Oligopoly Essay

Oligopoly is a market structure in which a few firm dominate the industry, it is an industry with a 5 firm concentration ratio of greater than 50%.

In Oligopoly, firms are interdependent; this means their decisions (price and output) depend upon how the other firms behave:

  • Barriers to entry are likely to be a feature of Oligopoly
  • There are different models to explain how firms may behave

The kinked demand curve model suggests firms will be profit maximisers.

Kinked Demand Curve Diagram

At p1 if firms increased their price, consumers would buy from the other firms, therefore, they would lose a large share of the market and demand will be elastic. Therefore, firms will lose revenue by increasing price

If firms cut price then they would gain a big increase in market share, however, it is unlikely that firms will allow this. Therefore, other firms follow suit and cut price as well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut and revenue would fall.

This model suggests price will be rigid because there is no incentive for firms to change the price

If prices are rigid and firms have little incentive to change prices they will concentrate on non-price competition. This occurs when firms seek to increase revenue and sales by various methods other than price.

For example, a firm could spend money on advertising to raise the profile of their product and try and increase brand loyalty, if successful this will increase market sales. Advertising is a big feature of many oligopolies such as soft drinks and cars. Alternatively, they could introduce loyalty cards or improve the quality of their after sales service. When buying a plane ticket price is not the only factor consumers look at, they may prefer airlines with more leg room, air miles e.t.c.

Non-price competition depends upon the nature of the product. For example, advertising is very important for soft drinks but less important for petrol.

However, in reality, this model doesn’t always occur. Often the objectives of firms are not to maximise profit. For example, they may wish to increase the size of their firm and maximise sales. If this is the case, they may be willing to take part in a price war, even if this does lead to lower profits. Price wars involve firms selling goods at very low prices to try and gain market share. For example, newspapers such as the Times and the Sun have recently been sold very cheaply. Price wars are more likely if:

  • 1. Large firms are able to cross subsidise one market from profits elsewhere
  • 2. In a recession, markets are more competitive as firms seek to retain customers

However, price wars may only be short-term

A firm may engage in predatory pricing, this occurs when the incumbent firm seeks to force a new firm out of business by selling at a very low price so that it cannot remain profitable.

Using game theory

Game theory looks at different possible outcomes of oligopoly – depending on how firms react to different decisions.

If the firms in oligopoly seek to increase market share the most likely outcome is that they both set low prices and make a low profit (£3m each) However if the firms could come to some agreement either formal or tacit collusion – they could both agree to raise prices. This will require the firms to reduce output and stick to the more limited supply. If they set high prices, then they will both be able to make monopoly profits (£8m each)

However, when prices are high, there is a temptation to undercut your rival and benefit from both high market prices and high output. This enables higher profit – £10m, but if firms start to cheat – then rivals are likely to retaliate by cutting prices too.

Collusion is possible in oligopoly, but it depends on several factors. Collusion is more likely if

1. There are a small number of firms, who are well known to each other – this makes it easier to stick to output quotas
2. A dominant firm, who is able to have a lot of influence in setting the price.
3. Barriers to entry, this is important to stop other firms entering to take advantage of the high profits
4. Effective communication and monitoring of output and costs
5. Similar production costs and therefore will want to raise prices at the same rate
6. Effective punishment strategies for firms who cheat
7. No effective government legislation, e.g. collusion is illegal in the UK.

Conclusion:

There is no certainty in how firms will compete in Oligopoly; it depends upon the objectives of the firms, the contestability of the market and the nature of the product. Some oligopolies compete on price, other compete on the quality of the product.

Examples of Competition in oligopoly

Petrol is a homogenous product and so is likely to be quite stable in prices. Firms often move petrol prices in response to changes in the oil price. However, the introduction of supermarket own brand petrol has changed the market. Tesco and Sainsbury’s are more willing to sell cheaper petrol to attract customers to shop at their supermarket.

Coffee market

This takeaway coffee at 99p is quite cheap – suggesting a competitive oligopoly. However, for many customers, the price of coffee is secondary to the quality and environment of the coffee shop. Traditional coffee shops like Costa and Starbucks use more non-price competition to attract customers – as much as offering cheap prices.

In fact, there is a danger selling cheap coffee – may indicate to consumers lower quality

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In society, the world of business is operated and separated into certain market forms that lay the groundwork for a specific infrastructure which lies within the different economical market systems. Through the view of economics, the science which studies human behavior as a relationship between ends and scarce means which have alternative uses (Deuriarte), the main criteria by which one can distinguish between different market forms are based upon several specific categories. Such categories may distinguish the type of market system involved within the criteria depending on the outline structure that leads an individual to answer an economists most basic queries; the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. After careful research and understanding of the economical degree of measure, certain, major forms of markets clearly stand out above all; a monopoly, oligopoly, and the monopolistic competition.

Each market structure consists of diverse characteristics; a monopoly is defined as a persistent market situation where there is only one provider of a kind of product or service. In contrast, oligopoly is a market form in which a market is dominated by a small number of sellers. Furthermore, the monopolistic competition is a common market form where many markets can be considered as monopolistic ally competitive, because there are many producers and many consumers in that given market. Still to this day, monopolies exist in our economy and thus set certain standards that portray the lack of economic competition for the good or service in that particular market. However, several important monopolies are prevalent that justify certain factors discussed, a pure monopoly which is a market whose sales are completely attributable to a single firm (Deuriarte 125) and a natural monopoly which is able to produce at the cheapest cost for society by virtue of its history and experience in the market and therefore is relatively free from any serious threat of entry by new firms (Deuriarte 125).

In a pure monopoly, the telecommunications industry has illustrated the ability to produce high profits and excessive revenue throughout the industry, allowing for the price setting power to be evident which establish authority standards and procedures that dictate the market. Thus, assuming that the firm aims to maximize profits (where MR = MC), one can establish a short run equilibrium as shown in the diagram below. The profit-maximizing output can be sold at price P 1 above the average cost (AC) at output Q 1. After observing the situation in careful detail, the firm is making abnormal "monopoly" profits or economic profits shown by the yellow shaded area. The area beneath ATC 1 shows the total cost of producing output Qm. Total costs equals average total cost multiplied by the output.

After sincere observation of the market trend, a firm by the name of Microsoft can readily be applied to such an argument. Microsoft is an ideal example of what a monopoly is defined as because it dominates the technology industry because of the capability to lure all competition to failed success in the market. Microsoft power is infinite and the profits continue to increase in patterns where no firms can compete even if they attempt to. In regards to the matter, constraints exist and a monopoly firm such as Microsoft pertains zero capacity for any substitutes or any products in that market that can possibly come to any relevant equivalence to the primitive goods. On the contrary, oligopolies differ because there are a few participants in this type of market, each firm is aware of the actions of the others.

Thus, oligopolistic markets are characterized by interactivity because the decisions of one firm influence, and are influenced by, the decisions of other firms. Furthermore, strategic planning by firms always involves taking into account the likely responses of the other market participants (Deuriarte). As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. Therefore, in an oligopoly, firms sales and revenue is calculated as a market share to the industry as a whole. For example, the industry revenue of twenty million dollars is calculated, but one firm has five million dollars of the revenue, which clearly explains that the firm has a twenty five percent market share.

As a result, firms utilize non price competition in order to accrue greater revenue and market share. In such a market system, a cartel can possibly form where oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may possibly collude to raise prices and restrict production in the same way as a monopoly. Certain few examples of oligopoly in the economy are prevalent in foreign countries in business sectors of automobile industry, consumer goods, and the steel production. A monopolistic ally competitive firm acts similar to a monopolist in the short run. This is due to the fact that the firm faces a downward-sloping demand curve, unlike the horizontal demand curve an individual firm faces in a perfectly competitive market.

The firm simply produces the quantity that maximizes economic profit. This occurs at the intersection of the marginal revenue and marginal cost curves. However, this situation does not exist for very long because as other firms notice that there is profit to be made, they will enter the market as there are no barriers to entry, unlike in a monopoly. Conversely, if firms are actually incurring losses, then they will exit the market. This fluctuation in supply will continue until firms are making zero economic profit (but firms would still probably record accounting profit) and the quantity demanded is at the point on the demand curve where price equals average total cost. Unlike in perfect competition, the firm does not produce at the lowest attainable average total cost.

Instead, the firm produces at an inefficient output level, reaping more in additional revenue than it incurs in additional cost versus the efficient output level. While monopolistic ally competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products - an impossible proposition in a market economy. In conclusion, after careful observation, the various market forms in the economic system are the fundamental infrastructure that maintains the product supply and demand in different industries. Whether a monopoly with one firm, an oligopoly with two or more, or a monopolistic competition composed of many firms, a degree of economic analysis in respect to the business world is available. Each must be governed and regulated by the government in order to maintain a stable economy and offer opportunity to get potential profits. So as the question implies unfair labor laws or great businessmen at work?

The United States government will have the last say.


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