Decision-Making Principles

Samuelson and Marks, Questions and Problems # 2, p. 294.
In granting (or prohibiting) proposed acquisitions or mergers in an industry, government regulators consider a number of factors, including the acquisition’s effect on concentration, ease of entry into the market, extent of ongoing price competition, and potential efficiency gains. In 2011, T-Mobile agreed to merge with AT&T at an acquisition price or $39 billion.

place order

However, facing opposition from the Department of Justice, the companies later abandoned their merger plans. In 2011, AT&T’s market share of the U.S. wireless market was 26.6 percent, with T-Mobile 12.2 percent, Verizon 31.3 percent, Sprint 11.9 percent, TracFone 5.0 percent, U.S. Cellular 3.1 percent, MetroPCS 2.3 percent, Cricket 1.6 percent, and numerous small providers making up the remaining 6 percent.

a. What would be the effect of the merger on the market’s concentration ratio? On the HHI?

b. Antitrust guidelines call for close scrutiny of mergers in moderately concentrated markets (HHI between 1,500 and 2,500) if the resulting HHI increase is more than 100 points. How would this rule apply to the AT&T merger with T-Mobile? 
How would it apply to a hypothetical merger between T-Mobile and TracFone?

c. AT&T argued that the merger would extend its network, providing more reliable and faster cell phone service (particularly to existing T-Mobile customers who on average have lower-grade service plans at cheaper rates). Market observers were worried that after the merger, AT&T would raise cellular rates to some customer segments. Briefly evaluate these pros and cons.\

Decision-Making Principles

  1. The key to making optimal decisions in an oligopoly is anticipating the actions of one’s rivals.
  2. In the dominant-firm model, smaller firms behave competitively, taking price as fixed when making their quantity decisions. Anticipating this behavior, the dominant firm maximizes its profit by setting quantity and price (and applying MR = MC) along its net demand curve.
  3. When output competition is between symmetrically positioned oligopolists (the Cournot case), each firm maximizes its profit by anticipating the (profit-maximizing) quantities set by its rivals.
  4. Intense price competition has the features of the prisoner’s dilemma; optimal behavior implies mutual price cuts and reduced profits.
  5. Advertising should be undertaken up to the point where increased profit from greater sales just covers the last advertising dollar spent.

Nuts and Bolts

  1. An oligopoly is a market dominated by a small number of firms. Each firm’s profit is affected not only by its own actions but also by actions of its rivals.
  2. An industry’s concentration ratio measures the percentage of total sales accounted for by the top 4(or8or20) firms in the market. Another measure of industry structure is the Herfindahl-Hirschman Index (HHI), defined as the sum of the squared market shares of all firms. The greater the concentration index or the HHI, the more significant the market dominance of a small number of firms. Other things being equal, increases in concentration can be expected to be associated with increases in prices and profits.
  3. There are two main models of quantity rivalry: competition with adominant firm or competition among equals. In each, equilibrium quantities are determined such that no firm can profit by altering its planned output. The industry equilibrium approaches the perfectly competitive outcome as the number of (identical) firms increases without bound.
  4. If a firm expects price cuts (but not price increases) to be matched by its rivals, the result is a kink in the firm’s demand curve. Prices will be relatively stable (because price changes will tend to be unprofitable).
  5. The prisoner’s dilemma embraces such diverse cases as pricewars, cartel cheating, armsraces, and resource depletion. Self-interested behavior by interacting parties leads to an inferior outcome for the group as a whole.

 

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