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    Home >> Economics >> Oligopoly

    Oligopoly

    Oligopoly is a type of a market structure where in which a small number of producers compete with each other. A large proportion of the industry’s profit is shared among small number of firms where there are high levels of market concentration. Examples of oligopolies are Sun, Smart and Globe who are the only three firms which are the service providers in the Philippines. Market share is the percentage of the total market or market segment captured by a producer. Market is where buyers (consumer) and sellers (producers) come together to establish an equilibrium price and quantity for a good or service. An example of market share is that HTC produces more that 70% of the electronic industry’s output. It does not need to be an actual place. Firm is an organization that utilizes the factors of production to produce and sell goods and services. An example of a firm is Apple which designs and sells electronics, computer software and computers.

    There are many ways a firm in an oligopolistic market can increase its market share. However, this essay focuses on price wars, the creation of entry barriers, collusive and non-collusive oligopoly, non-price competition, and more.

    There are many different types of oligopolies. Some compete with almost the same product and some produce highly differentiated products. Majority of the oligopolies have distinct barriers to entry which decreases the competition between the firms. Some of the barriers to entry are large scale production, strong brand name and more. However, there are some oligopolies which have low barriers to entry. An example of oligopoly is Nike which has high barriers to entry.

    Firms in oligopoly are interdependent which means that they can influence the market. As there are very few firms, they are careful about each other’s actions. Some oligopolies want to collude in order to avoid sudden changes and unexpected outcomes. In this way they can maximize industry profits. However, there are competitive firms who try to achieve greater market share. In collusive oligopoly, all the firms can collude and act like a profit maximizing monopoly. Therefore, the profit gets divided up amongst the firms. Cartel is when some oligopolies actually agreed upon a price. They give each other quotas. However, they can make an agreement on the market share and expenditures as well. This increases their market share as they merged together. Collusion is easier when there are fewer firms as they can share information more easily. This allows having more effective communication amongst them. Having monitoring systems can avoid any cheating as it would get identified. Having stable cost and demand conditions helps in allocating the quota more easily and measure the policy becomes easier to administer. Lastly, there are similar profits. Therefore, collusion helps to increase market share. An example of a cartel is Organization of the Petroleum Exporting Countries (OPEC). The diagram below is the cartel model.

    In some countries, some oligopolies are not allowed to keep the same price. Price war is a way in which oligopolistic firms could increase their market share. Since they are interdependent, oligopolies use game theory which is a strategy to increase market share. This leads to market stickiness which is when the firms tend to keep their prices at one level for long periods of time and then all change their prices at the same time. Game theory is the decision that a firm makes in oligopoly depends on its assumptions about other firms. It is defined as mathematical theory that deals with strategies for maximizing gains and minimizing losses within prescribed constraints, as the rules of a card game: widely applied in the solution of various decision-making problems, as those of military strategy and business policy.” (dictionaryrefenrce.com). Game theory is useful for market analysis for example pure conflict which the gains made by one player are the losses of another. Mixed conflict and cooperation is when players may cooperate to increase their joint payoff, but conflict arises about how to share it out. For example; Jollibee, McDonalds and Chow King probably use the game theory to predict each other’s reactions and increase the market share. 

    In oligopoly, firms are dependant to one another, so when changing its price, a firm must be carefully examine the possible moves of other firms. However, changing prices does not help firms in an oligopoly increase their market shares and earn greater supernormal profits in the long run. This theory can be explained through the kinked demand curve.

    Originally, the quantity demanded is at Q and price is at P, making equilibrium at PQ. If the oligopolists decide to increase their price from P1 to P2, then other firms will keep their prices as the customers of the Oligopolists will switch to another brand as they do not want to pay more if they can buy the good or the service at a lower price. This is known as the substitution effect (the tendency of people to substitute away from more expensive commodities to cheaper commodities).   This cause the demand of the good or service to be relatively price elastic. Therefore, the quantity demanded decreases from Q to Q1. This will result in the decrease in the revenue. Therefore, the oligopolists do not increase their price.

    However, a firm may think of decreasing the price to increase the revenue. The firm’s revenue will increase only until the competitors would not notice the price change. This causes the demand curve to become elastic as the consumers will be willing to buy the goods or services at a cheaper price. Upon hearing this, the competitors will reduce their price as well causing the demand curve to become relatively price inelastic. Although the quantity demanded increases from Q to Q1, the revenue for all the firms in the industry will decrease. Therefore, Oligopolies like to keep their price stable and changing the price does not result in the increase of market share.

    Some firms who do not compete through price focus on advertizing which increases the demand for the good or service that the firm produces. They differentiate their products to increase their market share which increases the brand loyalty. This results in more choice for consumers. This also helps in reducing the competition amongst the competitors. For example; Coca Cola advertizes a lot and have a big name in the industry. Therefore, it has gained brand name and brand loyalty which reduces the competition in the soft drinks industry. Now, coca Cola’s biggest competitor is Pepsi and Sprite.

    Another way of increasing the market share is predatory pricing which occurs when firms undercut their competitors to force them to exit the industry which is anti-competitive. Limit pricing is where large firms select the highest price which does not allow other firms to enter as the start up cost is high. However, if the firm does manage to enter the industry, due to the higher price, the supply will cause the price to decrease to such a point where they cannot function. Therefore, they will exit the industry in the long run. For example; a restaurant in Bayfield called Bailey’s practiced predatory.

    Another way to increase market share is to increase the amount of barriers to entry. There are many barriers to entry such as legal barriers to entry (the law that prevents other firms from entering the industry.), natural barriers to entry where it logical to have just one industry functioning at a place. For example; in Green Meadows which is a village located in Pasig, Philippines supplies all the houses with the same water supplier. It is logical to have only on water supplier which supplies one villages as building another water system in the village takes a lot of time and has high start up costs. Economies of scales are another barrier to entry which perhaps can lead to take over mergers of firms. For example Kraft and Cadbury merged together in order to save money and have economies of scale. This resulted in expansions which further led to more production of output. This in turn led to economies of scales. Therefore, their market share in the chocolate industry increased when they merged.

    1 b) Evaluate the view that producers, and not consumers, are the main beneficiaries of oligopolistic structures.

    The most important aspect in oligopoly is interdependence which refers to game theory. Oligopolistic firms are productively and allocatively inefficient as they keep the price below the profit maximization price as they are scared of the fact that other firms will reduce their prices and over produce. However, this scenario can be avoided through collusion. Collusive oligopoly exists when the firms in an oligopolistic market collude to charge the same prices for their products. There are two types of collusion. Formal collusion is when firms openly agree on the price that they will charge. An example of formal collusion is the Organization for petroleum Exporting Countries (OPEC). They set the production quotas and prices for the world oil markets. This is also known as a cartel. Cartel is beneficial for the producers for many reasons. Firstly, in cartel there is predictable revenue flow which is beneficial for the producers as it allows the cartel to plan in the long run. Secondly, they can make supernormal profit in the short run as well as long run. This is beneficial for the consumers as well as the producers can invest their supernormal profit for research and development. Third of all, since the firms have colluded, they reduce competition and as a result their market share increases which is again in favor of the producers. Cartels usually keep the price stable which is beneficial for the consumers as there are fewer chances of inflation. Plus, the cost of living of an average human being is not increasing in the short run. However, if a cartel decides to have a ridiculously high price as it can dictate price, then the cost of living would increase which harms the consumer sovereignty and they would not be able to enjoy price wars. Establishing a cartel is illegal in many countries in the Europe and North America as they result in a higher prices and less output which is against the interest of the consumer. The game theory suggests that cartels are unstable in the long run. However, this depends on the product of the firms. For example if the firms are selling homogenous products, then it is easier to make agreements on the price and therefore, the cartel would be more stable in the long run. If the products are differentiated, then it is harder to agree upon a price therefore being more vulnerable to being unstable in the long run. This is again not in the interest of the producers. There is a lot of incentive to cheat on each other in a cartel which is not beneficial for the producers in the long run as they become unsustainable and would not be able to double their revenue. An example of a cartel was between Unilever and Procter and Gamble who had been caught price fixing washing power in eight European countries.  Lastly, if there are many firms in a cartel, it is harder to manage and therefore it makes it harder to detect price cut which is not favorable for the producers in the long run and short run as it promotes unsustainability of a cartel.  The graph below represents the Oligopolistic Graph.

     Tacit collusion is when firms in the oligopoly charge the same prices without any formal collusion. This is good for the producers as they charge the monopoly price, make monopoly profit in the long run as well as short run and function as the profit maximization or the loss minimization point. However, they have to share the profit according to the market share which can be against the producer’s interest if they can make more profit functioning as an individual firm. Tacit collusion is beneficial for consumers as the price is usually stable which does not result in higher costs. A real life example is McDonalds which changes its price according to its competitors. 

    Non collusive oligopoly exists when firms in an oligopoly do not collude and so have to be aware of the reactions of other firms when making the price decisions. They use game theory where if one firm increases the price, they will lose consumers and therefore their revenue will decrease. Similarly, if the firm reduces the price, other firms will also cut their price which will also result in the loss of revenue. If both firms did not change their price, revenue would not change at all. Examples of non collusive oligopolies are Starbucks and Coffee Bean where they charge more or less the same price for their respective products. If Starbucks was more expensive than Coffee Beans, then Starbucks would lose consumers as the consumers would purchase from Coffee Beans and vice versa. Although this is an advantage for the producers as they can predict the reactions of other firms and can plan as to how they can further increase their market share, it is also a disadvantage for the consumers because this takes away the focus from production to predicting other firms’ reactions. This might result in the poor quality of products. If the consumers are really dissatisfied, the consumers would search for alternatives and the quantity demanded of the firm will decrease.  

    Non collusive oligopolies also use the kinked demand curve to predict how the increasing and the decreasing of the price will affect their revenue. Since increasing the price would result in the decrease in the consumers, trade, sales and profit, firms decrease their price. Because of this, they gain the number of consumers and their revenue increases. However, this is only possible in the short run. This is not possible in the long run because then the other firms will hear about the price cut and they will decrease their price as well. Therefore, both firms will lose revenue. Therefore, this is not an effective method for the producers if they want to increase their revenue. Secondly, the producers are limited in their options as they have to increase their market share. Whereas for consumers, they will enjoy the price war, the low price and can find substitutes. For instance huge motor cycle companies such as Ducati, Harley Davidson and Yamaha control the majority of the motor cycle industries’ market share. Due to the game theory and the kinked demand curve, they rarely have sales on their output. 

    When oligopolistic firms do not compete with price, Non-price competition becomes important. There are many kids of non-price competition. Firms can compete through brand names, packaging, special features, special distribution features (e.g.: Free home delivery, and after sales service), advertizing, sales promotion, personal selling, publicity, sponsorship deals and many more. Branching or advertizing is beneficial for the producers as it increases the demand for the product in the long run. It makes the product less elastic. However, they misuse the resources which are scarce. Since it increases the demand, it decreases the competition among other firms in the industry which is good for the producers as they can increase their market share and have more control over the price than its competitors. However, it is not beneficial for the consumers are it is limiting the choice. This is not beneficial for the producers in the short run as advertizing is extremely expensive which can result a massive deduction in the profit and diseconomies of scale. If firms do fail, they increase the price which harms the consumer sovereignty. There are many examples of firms who compete through non-price competition for example Nike and Adidas, Coke and Pepsi and more.

    Dynamic efficiency is prevalent in oligopoly because there is some product differentiation. This is favorable for the consumers as they are presented with more choice. Secondly, they can always find alternatives for the product if the price is too high of a good or service. Social efficiency depends on whether the good or service is a merit or a demerit good. For example; in the tobacco industry Marlboro is socially inefficient because the third person gets affected due to second hand smoking. Merit goods such as Hand Sanitizers (Himalaya) are socially efficient because it reduces the spreading of the disease and getting infections. 

    Oligopoly is good as there are limited numbers of firms controlling the industry which avoids other firms from entering which might have high prices. This is favorable for the consumers as they do not have to pay high prices. Oligopolies have stable prices in the long run as well as short run. This is beneficial for the producers as this avoids the gaining and the loosing of the customers as having stability is better than fluctuation. Due to this, the suppliers would not inflate the prices which is beneficial for the consumers as their consumer sovereignty is not harmed (they does not have to pay a lot.). This lowers the profit margin for the other companies which are good for the producers as they can maintain their market power.  Oligopolies innovate which is good for the producers and consumers. It is beneficial for consumers as consumers have more choice. Producers benefit from this as by providing more choices, they are increasing the demand for their product. However, a lot of money is needed for research and development and innovation which might result in diseconomies of scale in the long run. For example Tata Nano is a new car which was launched in India by Tata. However, the majority of the cars turned out to be defective because they kept on catching fire. Thus, Tata had to deal with a huge loss which resulted in diseconomies of scale.

    Oligopolies have high barriers to entry for example economies of scale, access to technology, patents. This is good for the existing oligopoly as they have a higher market share. They can mass produce, control price and they will get brand name if they advertize. For example; Visa which is in the credit card industry has high barriers to entry and therefore only three main credit card companies have the highest market share in the industry.

    Oligopolies have high start up costs. This is advantageous for the existing firms as they can maintain their market power. This is not advantageous for other firms who want to enter the industry as they cannot. For example starting a railway business or property has high start up costs.      

    Some oligopolies have low barriers to entry which allows other firms to enter the industry. This is good for consumers as they have more choice. However, this is not favorable for the producers as their market share decreases. However, this can result in the increase in the demand for the product in general. For example; in India Kurkure and Uncle Chips dominate the chips industry. However, the price for Kurkure chips is just 10 rupees which is approximately 0.22 dollars. Since the price is so low, other companies enter the industry and reduce the market share of Kurkure and Uncle Chips. However, this increased the overall demand for chips. Some oligopolies do not innovate due to the low competition. They do not strive to do better. This effects quality of the product and harms the consumer sovereignty and affects the dynamic efficiency. This again leaves consumers with less choice. This is bad for the producer as well because in the long run, if the quality continues to deteriorate, the demand will decrease and eventually the consumers will turn to alternatives. An example of this is Ambuja cement which is an Indian company in the cement industry. They produce cement which is undifferentiated and therefore they did not innovate as much as they should have. They last came up with a new scheme in 2000.

     It seems the both the consumers as well as the producers benefit. However, producers benefit more than the consumers as producers earn supernormal profit in the short and long run. Although they do not have the same freedom as a firm in the monopolistic market structure, they can easily maintain the market share and market power due to high barriers to entry. There is very little competition. Thus, the oligopolies do not have to worry much about the consumer sovereignty. However, if the price is too high or the quality is dissatisfactory, then the consumers will find an alternative which will lower the demand for the product and decrease the revenue.

     

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