Oligopoly

Characteristics of Oligopoly

Oligopoly is the dominant market structure in advanced economies. Oligopolistic markets have the following characteristics:

1. The Market is Dominated by a few Large firms

There may be a large number of firms, but a large percentage of the market is accounted for by a few big firms. For instance there is a large number of food retailers, but the leading supermarkets get most of the trade. The extent to which markets are dominated by big firms can be measured by using concentration ratios. For instance, if in industry A, the four largest firms have 60% of the market, but in industry B they only have 55%, we would say that the four firm concentration ratio is higher in industry A, and therefore the biggest firm in industry A have more market power than their equivalents in industry B.

However, the use of concentration ratios to compare markets raises some questions:

1. What if the four biggest firms in industry A all have 15% each of the market, but in industry B, the biggest has 40%, and the next three have 5% each? Would we still say that industry A is more concentrated than B? There is no clear answer.
2. We might get a different picture depending on the number of firms we include. For instance, the seven firm concentration ration might be higher in industry B than A.
3. How concentrated a market is depends in part on how widely, or narrowly we define the market in question. For instance the package tour holiday market is dominated by a few big operators, but the holiday market as a whole is much less concentrated, and consumers have a choice between a package holiday and booking separate flights and hotels.

2. High Entry Barriers

Oligopolistic markets are often difficult for new firms to enter, for the following reasons:

Economies of scale – Existing firms may be producing at the minimum efficient scale and therefore have significant cost advantages over a new firm, which is unlikely to generate enough sales in the short or medium term to get costs down. The car industry is a good example of this. It is dominated by a small number of giant global firms such as VW, Toyota and Ford, each of which produces millions of vehicles each year.

Capital costs – Some industries require huge investment in buildings and machinery before any production is possible. Shipbuilding, car manufacturing and mobile phone networks are all examples. This makes it difficult for new firms to enter, as they may struggle to raise the capital.

Natural cost advantages – Some producers may own or have better access to superior or cheaper resources which makes it difficult for new producers to compete. For instance most of the world’s ‘rare earth’ minerals used in making mobile phones are in China. This gives Chinese mining companies a huge advantage over potential rivals who have to find scarcer, more expensive sources of minerals elsewhere.

Legal barriers – In some industries firms may be protected from new entrants by legal restrictions. For instance, the government grants broadcasting licences to a limited number of TV and radio stations. It also licences only a handful of mobile phone networks. It is possible for new mobile phone service providers to set up, but they have to use one of the networks already set up and pay for the access, restricting their ability to compete.

All of the above barriers are described as innocent entry barriers. This is because they arise without deliberate intent or action on the part of existing firms (sometimes referred to as incumbent firms). In addition, there are other barriers, which existing firms can deliberately create. They are sometimes called artificial entry barriers. They include the following:

Limit pricing – This is a pricing policy that can be used by incumbent firms. Price may be set below the short-run profit maximising level in order to deter entrants. This may help firms to make higher long-run profits as the industry looks less attractive to potential entrants.

Marketing barriers – Firms in oligopolistic markets are likely to spend a lot of money on branding and advertising. They can spread this spending over a very large output, so the cost per unit is very low. Successful branding and advertising makes it harder for new firms to penetrate a market. Existing firms may also use multiple branding, which involves selling very similar products under different brands. This increases the number of brands that new entrants have to compete with, making it harder for them to win market share. Detergents are a good example; Unilever and Procter & Gamble each sell a variety of washing powders under different brand names.

Anti-competitive practices – Incumbent firms can restrict a rival’s access to the market in a number of ways:

A manufacturer can threaten to cut off supplies to a retailer if the retailer stocks the product of a rival.

A firm may boycott a supplier if it supplies a rival firm.

Incumbent firms sometimes use predatory pricing to deter or drive out competitors. It involves lowering the price in a part of the market where an entrant is competing to a level below cost, so deliberately incurring a loss. Once the entrant has been driven out, an incumbent can then push price back up again. The practice usually involves a cross-subsidy, where the firm uses its profits from other parts of the business to support the losses until the competitor is driven out.

Anti-competitive practices are usually illegal and can result in large fines and prosecutions.

3. Exit Barriers

Where it is difficult for a firm to leave a market without incurring a high cost or some other penalty, an exit barrier exists. The most important of these is sunk costs. These are costs that cannot be recovered if a firm leaves the market. For instance a firm setting up to compete in the fizzy drinks market might be able to sell its plant and equipment if it leaves the market, but it won’t be able to recover any of the costs of the marketing costs, which are likely to be high if it takes on the likes of Coca Cola.

Exit barriers are also entry barriers, since firms may be reluctant to enter markets they cannot easily leave.

4. Interdependence

An important characteristic of oligopolistic markets is that firms are interdependent. This means that the price, output and other decisions taken by one firm will affect the other firms in the market. For instance, if Tesco cuts its prices, this will affect sales at other supermarkets. If Renault launches a new model or increases its production, this will affect sales of other car makers.

Interdependence is a unique characteristic of oligopoly. In perfect competition and monopolistic competition, no individual firm is big enough to have any influence on the market. Under monopoly, there are no other firms at all.

Because of this interdependence between firms, it is not possible to construct a demand curve. This is because if a firm cuts or raises its price, it is not possible to know how much it will sell, since other firms may react with price changes of their own. In other words the ceterus paribus assumption on which constructing a demand curve depends does not apply.

It therefore follows that we cannot construct diagrams to predict equilibrium output and price, since we cannot construct revenue curves.

5. Product Differentiation

Firms can reduce interdependence to some extent by making their product as distinctive as possible, through a mixture of design features, branding and after-sales service. Product differentiation is easier in some markets than others. Car makers, for instance can introduce all sorts of features that differentiate their cars from those of rivals, but it is much harder for a supplier of gas or electricity to do this.

Collusion

In some oligopolistic markets, firms may engage in collusion with rival firms. This means making agreements with other firms to restrict competition in order to increase profits. Collusion is most likely to occur under the following conditions:

1. Where the number of firms in the industry is very low: - the smaller the number, the more easy it is to make an agreement and see that it is being kept to
2. Where the firms are of roughly similar size and face similar costs: - under these conditions it is harder for any firm to win a ‘price war’ (see notes below) which would reduce the profits of all the firms.
3. Where there is little opportunity to compete through product differentiation and other forms of non-price competition (see notes below).

Collusion can take a number of forms. In some industries there is__ informal (or tacit) collusion__. This means that there is no formal agreement between firms, but there is an established pattern of behaviour that firms keep to.

The most common form of informal collusion is price leadership. This is where the largest firm sets the price. If the price leader raises or lowers price, the price followers will do the same. This is a way of avoiding damaging price wars and also avoids the risk of losing market share as a result of raising price. Price leadership has often been suspected to take place at petrol/diesel filling stations.

Other forms of informal collusion include avoiding trying to ‘poach’ customers from other firms.

Formal collusion involves an explicit agreement (written or verbal) to restrict competition. The firms involved share out the market between them, resulting in higher prices and profits for all firms. The main examples are:

- Cartels - A cartel exists if the firms involved reach an agreement on both price and how much each firm can sell (called a quota). In effect the firms behave as if they were a single enterprise, and can therefore enjoy _monopoly __profits (_see notes on 3.4.5).

Cartels are likely to be unstable agreements. This is because there will be a strong temptation for individual members to ‘cheat’, by either increasing their production beyond their quota, and/or selling some output below the agreed price, in order to win market share.

Cartels are illegal in most developed countries, and so the agreements are hard to enforce.

Governments may also encourage ‘whistle blowing’ by not prosecuting firms that own up to the practice and inform on other members of the cartel.

- Bid Rigging – This involves firms agreeing between them not to compete openly to win contracts from the government or other big organisations. The firms concerned effectively take it in turn put in a bid that is likely to be accepted; the others put in deliberately over-priced bids.

- Geographical Market Sharing – Firms can share out a national market by agreeing to allow each other dominance in different regions. It could be achieved by firms not competing for contracts outside their area, or by selling to each other regional outlets for their businesses; eg hotel chains could swap hotels between them to give them regional dominance.

Price Competition

Where collusion is considered too risky, and there is little opportunity for product differentiation, it is likely that there will be price competition. Occasionally this may develop into a full-blown ‘price war’ in which a firm may attempt to drive rivals out of the market altogether. Provided that prices genuinely reflect a firm’s costs, it is fair competition. But if a firm deliberately sustains losses, financed by profits or resources from elsewhere (see notes on ant-competitive practices above), it is not legal and considered to be predatory pricing.

Game Theory - the ‘Prisoner’s Dilemma’

A major decision for firms in oligopolistic markets is whether to collude or not. If all the conditions identified above (small number of firms, of similar size, limited product differentiation) a further important consideration is whether or not the firms concerned trust each other. If there is a high degree of trust, collusion is much more likely. This is demonstrated by the __‘prisoner’s dilemma’ __scenario, which is an example of game theory.

Two prisoners are being held by police in separate cells. The police have enough evidence to convict both for a minor offence, but suspect both have been involved in a much more serious crime. The prisoners are offered a deal with the following possible outcomes:

1. A fine for a minor offence if both prisoners keep silent.
2. No punishment for one prisoner who confesses to the serious crime and informs on the other, but a life sentence for the other prisoner.
3. A two-year sentence for both prisoners if they both confess.

Game theory suggests that if they trust each other they will both keep silent and just pay a fine. If there is little or no trust, the rational course of action for each prisoner is to confess and inform on the other, since the certainty of a two-year sentence (or just getting a fine) is preferable to the possibility of a life sentence.

We can transfer this reasoning to the simple situation where there are two firms in a market. Each firm can either raise its price or leave it unchanged. If both raise prices, they will both be better off (more profit) than by leaving price unchanged. But if one raises price and the other doesn’t, the firm that raises price will make a loss, while the other firm makes even more profit than if both firms raised prices.

The theory predicts that the outcome depends on the level of trust and opportunity to get together and collude. If they trust each other and can get together, they will both raise prices. Otherwise, the safe option is to leave price unchanged, to avoid the risk of making a loss.

Governments can reduce the likelihood of collusion (and therefore higher prices for consumers) by increasing the risks for firms, in the form of very large fines, and/or imprisonment. ‘Whistle blowing’ is also encouraged by not prosecuting firms that inform the authorities; this will discourage collusion in the first place.

Evaluation of Oligopoly

Where there is collusion, it is likely that firms will earn abnormal profit and consumers may be exploited, as prices will be higher than in a market where the firms compete.

It is also likely that price will be above marginal cost, if firms collude, so the market will not be allocatively efficient.

If there is no collusion, and little or no product differentiation, firms are likely to produce at, or close to minimum long run average cost (ie at the minimum efficient scale). This means that the industry will be productively efficient. If there is collusion, there will be less incentive to reduce costs and less productive efficiency.

Firms in oligopolistic markets may be dynamically efficient if they earn abnormal profit and face significant competition from rivals. They will have resources to invest in new products and technologies and have the incentive to inovate.

Explain why collusion amongst firms is more likely to occur amongst airlines operating on routes from Europe to North America, compared to hairdressers in a major city.

Your answer should include: number of firms / concentration / product differentiation / oligopoly / imperfect competition

Non-price Competition

Where it is relatively easy to differentiate products, firms can compete on price and other elements of the marketing mix. The marketing mix comprises four elements that can be adjusted to create a competitive position in the market:

1. Price
2. __Product __– the design of the good or service; its functions, appearance, quality, size, after sales service etc
3. __Promotion __– advertising and marketing, including the attempt to build up a powerful brand with a loyal following. A strong brand is a major source of power in the market.
4. __Place __- how the customer can buy the product; for instance on-line retailing has taken a large market share from traditional high street shops.