, output, product’s characteristics and money spent on advertising. Thus Oligopolists are described by mutual interdependence: a situation in which firm’s profits doesn’t depend completely on its price and sales policy, but also on that of rivals. For example, before increasing the price of its drinks Pepsi should predict the response of other major producers, like Coca-Cola.
   Entry-Barriers
   Similar entry barriers created in pure monopoly are also created in oligopoly. Economies of scale are a factor that serves as barrier to entry in some oligopolistic industries, such as aircraft, car-producing, and cement industries. In this kind of industries three or four firms control the market supply, so that they have enough money to produce economies of scale, but other firms even if they will want to enter this market will have a small market share so that they won’t be able to have enough revenues to produce economies of scale. They would be high-cost producers, so that these firms won’t be able to survive in this industry.
   Ownership and control of raw materials are another explanation why it’s very difficult to enter in oligopolistic market system. Oligopolists also prevent the entry of new competitors by preemptive pricing and advertising strategies.
Mergers
   Some oligopolies have started because of very fast growth of dominant firms in some industries. But other however, produced an oligopoly by merging with other competing firms. Merging or combination of two or more firms may increase their revenues and economies of scale, because of increased market share they got.
   Another explanation of “urge to merge” is the want for a higher monopolistic power, since larger firm has a greater control over market supply and on the price of its product. Also, because of higher economies of scale they get less costs on producing some goods and services than their rivals.
Is merge between Google and Facebook possible and also profitable?

Monopolistic Competition: Price and Output

Efficiency
   Economic efficiency requires the following triple equation P=MC=minimum ATC. The equality of price and minimum ATC yields productive efficiency (and results in fair price return). The goods are produced in least costly way, and the price is just sufficient to cover average total costs (ATC), so the firm gets a normal profit. The equality of price and MC yields in allocative efficiency(and results in socially optimal price). So, the right amount of output is produced , and the scarce resources are used in the most efficient way.
   But, is monopolistic competition efficient as measure by our triple equation?

Productive and Allocative efficiency
   In monopolistic competition, neither productive nor allocative efficiency is achieved in long-run. Since in this kind of market system profit-maximizing price is slightly higher than lowest average total cost (ATC) then this results in productive inefficiency(society has to pay higher than optimal price for some goods). Also, firms in monopolistic competition have profit-maximizing prices which are higher than marginal cost (MC), that’s why monopolistic competition causes an underallocation of resources. Society values each addition unit of output higher than goods it would have to forgo to produce these items. That’s why monopolistic competition fails the allocative-efficiency test. Consumers pay higher than optimal price and get less than optimal output. Besides, monopolistic competitors must charge higher-than-optimal-price to get a normal profit.

Excess Capacity
   In monopolistic competition, the difference between the minimum average total cost (ATC) output and profit-maximizing output identifies excess capacity: underused plant or equipment because the firm produces less that minimum ATC output. If the monopolistic competitive firms produce at minimum ATC output, then the quantity supplied totally by all firms will be very high, so product will be sold at lower price. That’s why this type of market system is overcrowded by firms that produce bellow their optimal capacity. An example of this situation can be the high number of mini-markets or super-markets in each city that operates at less than their half capacity.

Monopolistic Competition

So, monopolistic competition is characterized by differentiated products (promoted by advertising), a relatively large number of seller, easy entry and exit from the industry.  First characteristic is an aspect of monopolistic industry, but second and third are an aspect pure completion industry. In general monopolistically competitive industries are more competitive then monopolistic.
 Differentiated Product
In this type of market system, in contrast to pure competitive one, products diverse, that’s why we say that monopolistic competition is described by product differentiation. So firms produce variations of a specific product.  They may change, for example, some physical characteristics, or they have different attitudes towards customers’ service, even may proclaim some qualities of the product that may be real or imaginary ones.
Product Characteristics
Products may have diverse physical or qualitative aspects. Real difference in design, functions, resources used as a raw materials or quality of work provides vital aspects for product differentiation. For example, car producers try to differentiate their products by offering cars with different aspects of engine power, safe system, and design to attract more buyers.

Service
Service and conditions that characterize selling of the products are some kind of product differentiation too. For example, some shops’ directors may stress more on providing some environment-friendly bags and have a higher price of goods, but others may offer the service of their clerks who will carry your products to your car for free. Prestige of the firm, appeal of the products, and helpfulness of the clerks are examples of product differentiation.
Location
Goods may also be differentiated by their accessibility and location. For example, some mini-markets may compete with super-markets, even if their offer small amount of products and charge higher prices for goods, because their location is very convenient for buyers. So a lot of firms in monopolistically competition industry compete on the basis of location.
Brands
Product differentiation can be made by using brand names, trademarks, and celebrity ads. For example, a lot of producers are supplying sugar, but consumer’s choice may be influenced by superiority of some firms (who are known to have higher quality than others, even if it is real or not). For example, when a celebrity’s name is related with some clothing stuff or shoes, buyers may be willing to increase their demand for that product.  Beautiful Packaging of some jewelry, natural water or gifts may attract additional costumers.

 Price control
Even if there are a lot of firms in monopolistic competitive industries, they may have some control over price, because of price differentiation. If the consumers love the products of a specific seller, then they may pay higher prices to satisfy willingness to by that good. So, sellers and demanders aren’t connected randomly, like in a competitive market. So, monopolistic competitors may have some control over price, but it is quite limited, since there are a lot of substitutes for the goods they produce.

Entry and Exit
Entry and exit into monopolistically competitive industries is relatively easier than in pure monopoly and oligopoly. Because monopolistic competitors are typically very small, then economies of scale and capital resources are small enough for new firms to entry. But there may be some financial barriers when these firms will develop and advertise their products from rival’s. Some firms may possess even patents or copyrights, so the entry in this kind of industry will be quite difficult.
However, exit from this kind of market system is very easy. Nothing prevents an unprofitable firm to shut-down their activity.

Advertising
The product’s differentiation policy would be inefficient if the firm won’t be able to tell consumers about them. That’s why monopolistic competitors sometimes advertise their products heavily. So the goal is “non-price” competition which means that prices are a small factor in buyers’ purchases.

Regulation of Monopoly

   Sometimes natural monopolies are subjected to price regulation (rate regulation), although more important for now is to deregulate those markets where competitions is possible. Some examples may be provincial and municipal commissions that regulate the price of gas, electricity that suppliers are charging.

   In the figure above it is presented the regulation of local monopoly, for example the distributor of electricity. In this figure there are plotted demand curve and cost curves that our supplier is facing. Because of economies of scale demand curve cuts ATC curve at a point where this curve is still falling, so it’s inefficient to have more firms in this industry because each of them would produce a smaller quantity of output, thus they will operate at a point which is much more inefficient than for just one operating firm, since in short run their ATC will be higher than for just one single firm. So in this case it’s better to have just one seller.
   We know from MR=MC rule that Q_m and P_m are profit maximizing output and price that is more likely to be chosen by monopolist. At the quantity Q_m the produce will enjoy an economic profit. Since price exceeds marginal then an underallocation of resources (allocative inefficiency) is being present. How can government regulate the price so that this will bring better results for the entire society?

Social Optimal Price P=MC
   If the regulatory commission has the task to achieve the allocative efficiency then it will attempt to set a price where P  will be equal with MC. Each point on demand curve shows a price-quantity combination. So, at point “r” we will have P_r which is equal to marginal cost.
   Confronted with price P_r monopolists will maximize profits or minimize losses by producing Q_r units of output. By making it illegal to charge a price higher than P_r , the firm won’t be able to produce other quantity of goods to increase the revenues.
   The regulatory commission can stimulate allocative efficiency to be produced by imposing the only legal price P_r and letting the monopolist to choose its profit-maximizing or loss-minimizing output. So, production will take place at point where P_r=MC, and this equality will indicate an efficient allocation of resources to this good or service. The price that achieves allocative efficiency is called socially optimal price.

Fair-Return Price P=ATC
   Social Optimal price, P_r, may be so low that the firm won’t be able to cover its average total costs (ATC). The result may be a loss for the firm. In our figure average total costs are more likely to be higher than P_r at the intersection of MR (P)=MC curve. Therefore forcing this firm to operate at social optimal price may result in short-run losses or even in bankruptcy in long-run.
   What to do in this case? One solution is to provide subsidies by government that will cover these losses. Another option for regulatory commission is to modify the allocative efficiency policy P=MC, so that firms may establish a fair-return price. In this case firms will have only a normal profit and this price is determined by intersection of ATC and demand curves (in our case point “f”). So P_f permits a fair returnfor firms. The corresponding output for this price will be Q_f. In this case the firm will realize only a normal profit.

Regulation’s Dilemma
   Comparing results given by socially optimal price (MC=P) and fair-return price (P=ATC) sometimes and dilemma, called dilemma of regulation arises. When the price is set to achieve allocative efficiency ( P=MC) regulated monopoly is more likely to suffer losses. Conversely, when the price is set for productive efficiency/ fair-return price (P=ATC) monopolists can cover its costs, but in this case underallocation of resources problem is solved only partially, since the quantity output increases from Q_m to Q_f, while the social optimal price is Q_r. Besides this dilemma regulations can improve results of monopoly from social point of view. Price regulation process reduces price, increases output, and reduces economic profit of monopolies.