Industry with small firms

Majority of canada’s output are from small firms

Small firms: relative size to industry

Theory of monopolistic competition explains why there are many small firms, but each firm have
some degree of market power

Industries with few large firms

Monopolies typically owned by government

Internet, telephone, cable are subjected to government regulation

Theory of oligopoly helps understand industries where small number of large firm with
considerable market power

Ex. airline industry dominated by air Canada and west jet

Industrial concentration

High concentrated: small number of relatively large firms

Concentration ratio: formal measure of industrial concentration

Concentration ratio

When measuring whether industry has power concentrated over few firms or dispersed over
many, not sufficient to count firms

Ex. industry with one enormous firm and 29 very small firms are more concentrated in
meaningful sense than industry with five equal-sized firms

Concentration ratio shows fraction of total market sales controlled by largest sellers

Defining the market

Market may be smaller than whole country

Ex. concentration ratio in national cement sales are low, but understate market power
of cement companies because high transportation costs divide the cement industry into series of
regional markets with each having relatively small firms

More common for companies producing raw materials

Firms differentiate their product

Ex. new smartphone industry, firm must decide on characteristics of new products to design and
sell

Develop its own variations on existing products or product with new capability

Differentiated product: group of products similar enough but not identical

Firms set their price

Each firm must decide on a price to set

Ex. single price not established for products equate to overall demand with overall
supply

One manufacturer typically have several product lines that differ from each other and from
competing product lines of other firms

Price setters: firms that choose their prices

Each firm has expectations about quantity it can sell at each price that might set

Unexpected demand fluctuation might cause unexpected variations in quantities sold at price

Firms that sell differentiated products have many distinct products

Changing long list of prices is often costly that it is done infrequently

Cost of changing prices include printing new list prices and notifying customers and
difficulty of keeping track of changing prices for accounting purposes and loss of customers and retailer
goodwill caused by frequent price changes

Imperfectly competitive firms respond to fluctuations in demand by changing output and

holding prices constant

Firms that rely on online sales do not follow this behavior

Ex. airlines have websites where they post their prices and can change frequently

Firms engage in non-price competition

Advertising

Many firms spend large sums of money on advertising

Attempt to shift demand curve for industry product and to attract customers from competing
firms

Firm in perfectly competitive market don’t engage in advertising because firm faces perfectly
elastic demand curve at market price

Advertising involve costs that wouldn’t increase firm’s revenue

Monopolist has no competitors in industry and won’t advertise to attract customers away from
other brands

Sometimes monopolist will advertise to convince consumers to shift spending away from other
types of products and towards monopolist product

Product quality

Ex. Samsung competes against each other by offering new products with innovative designs and
applications

Entry barriers

Firms engage in activities to hinder entry of new firms by preventing erosion of existing profits

ex. price match

Oligopoly and game theory

Oligopoly: industries that make up small number of large firms and have market structure

Industry that contains two or more firms

Oligopolistic: high concentration ratio for firms serving one market

Negatively sloped demand curves

Profit maximization is complicated

Oligopolist want to maximize profits that produces level of output where marginal revenue =
marginal cost

Determining level of output more complicated for oligopolist

Firm’s marginal revenue depends on what rivals do

Ex. if Toyota increase production of compact cars to make MR = MC, Ford and Nissan may
respond by increasing their output of compacts and reducing Toyota’s marginal revenue

Or Ford and Nissan can reduce output of compacts and focus on market niches that Toyota plays
a smaller role in

Or leave output levels unchanged and introduce new options on compact cars to attract
customers to products

Strategic behavior: behavior designed to take account of rival’s reaction

Basic dilemma of oligopoly

Firms can cooperate in attempt to joint profits or they can compete in effort to maximize
individual profits

To compete or cooperate depends on how rivals will respond

If firms cooperate, they reach cooperative outcome

Worthwhile for any one of them to cut prices or raise output so long as others don’t

If every firm does the same, they are worse off as a group and worse off individually

Non cooperative outcome: an industry outcome when firms maximize own profits without
cooperating
Simple game theory

Game theory: decision making in situations where one player anticipates reaction of other
player

Game theory applies to oligopoly when

Players are firms

Game played in market

Strategies are price out output decisions

Payoffs are profits

If firms cooperate, each firm produces one-half of monopoly output and each earn high profit

If firms compete, they produce more than half of monopoly output and earn low profit

Nash equilibrium: equilibrium that results when each player doing its best and given current
behavior of other player

Has both firms competing and producing higher level of output

Extensions in game theory

Game theory can be used in other settings

How firms interact when charge different prices for differentiated products

How firms interact when developing new product

Oligopoly in practice

Cooperative behavior

Collusion: agreement among sellers to act jointly in common interest, may be overt, covert,
explicit or tacit

When firms agree to cooperate to restrict output and raise prices

When explicit agreement occurs, it is overt or covert depending if agreement is open or closed
Competitive behavior

Firms in oligopoly choose to compete actively with each other to attract consumers away from
rivals to increase overall share of market and to increase profits

Actions good for consumers because results in lower prices, better products, or better services

Winners find profits rising and business expanding

Losers see business shrinking and profits falling

Firms with differentiated products compete by reducing prices and hoping to attract customers

Actively engage in non-price competition through advertising campaigns and product quality

Can develop new products by making significant improvements in existing ones

Importance of entry barriers

Oligopolistic firms must create entry barriers if they want profits in long run

Brand proliferation

Altering characteristics of differentiated product, it’s possible to produce an array of variations

on general theme of product

Ex. soaps produces several brands

Brand proliferation is response to consumer’s preferences and can have effect of discouraging
entry of new firms

Large number of differentiated products leaves small market share available to new firm

Advertising

Where heavy advertising established strong brand images for existing products, new firms must
spend heavily on advertising to create brand image

If firm’s sales are small, advertising costs per unit will be large and price must be
correspondingly high to cover

Combined use of brand proliferation and advertising creates powerful entry barrier

Predatory pricing

Firm will not enter market if it expects continued losses after entry

Existing firm can create this by cutting prices below costs until new entrant is bankrupt

Existing firms sacrifices profits doing this, but sends discouraging message to potential future
rivals and present ones

If strategy is costly in terms of lost profits in short run, pay for itself in long run by creating
reputation effects that deter entry of new firms
Oligopoly and economy

Firms in oligopolistic industries come close to joint profit maximization in short run

Oligopolistic industries firms compete they come close to achieving competitive prices and
outputs

To extent that price remains above competitive levels and output below, oligopolies are less
efficient than perfect competition

In long run, profits that survive competitive behavior attract entry

Oligopoly leads to more innovation than monopoly or perfect competition

Oligopolist face strong competition from existing rivals and can’t afford relaxed life of
monopolist