Economic Analysis

Module 5. Concepts of market

Lesson 22
OLIGOPOLY

22.1 Introduction

While the concentration of an industry is important, it does not tell the whole story. Indeed, to explain the behavior of imperfect competitors, economists have developed a field called industrial organization. We can cover this vast area here. Instead, we will focus on three of most important cases of imperfect competition-collusive oligopoly, monopolistic competition, and small-number oligopoly.

In analyzing the determinants of concentration, economists have found that three major factors are at work in imperfectly competitive markets. These factors are economies of scale , barriers to entry, and strategic interaction . When the minimum efficient size of operation for a firm occurs at a sizable fraction of industry output, only a few firms can profitably survive and oligopoly is likely to result. When there are large economies of scale or government restrictions to entry, they will limit the number of competitors in an industry.

When only a few firms operate in a market, they will soon recognize their interdependence. Strategic interaction, which is a genuinely new feature of oligopoly that has inspired the field of game theory, occurs when each firm’s business depends upon the behavior of its rivals.

Why are economists particularly concerned about industries characterized by imperfect competition? The answer is that such industries behave in certain ways that are inimical to the public interest. For example, imperfect competition generally leads to prices that are above marginal costs. Sometimes, without the spur of competition, the quality of service deteriorates. Both high price and poor quality of service deteriorates. Both high price and poor quality are undesirable outcomes.

22.2 Oligopoly

The term oligopoly means “few sellers”. Few, in this context, can be a number as small as 2 or as large as 10 or 15 firms. The important feature of oligopoly is that each individual firm can affect the market price. In the airline industry, the decision of a single airline to lower fares can set off a price war which brings down the fares charged by all its competitors.

Oligopolistic industries are relatively common especially in the manufacturing, transportation, and communications sectors. For example, there are only a few car makers, even though the automobile industry sells many different models. The same is true in the market for household appliances; stores are filled with many different models of refrigerators and dishwashers, all made by a handful of companies. You might be surprised to know that the breakfast cereal industry is an oligopoly dominated by a few firms even though there seem to be endless varieties of cereals.

When studying oligopolies, it is important to recognize that imperfect competition is not the same as on competition. Indeed, some of the most vigorous rivalries in the economy occur in markets where there are but a few firms. Just look at the cutthroat competition in the airline industry where two or three airlines may fly a particular route but still engage in periodic fare wars.

How can we distinguish the rivalry of oligopolists from perfect competition? Rivalry encompasses a wide variety of behaviour to increase profits and market share. It includes advertising to shift out the demand curve, price cuts to attract business, and research to improve product quality or develop new products. Perfect competition says nothing about rivalry but simply means that no single firm in the industry can affect the market price.

Fig. 22.1 Market structure under oligopoly

In oligopoly costs turn up at a higher level of output relative to total industry demand DD. Coexistence of numerous perfect competitors is impossible, and oligopoly will emerge.

As a result of high prices, oligopolistic industries often have supernormal profits. The profitability of the highly concentrated tobacco and pharmaceutical industries has been the target of political attacks on numerous occasions. Careful studies show, however, that concentrated industries tend to have only slightly higher rates of profit than unconcentrated ones. This is a surprising finding, and it has especially perplexed critics of big business, who expected to find the biggest companies earning enormous profits.

Historically, one of the major defenses of imperfect competition has been that large firms are responsible for most of the research and develop (R & D) and innovation in a modern economy. There is certainly some truth in this idea, for highly concentrated industries sometimes have high levels of R & D spending per dollar of sales as they try to achieve a technological edge over their rivals. At the same time, individuals and small firms have produced many of the greatest technological break- throughs. We will review this important question in detail later in this chapter.

22.3 Collusive Oligopoly

The degree of imperfect competition in a market is influenced not just by the number and size of firms but by their behavior. When only a few firms operate in a market, they see what their rivals are doing and react. For example, if there are two two airlines operating along the same route and one raises its fare, the other must decide whether to match the increase or to stay with the lower fare, undercutting its rival. Strategic interaction is a term that describes how each firm’s business strategy depends upon its rivals’ business behavior.

When there are only a small no of firms in a market, they have a choice between cooperative and non cooperative behavior. Firms act non cooperatively when they act on their own without any explicit or implicit agreement with other firms. That’s what produce price wars. Firms operate in a cooperative mode when they try to minimize competition. When firms in an oligopoly actively cooperate with each other, they engage in collusion. This term denotes a situation in which two or more firms jointly set their price or outputs, divide the market among themselves, or make other business decisions jointly.

During the early years of American capitalism, before the passage of effective antitrust laws, oligopolists often merged or formed a trust or cartel. A cartel is an organization of independent firms, producing similar products, that work together to raise prices and restrict output. Today with only a few exceptions, it is strictly illegal in the United States and most other market economies for companies to collude by jointly setting prices or dividing markets.

Nonetheless, firms are often tempted to engage in tacit collusion, which occurs when they refrain from competition without explicit agreements. When firms tacitly collude, they often quote identical high prices, pushing up profits and decreasing the risk of doing business. A recent examination found that about 9 percent of major corporations have admitted to or been convicted of illegal price fixing. In recent years, makers of infant formula, scouring pads, and kosher Passover products have been investigated for price fixing, while private universities, art dealers, the airlines, and the telephone industry have been accused of collusive behavior.

The rewards of successful collusion can be great. Imagine a four-firm industry-call the firms A, B, C, and D-where all the rivals have tired of ruinous price wars. They tacitly agree to charge the same price and not undercut each other. The firms hope to form a collusive oligopoly by finding the price which maximizes their joint profits. Figure 4 illustrates oligopolist A’s demand curve, D_AD_A, is drawn assuming that the other firm all follow A’s pricing policy and charge the same prices; each firm’s demand curve will have the same prices; each firm’s demand curve will have the same elasticity as the industry’s DD curve. Firm A will get one-fourth of the shared market as long as all firms charge the same price.

Fig. 22.2 Collusive oligopoly looks much like monopoly

The maximum-profit equilibrium for the collusive oligopolist is shown in fig 10-2 at point E, the intersection of the firm’s MC and MR curves. Here, the appropriate demand curve is D_AD_A, just above point E. This price is identical to the monopoly price: it is well above marginal cost and earns the colluding oligopolists a handsome monopoly profit.

When oligopolists can collude to maximize their joint profits, taking into account their mutual interdependence, they will produce the monopoly output and price and earn the monopoly profit.

There is no single model describing the operation of an oligopolistic market. The variety and complexity of the models is because you can have two to 10 firms competing on the basis of price, quantity, technological innovations, marketing, advertising and reputation. Fortunately, there are a series of simplified models that attempt to describe market behavior under certain circumstances. Some of the better-known models are the dominant firm model and the kinked demand model

22.4 Price Leadership or Dominant Firm Model

In some markets there is a single firm that controls a dominant share of the market and a group of smaller firms. The dominant firm sets prices which are simply taken by the smaller firms in determining their profit maximizing levels of production. This type of market is practically a monopoly and an attached perfectly competitive market in which price is set by the dominant firm rather than the market. The demand curve for the dominant firm is determined by subtracting the supply curves of all the small firms from the industry demand curve. After estimating its net demand curve (market demand less the supply curve of the small firms) the dominant firm maximizes profits by following the normal p-max rule of producing where marginal revenue equals marginal costs. The small firms maximize profits by acting as PC firms–equating price to marginal costs.

Notice first the total market demand curve for the industry as a whole. Then notice the marginal cost curve for the competitive fringe of firms. This is a model in which there is one firm which is dominant and then a fringe of small firms who are so small that they behave like perfectly competitive firms – they take the price that is give by the dominant firm (and then set P = MC to profit maximize).

The basic story in this model is that the dominant firm leaves room for the competitive fringe (and therefore profit maximizes according to the “residual” demand curve. Since the fringe of firms behaves like perfect competitors, the sum of their marginal cost curves is essentially their supply curve. It represents the amount that these firms together will want to supply at any possible price.

Therefore, the residual demand curve is total demand minus this supply by the competitive fringe. This is exactly what the curve labeled D_DF represents.

Our story is that the dominant firm profit maximizes using this residual demand curve. That means setting MR = MC for this demand curve. This is exactly where Q*_DF comes from (it is the quantity at which MR is just equal to MC for the dominant firm. The dominant firm will charge the profit-maximizing price, which is P*.

Once P* is established by the dominant firm, the competitive fringe (who are price takers) will just take this price and set P* = MC. This gives us the profit-maximizing quantity Q*_CF for the competitive fringe.

Fig. 22.3 Price leadership model

22.5 Kinked Demand Model

In an oligopoly, firms operate under imperfect competition . With the fierce price competitiveness created by this sticky-upward demand curve , firms use non-price competition in order to accrue greater revenue and market share.

"Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend–"kink". Thus the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve .

Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition ) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.

The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price decreases. Firms will often enter the industry in the long run.

Fig. 22.4 Kinked demand curve