Expert Answer:Market Power And The Herfindahl-hirschman Index Di

  

Solved by verified expert:This unit is focused on the different environments in which companies operate and the market power related to each of these environments.The environment in which a company operates is referred to as a market structure. There are four primary structures: perfect competition; monopolistic competition; oligopoly; and, monopoly. A perfection competition has no market power to influence pricing while a monopoly has market power because it can set prices and in turn increase profits. The other two structures vary in degrees of market power based on strategies they implement.You have learned about the different market structures some are viewed as being at the opposite ends of the spectrum: Perfect Competition where there are many sellers who are price takers, Monopolies where one single company produces a product with no close substitute products and sets the market price, and Monopolistic Competition where several small companies have some market power by producing differentiated products.The level, or degree, of a company’s market power is directly related to the principle of barriers into the market. Barriers are defined as any structural, legal, or regulatory characteristics of the company and the market structure that prevent other companies from producing comparable products at the same costs. Firms with market power will use several strategies to create these barriers: pricing; cost reduction; and, new product development.Select one of the major market structures outlined in the textbook, and then identify two existing companies that you believe represent this structure and explain why. Using the Herfindahl-Hirschman Index of the textbook/or outside research identify the market power of at least two companies.Minimum 250 words and cite any sources used. Refer to attached PDF of the textbook for reference.
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9
Market Structure: Oligopoly
I
n this chapter, we examine the fourth market model, oligopoly. This
model is close to the monopoly model and at the other end of the market
structure spectrum from the model of perfect competition.
Oligopoly firms typically have market power derived from barriers to
entry. However, the key characteristic of oligopoly is that there are a small
number of firms competing with each other, so their behavior is mutually
interdependent. This interdependence distinguishes oligopoly from all other
market structures. In perfect competition and monopolistic competition,
there are so many firms that each firm doesn’t have to consider the actions of
other firms. If a monopolist truly is a single firm producing a product with no
close substitutes, it can also form its own independent strategies. However,
when 4, 6, or 10 major firms compete with each other, behavior is interdependent. The strategies and decisions by managers of one firm affect managers of
other firms, whose subsequent decisions then affect the first firm.
This chapter begins with the case of interdependent behavior in airline pricing. We’ll then examine additional cases of oligopoly behavior drawn from the
news media. Next we’ll look at several models of oligopoly to see how economists have modeled both noncooperative and cooperative interdependent
behavior. The goal is not to cover the huge number of oligopoly models that
have been developed over the years, all of which attempt to illustrate different aspects of interdependent behavior. Instead, we’ll present the insights of a
few models and then illustrate these principles with descriptions of real-world
oligopolistic behavior. We’ll conclude by describing how government antitrust
legislation and enforcement influence oligopoly behavior.
260
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Case for Analysis
Oligopoly Behavior in the Airline Industry
Oligopolistic airline pricing behavior has occurred for many
years. There are a small number of players in the airline industry, so that price changes by one airline affect the demand for
flights of its competitors. As discussed later in this chapter, overt
price fixing is illegal in this country and even tacit collusion can
be dangerous for firms in terms of antitrust enforcement. Thus,
the airlines often try to coordinate their strategies with one company taking a leadership role and then watching for the reactions
of its competitors. Price changes are usually implemented on
Thursdays or Fridays, so that the lead airline can watch the reaction over the weekend and then make adjustments by Monday.
These reactions typically vary by the size and market power of
the airline and may differ by the route flown. These behaviors
have often been characterized as an intricate chess game.
In March 2002, American Airlines increased its three-day
advanced purchase requirement on low-priced business tickets
to seven days with the hope that competitors would follow this
implicit price increase.1 When the competitors refused to do so,
American retaliated by offering deep discounts on business fares
in several of the competitors’ markets. In response, Northwest
Airlines began offering $198 round-trip fares with connections
on three-day advanced purchase tickets in 160 of American’s
nonstop markets, where the average unrestricted business fare
was $1,600. American then offered $99 one-way fares in 10 markets each flown by Northwest, United, Delta, and US Airways.
Only Continental Airlines’ markets were excluded from these
low fares, an outcome that probably resulted because Continental
had matched American’s original change in all markets.
In March 2004, Continental Airlines tried to raise its fares
across the board to cover the rising cost of fuel. Low-cost
rivals Southwest and JetBlue refused to follow because they
had protected themselves against rising fuel costs with hedging agreements. Continental hedged fuel for 2003 but stopped
1
Scott McCartney, “Airfare Wars Show Why Deals Arrive and
Depart,” Wall Street Journal, March 19, 2002.
buying the contracts when they became more expensive due to
the rising oil prices. For an entire month, one airline or another
tried to impose network-wide fare increases but had to back off
because all of their rivals would not follow the increases except
on certain routes.2
By spring 2005, the airlines had some greater pricing
power, having achieved seven fare increases in the first five
months of the year. Demand for airline seats had been increasing, particularly with the approach of summer. In May 2005,
the price increase was led by American Airlines and was
imposed even in markets where it competed with Southwest.
As of the Friday afternoon when it was announced, Delta,
Continental, Northwest, United, and US Airways had all
matched the increase in varying combinations.3
By 2011 and 2012, high fuel prices forced most airlines to
attempt to raise fares.4 In February 2011, Delta led the increase
and was quickly followed by American. However, given the
impact of the slow recovery from the economic recession in
2008, both airlines backed off from the fare increases later in
the week. These decisions were also influenced by the reaction of Southwest Airlines, the largest discount carrier in the
United States, which did not raise prices. In early 2012, the airlines, which had quietly raised prices for the last half of 2011,
continued to try to do so even before the summer 2012 travel
season. It appeared that at this time even Southwest Airlines
was more willing to accept the price increases than it had in
the past.
2
Elizabeth Souder, “Continental Attempts Fare Hike, But Rivals
Won’t Budge,” Wall Street Journal, March 26, 2004.
3
Melanie Trottman, “U.S. Airlines Attempt New Round of Fare
Increases,” Wall Street Journal, May 16, 2005.
4
This discussion is based on Gulliver, “The Big Airlines Get
Cold Feet,” The Economist (Online), February 20, 2011; and
Kelly Yamanouchi, “Airlines Keep Adapting to High Fuel Costs,”
Atlanta Journal Constitution (Online), March 4, 2012.
261
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262
PART 1 Microeconomic Analysis
Case Studies of Oligopoly Behavior
Oligopoly
A market structure characterized by
competition among a small number
of large firms that have market
power, but that must take their
rivals’ actions into account when
developing their own competitive
strategies.
The behavior just described represents the interdependence of firms operating
in an oligopoly market. This behavior has become more pervasive as oligopolies
have come to dominate many industries in the United States, as shown in Table 9.1.
We next discuss oligopoly behavior in several key industries.
The Airline Industry
In addition to the pricing strategies discussed in the opening case study, there are
numerous other examples of oligopoly behavior in the airline industry. In the late
1990s, Frontier Airlines was the small upstart carrier trying to compete with United
Airlines, particularly at the Denver airport. Frontier developed strategies to compete with its rival by “getting inside United’s corporate head, anticipating its moves
and countermoves, and chipping away as much business as it can get away with.”5
Frontier officials developed aggressive strategies on pricing and flight scheduling,
but restrained these strategies enough to avoid provoking a substantial competitive
response from United, which would have had a detrimental impact on Frontier.
Frontier learned from experience that United was likely to tolerate not more
than two flights a day to one of its competitive cities and that timing Frontier’s
flights outside United’s windows of connecting flights would make United unlikely
to establish a new head-to-head competing flight. Frontier’s managers also waited
to announce the company’s new flights from United’s hub at Denver International
Airport to Portland, Oregon, until United had loaded its summer schedule into the
computer system. This tactic made it difficult for United to rearrange its published
schedule of flights to compete against Frontier. Frontier’s pricing strategy was to
raise ticket prices enough to avoid a price-cutting response from United, but to
keep prices low enough to appeal to customers and attract new business. Setting
TABLE 9.1 Oligopolistic Industries in the United States
INDUSTRY
NUMBER OF FIRMS
MARKET SHARE (PERCENT)
Carbonated soft drinks
3
80
Beer
3
80
Cigarettes
3
80
Recorded music
4
80
Railroad operations
4
100
Movies
6
85
Razors and razor blades
3
95
Cookies and crackers
2
80
Carpets
2
75
Breakfast cereals
4
80
Light bulbs
2
85
Consumer batteries
3
90
Source: Stephen G. Hannaford, Market Domination! The Impact of Industry Consolidation on Competition, Innovation,
and Consumer Choice (Westport, CT: Praeger, 2007), 5. Reprinted by permission.
5
Scott McCartney, “Upstart’s Tactics Allow It to Fly in Friendly Skies of a Big Rival,” Wall Street Journal,
June 23, 1999.
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CHAPTER 9 Market Structure: Oligopoly
263
prices far below those of United would have resulted in United not only lowering
prices, but also scheduling many more flights to compete with Frontier. However,
United’s managers needed to make certain that their competitive strategies did not
violate U.S. antitrust laws. The U.S. Justice Department had previously accused
American Airlines of cutting prices and increasing capacity to stifle new competition in its Dallas–Fort Worth hub airport.
By the summer of 2003, there was a three-way struggle among United, which was
now reorganizing its business in bankruptcy court; Frontier, the growing low-cost
airline; and the city of Denver, which operated the city’s airport, the hub for this competition.6 Frontier claimed that while United’s market share at the Denver airport
had declined from 74 to 64 percent, the airport had increased the number of United’s
gates from 43 to 51. Frontier’s market share had more than doubled, increasing from
5.6 to 13.3 percent, while the number of its gates increased from only 6 to 10. United
also demanded that the city build a new $65 million regional jet terminal with an
additional 38 gates. United wanted to hold its existing gates for future expansion,
while Frontier argued that it could put many of those gates to more productive use.
The city was caught between the demands of its dominant airline, which had less
market power than before 1999, and those of the aggressive low-cost competitor.
Competition for amenities has been another aspect of oligopolistic strategies,
particularly among international airlines. Lufthansa Airlines opened a first-class
terminal in Frankfurt in 2005 where passengers could have a bubble bath, rest in a
cigar room, and be driven to the plane in a Mercedes or Porsche. Middle Eastern
carriers have installed lavish closed-door suites in the front of planes, while Virgin
Atlantic opened a Clubhouse at London’s Heathrow Airport with a beauty salon,
cinema, and Jacuzzi.7 In the fall of 2007, Singapore Airlines began the first commercial flight of the Airbus A380, the biggest passenger jet ever built, with 12 firstclass passengers housed in fully enclosed cabins with expandable beds, while 60
seats in business class were 34 inches wide—twice the width of a typical economy
seat.8 Competition on lie-flat seating began in 1999 when Virgin Atlantic Airways
introduced a flying bed for its Upper Class cabin that was slightly less than horizontal. British Airways responded by unveiling a fully horizontal business-class lie-flat
seat in 2000. Virgin countered in 2003 with a bigger lie-flat seat angled to the aisle,
herringbone style with seats arranged head to toe. Delta adopted the herringbone
style, while Deutsche Lufthansa announced a Flying V style pattern in 2012 that
paired seats with feet closer together than heads.9
By the spring of 2008, with the slow economy and oil prices exceeding $130 per barrel, all of the major U.S. airlines were adopting similar strategies to cut costs and raise
prices. In June 2008, United Airlines followed the lead of American Airlines in charging passengers for the first checked bag. United had been the first airline to charge
for the second checked bag in February 2008, and rivals soon followed. The airlines
grounded planes and removed flights from schedules to limit the supply of seats and
raise prices. They also searched for new ways to reduce costs, including installing
winglets on jets to improve performance, eliminating magazines in cabins to reduce
weight, carrying less fuel above required reserve levels, and washing jet engines with
new machines that could deep clean while collecting and purifying the runoff.10
6
Edward Wong, “Denver’s Idle Gates Draw Covetous Eyes,” New York Times, August 5, 2003.
Scott McCartney, “A Bubble Bath and a Glass of Bubbly—at the Airport,” Wall Street Journal, July 10, 2007.
8
Bruce Stanley and Daniel Michaels, “Taking a Flier on Bedroom Suites,” Wall Street Journal, October 24,
2007.
9
Daniel Michaels, “Airlines Escalate Race in Lie-Flat Seating,” Wall Street Journal (Online), March 8, 2012.
10
Scott McCartney, “As Airlines Cut Back, Who Gets Grounded?” Wall Street Journal, June 6, 2008; Scott
McCartney, “Flying Stinks—Especially for the Airlines,” Wall Street Journal, June 10, 2008; Jessica Lynn
Lunsford, “Airlines Dip into Hot Water to Save Fuel,” Wall Street Journal, June 11, 2008; Mike Barris,
“United Matches American Airlines in Charging for First Checked Bag,” Wall Street Journal, June 13, 2008.
7
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264
PART 1 Microeconomic Analysis
The Soft Drink Industry
Although Coca-Cola Company and PepsiCo Inc. have long battled each other in
the cola wars, their interdependent behavior has moved into the bottled water
market with Coke’s Dasani and Pepsi’s Aquafina brands.11 Although bottled water
comprised less than 10 percent of each company’s beverage sales in 2002, bottled
water sales in the United States grew 30 percent in 2001 compared with 0.6 percent growth for soft drinks. The bottled water market in 2001 was dominated by
a few large firms: Nestle’s Perrier Group (37.4 percent market share), Pepsi (13.8
percent), Coca-Cola (12.0 percent), and Danone (11.8 percent). Coke and Pepsi
tried to avoid the pricing wars in grocery stores that occurred with the colas, so
they concentrated on selling single, cold bottles in convenience stores or vending machines. However, price discounting was already occurring in some grocery
stores as more consumers bought water to take home. The rivals also focused on
making the product readily available and packaging the water in convenient and
attractive bottles. Pepsi launched its Aquafina in a new bottle with a transparent
label, while Coke developed a Dasani bottle with a thin, easy-to-grip cap for sports
enthusiasts.
The rivals have used different strategies to market goods that are virtually identical. Coke developed a combination of minerals to give Dasani a clean, fresh taste.
The formula for this mix is kept as secret as the original Coke formula. Managers
also paid much attention to developing the Dasani name, which was intended to
convey crispness and freshness with a foreign ring. Pepsi claimed that Aquafina
was purer because nothing was added to its exhaustively filtered water and focused
its marketing activities around customers “wanting nothing.” Both companies
developed enhanced versions of their waters. Coke launched Dasani Nutriwater,
with added nutrients and essences of pear and cucumber, in late 2002, while Pepsi
introduced Aquafina Essentials, with vitamins, minerals, and fruit flavors, in the
summer of 2002. In a joint venture with Group Danone, Coke also took over distribution of Dannon bottled water, which gave the company a low-priced brand that
would complement the mid-priced Dasani.
By 2008 the two rivals were both managing a complex portfolio of drinks, given
that U.S. consumers were buying fewer soft drinks and more beverages such as
teas, waters, and energy drinks. From 2003 to 2008 noncarbonated beverages grew
from one-quarter to one-third of the nonalcoholic beverage market. Pepsi diversified first by signing joint ventures with Lipton in 1991 and Starbucks in 1994 and
acquiring SoBe in 2000 and Gatorade in 2001. These moves gave it the lead in teas,
ready-to-drink coffees, and sports drinks. Coca-Cola countered by buying Glaceau
enhanced waters and Fuze juice drinks and reaching agreements for Campbell’s
juice drinks and Caribou and Godiva bottled coffees. Coke and Pepsi continue to
try to gain an advantage even in small markets by searching for nuances or trends
to determine the best product mix.12
The cola wars heated up again in 2011 and 2012 when in March 2011 it was
announced that Pepsi had fallen to No. 3 in U.S. soda sales, trailing both Coke and
Diet Coke.13 Coke had battled Pepsi ever since Coke’s founding in 1886 and Pepsi’s
11
Betsy McKay, “Pepsi, Coke Take Opposite Tacks in Bottled Water Marketing Battle,” Wall Street Journal,
April 18, 2002; Scott Leith, “Beverage Titans Battle to Grow Water Business,” Atlanta Journal-Constitution,
October 31, 2002.
12
Joe Guy Collier, “Cola Wars Aren’t Just About Cola Any More,” Atlanta Journal-Constitution, March 28, 2008.
13
This discussion is based on Natalie Zmuda, “How Pepsi Blinked, Fell Behind Diet Coke: Rough Patches,
Risky Moves Cost It Share: Will Return to Basics Be Enough to Get It Back in the Game?” and “Coke Vs.
Pepsi: A Timeline,” Advertising Age (Online), 82 (March 21, 2011), 1; Mike Esterl and Valerie Bauerlein,
“PepsiCo Wakes Up and Smells the Cola,” Wall Street Journal (Online), June 28, 2011; and Mike Esterl and
Paul Ziobro, “PepsiCo Overhauls Strategy,” Wall Street Journal (Online), February 10, 2012.
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CHAPTER 9 Market Structure: Oligopoly
265
founding in 1898. Pepsi was accused of changing its focus from cola to products
that are “better for you” and engaging in activities such as the Refresh Project,
which gave grants to consumers with “refreshing ideas that change the world,”
but may not have helped the company’s profits. In 2010 and early 2011, the company set a goal of more than doubling revenue from its nutritious products by 2020
while developing a corporate image focusing on health and global responsibility.
In response to the loss of market share, Pepsi announced in 2012 that it was cutting 8,700 jobs and increasing its marketing budget by $600 billion that year with
most of this budget directed to five key brands: Pepsi, Mountain Dew, Gatorade,
Tropicana, and Lipton. In February 2012, the company ran its first Super Bowl TV
ad for Pepsi in three years.
The Doughnut Industry
In the summer of 2001, Krispy Kreme Doughnuts of Winston-Salem, North
Carolina, announced its plans to open 39 outlets in Canada over the following six years to compete directly with Tim Hortons—an American-owned, but
Canadian-operated chain that is considered to be somewhat of a national institution in Canada.14 Canada is a profitable market because the country has more
doughnut shops per capita than any other country. Tim Hortons was already the
second-largest food service company in Canada, with 17 percent of quick-service
restaurant sales. It drove out much of the competition through efficient service
and aggressive tactics, such as opening identical drive-through outlets on opposite sides of the same street to attract customers traveling in either direction.
Krispy Kreme is another large company, with $448.1 million in sales in 2001 and
192 stores across 32 states.
As Krispy Kreme managers made the decision to move north to Canada, Ti …
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