OLIGOPOLYManagerial Economics

Lecturer: Jack Wu

SAMSUNG ELECTRONICS Oligopoly: Market with a small number of

sellers who behave strategically Samsung

How to adjust pricing and capacity as Korean Won appreciates against U.S. dollar?

2(c) 1999-2012, I.P.L. Png

OUTLINE

Price competition Limit pricing Capacity competition Capacity leadership

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STRATEGIC VARIABLE FOR OLIGOPOLISTIC SELLERS

In the short run, the strategic variable for oligopolistic sellers is price.

In the long run, the strategic variable for oligopolistic sellers is production capacity.

PRICE COMPETITION

The outcome of oligopolistic competition on price depends on whether the product is homogeneous or differentiated.

BENCHMARK: MONOPOLY

PRICE COMPETITION:HOMOGENEOUS PRODUCT• Simple Case: Duopoly in Wireless

Telecommunication• Luna Cellular and Mercury Wireless

– Produce at constant marginal cost with unlimited capacity

– Compete on price to sell a homogeneous product.

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BERTRAND MODEL

• Under these conditions, the market equilibrium is perfectly competitive. Even though the industry is duopoly, the outcome is the same as with perfect competition. Demand curve is infinitely elastic with respect to a price cut.

• Extreme competition – selling undifferentiated commodities

• Game in strategic form – competing sellers set prices simultaneously.

PRICE COMPETITION: HOMOGENEOUS PRODUCT Marginal cost = $30 per subscriber per month Suppose that Luna charges $32. Mercury has three choices:

Price > $32: no customersPrice = $32: split the market demand in halfPrice < $32: gain the whole market – the best

strategy. Nash equilibrium: Both sellers charge price = $30

(marginal cost).

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PRICE COMPETITION: DIFFERENTIATED PRODUCTS• Case: Luna Cellular and Mercury Wireless

– Produce at constant marginal cost with unlimited capacity

– Compete on price to sell a product differentiated by distance from consumer.

– The price cutter’s demand is not infinitely elastic.

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HOTELLING MODEL• Suppose that consumers are located

uniformly along a street one mile long, with the Luna and Mercury dealers at each end of the street.

• Assumption: Differentiation is due to the difference in the consumer’s distances from the two dealers. The competing products are differentiated by location.

• Game in strategic form – competing sellers set prices simultaneously

PRICE COMPETITION: DIFFERENTIATED PRODUCTS

Residual demand: Demand given the actions of competing sellers.

Given Mercury's price and any price that Luna could setConsumers relatively closer to Luna would

buy from Luna Consumers relatively closer to Mercury

would buy from Mercury Residual demand curve slopes downward

If Luna raises price, some consumers (located relatively far from Luna) would switch to Mercury

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PRICE COMPETITION: DIFFERENTIATED PRODUCTS

PRICE COMPETITION: DIFFERENTIATED PRODUCTS

Luna’s profit maximumProduce at scale where residual marginal

revenue = marginal costSet price accordingly – as function of Mercury’s

price Best response function: Seller’s best action as a

function of the actions of competing sellers.

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PRICE COMPETITION: DIFFERENTIATED PRODUCTS

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PRICE COMPETITION: DIFFERENTIATED PRODUCTS In fact, Hotelling model applies to differentiation in

terms of any attribute on which consumers have differing preferences.

“Transport cost” = consumer’s disutility from consuming any attribute that differs from the ideal or most preferred= strength of consumer preference

Extreme case: : zero transport cost => consumers consider that products are homogeneous => Hotelling model collapses to Bertrand model

Higher transport cost (stronger consumer preference) Residual demand more inelastic => higher price Best-response function shifts toward higher prices Nash Equilibrium: Higher prices

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PRICE COMPETITION: DIFFERENTIATED PRODUCTS

Higher demandHigher residual demandBest-response function shifts toward higher

pricesNash Equilibrium: Higher prices

Higher marginal cost Best-response function shifts toward higher

pricesNash Equilibrium: Higher prices

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STRATEGIC COMPLEMENTS

Strategic complements: Adjustment by one party leads other parties to adjust in the same direction

Hotelling model: Prices are strategic complementsBest-response functions slope upward

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LIMIT PRICING What if one seller can act before others? Game in extensive form – competing sellers set

prices in sequence

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LIMIT PRICING

Limit pricing Entrant must incur fixed cost of production Set such price so low that potential competitor’s

residual demand is so low that potential competitor cannot break even.

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LIMIT PRICING

LIMIT PRICING

Luna’s average cost curve is “U” shaped because of fixed cost

Mercury (incumbent, first-mover) sets its price so that:• Luna’s (entrant) residual demand curve is below

its average cost curve

LIMIT PRICING

Limit pricing – Necessary conditionsProduction requires substantial fixed cost Leader’s price must be credible

Potential competitors must believe that leader will not change price if potential competitor enters

For leader, must be more profitable to produce at entry-deterring price than to accommodate entry and produce an equal share with competitors.

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CAPACITY COMPETITION: HOMOGENEOUS PRODUCT

Luna Cellular and Mercury Wireless Produce at constant marginal costCompete on capacity to sell a homogeneous

product Game in strategic form – competing sellers set

capacities simultaneously Cournot Model: The market price equates the

demand with the total capacity offered by the two providers.

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CAPACITY COMPETITION: HOMOGENEOUS PRODUCT

Residual demand: Demand given the actions of competing sellers.

Given Mercury’s capacity, Luna’s residual demand curve slopes downward

Luna’s profit maximumProduce at scale where residual marginal

revenue = marginal costSet capacity accordingly – as function of

Mercury’s capacity

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CAPACITY COMPETITION:HOMOGENEOUS PRODUCT

CAPACITY COMPETITION: HOMOGENEOUS PRODUCTBest response function: Seller’s

best action as a function of the actions of competing sellers.

CAPACITY COMPETITION: HOMOGENEOUS PRODUCT Higher demand

Higher residual demandBest-response function shifts toward

higher capacityNash Equilibrium: Higher capacities

Higher marginal cost Best-response function shifts toward lower

capacityNash Equilibrium: Lower capacities

Seller with lower cost gainsDirectly, from lower cost(Strategic response) Forces competitor to

reduce capacity 28

STRATEGIC SUBSTITUTES Strategic substitutes: Adjustment by one party

leads other parties to adjust in opposite direction Cournot model: Capacities are strategic

substitutesBest-response functions slope downward

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STRATEGIC COMPLEMENTS OR SUBSTITUTES?

Generally , there may be either strategic complements or strategic substitutes depending on the relevant demand and cost conditions.

Examples: Advertising & R&D Increased R&D spending can have a similar

effect to increasing capacity. On the other hand, an increase in one seller’s R&D spending may drive competitors to increase R&D as well, particularly when they compete for patents. So, R&D spending might be strategic complements or strategic substitutes depending on circumstances.

CAPACITY LEADERSHIP What if one seller can act before others? Game in extensive form – competing sellers set

capacities in sequence Stackelberg model: Leader commits to capacity

to grab larger share. Trade-off

Larger market share => higher profitLarger total capacity (all producers) => Lower

profitLeader does not drive out competitor, simply

reduces the follower’s share

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CAPACITY LEADERSHIP

CAPACITY LEADERSHIP

First mover advantage Necessary conditions -- Leader’s capacity must be

crediblePotential competitors must believe that leader

will not change capacity if potential competitor enters

For leader, must be more profitable to produce at Stackelberg capacity than to accommodate entry and produce an equal share with competitors.

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