ECONOMICS FOR MANAGERS

PSG INSTITUTE OF MANAGEMENT MBA 2011-13 BATCH I Trimester

Session XIV- For Batch C and D Markets and Competition- Oligopoly

Oligopoly
We now move away from the fairly straightforward world

of perfect competition and monopoly into the complex and uncertain world of oligopoly .We find that many market structures tend towards being an oligopoly as time progresses. They are frequently fascinating markets to look at!
An oligopoly is a market dominated by a few

producers, each of which has control over the market. It is an industry where there is a high level of market concentration. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure. The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. Normally an oligopoly exists when the top five firms in the market account for more than 60% of total market demand/sales.
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Oligopoly- Characteristics

1. A few large dominant firms, with many 2. 3. 4. 5.

small ones, A product either standardized or differentiated, Power of dominant firms over price, but fear of retaliation, Technological or economic barriers to become a dominant firm, Extensive use of non-price competition because of the fear of price wars.

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Oligopoly- Characteristics 6) Entry barriers: Significant entry barriers into the

market prevent the dilution of competition in the long run which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on market prices and output. 7) Interdependent decision-making: Interdependence means that firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. In perfect competition and monopoly, the producers did not have to EFM Faculty P.Uday Shankar 26/09/11 4 consider a rivals response when choosing

Oligopoly- Characteristics

8) Mergers: While many oligopolies have emerged through the growth of dominant firms in a certain industry, many have also emerged through mergers.
Ex.steel, airlines, banking, and entertainment industries

Merging of two or more competing firms is beneficial

in that it may increase their market share significantly, and thus achieve greater economies of scale. In this way, competition can also be reduced. Firms may also merge hoping to achieve monopoly power. The larger firm that results from a merger would have greater control over market supply and price than a few smaller firms.
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Oligopoly- Characteristics 9) Measures of Industry Concentration Price Leadership is when one firm has a dominant position in the market.That firm will set a market price and firms with lower market shares will follow the change.

10) The Four Firm Concentration Ratio Is the scale that determines whether a industry is monopolistic competition or oligopoly. If the combination of market share of the four largest firm in a single industry is equal or greater than 40%, the industry is consider as oligopoly. A concentration ratio reveals the percentage of total output produced and sold by the industry's largest firms. 11) Herfindahl Index (Herfindahl-Hirschman Index or HHI) The HHI measures of the number and size of firms in ratio to the industry. It serves as an indicator of the amount of competition within a market. It is defined as the sum of the squares of the market shares of each individual firm.
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Cartel in Beggary !!!!

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Oligopoly- Characteristics

Product branding: Each firm in the market is selling a branded (differentiated) product 2. Entry barriers: Significant entry barriers into the market prevent the dilution of competition in the long run which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on market prices and output 3. Interdependent decision-making: Interdependence means that firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. In perfect competition and monopoly, the producers did not have to consider a rivals response when EFM Faculty P.Udayoutput and price. choosing Shankar 26/09/11
1.

Oligopoly- Characteristics

4) Non-price competition: Non-price competition s a consistent feature of the competitive strategies of oligopolistic firms. Examples of non-price competition includes:
Free deliveries and installation Extended warranties for consumers and credit

facilities Longer opening hours (e.g. supermarkets and petrol stations) Branding of products and heavy spending on advertising and marketing Extensive after-sales service Expanding into new markets + diversification of the product range
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Oligopoly and the Kinked Demand Curve

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Oligopoly- Kinked Demand Curve

In the above figure the demand of a firm in oligopoly is made of two segments of two separate demand curves. The upper part is highly elastic because if the firm raises its price, the other firms will not follow, and the firm will lose its market share. The lower part is inelastic because if the firm lowers its price, the other firms follow, and no firm can expand its marketP.Uday Shankar EFM Faculty share. 26/09/11 11

Oligopoly and the Kinked Demand Curve

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Oligopoly and the Kinked Demand Curve

The kinked demand curve model developed first by the economist Paul Sweezy assumes that a business might face a dual demand curve for its product based on the likely reactions of other firms in the market to a change in its price or another variable. The common assumption of the theory is that firms in an oligopoly are looking to protect and maintain their market share and that rival firms are unlikely to match anothers price increase but may match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm.
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Oligopoly and the Kinked Demand Curve

If a business raises price and others leave their

prices constant, then we can expect quite a large substitution effect away from this firm making demand relatively price elastic. The business would then lose market share and expect to see a fall in its total revenue. If a business reduces price but other firms follow suit, the relative price change is much smaller and demand would be inelastic in respect of the price change. Cutting prices when demand is inelastic also leads to a fall in total revenue with little or no effect on market share. The kinked demand curve model therefore makes a prediction that a business might reach a stable profit-maximising equilibrium at price P1 and 26/09/11 EFM Faculty P.Uday Shankar 14 output Q1 and have little incentive to alter prices.

Oligopoly

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Oligopoly- Importance of Non-price Competition

The importance of non-price competition under oligopoly Non-price competition assumes increased importance in oligopolistic markets. Non-price competition involves advertising and marketing strategies to increase demand and develop brand loyalty among consumers. Businesses will use other policies to increase market share: 1. Better quality of service including guaranteed delivery times for consumers and low-cost servicing agreements 2. Longer opening hours for retailers, 24 hour telephone and online customer support 3. Extended warranties on new products 4. Discounts on product upgrades when they become available in the market 5. Contractual relationships with suppliers - for example the system of tied houses for pubs and EFM Faculty P.Uday agreements with franchises (exclusive 26/09/11 16 contractual Shankar distribution agreements)

OLIGOPOLY CONCENTRATION
An oligopoly form of market is characterized by the

presence of a few dominant firms. There may be a large number of small firms, but only the major firm have the power to retaliate. This results in a high concentration of the industry in only 2 to 10 firms with large market shares. The most notable causes for the high concentration in oligopoly type of markets are - economies of scale present in production of certain goods, - business cycles eliminating weak competitors, - benefits from firms merging, and - other barriers such as technological development and Faculty P.Uday Shankar EFM 26/09/11 17 advertising.

Oligopoly- Collusion

All firms benefit from avoiding price wars and

seeking to agree on higher prices and protected sale volumes. These agreements are generally illegal. Thus, secret agreements are sought: these constitute collusion. In the simplest form of collusion, overt collusion, firms openly agree on price, output, and other decisions aimed at achieving monopoly profits. Firms that coordinate their activities through overt collusion and by forming collusive coordinating mechanisms make up a cartel.
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Oligopoly- Cartel
CARTEL

A cartel is an official agreement between several firms in an oligopoly. The agreement sets the price all firms will charge and often specifies quotas or market shares of the various firms. Cartels are illegal in most countries of the world. OPEC is a major example of a cartel. It exists because it is beyond the control of an individual country. OPEC is naturally the prototype of a successful cartel. Output quotas of its members produced staggering price increases (from $1.10 to $11.50 per barrel in the early 1970's, and up to $34.00 in the late 1970's: an increase of 3400% in ten years). EFM Faculty P.Uday Shankar 26/09/11 19 Recent

Oligopoly- Mutual Interdependence

The mutual interdependence of firms in oligopoly

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is demonstrated in the necessity to maintain price stability ahown in the kinked demand. It may lead firms to follow strategies which do not constitute outright collusion but produce a similar outcome. These strategies include - price leadership where one firm - usually, the dominant or most dynamic firm - is the first to change its price and all firms follow, and - cost plus pricing where prices are aligned because all firms haveFaculty P.Uday Shankar the same profit or markup margin on similar EFM 26/09/11 costs.

Oligopoly- Economic Effect

The oligopoly form of market is harmful to

society in comparison to perfect competition because of the loss of productive and allocative efficiency. In addition, the undesirable effect may even be worse than in monopoly because supervision is not possible, less economies of scale are present and more wasteful non-price actions are used. However, some beneficial effects are argued to exist from technology progress and scale of production. The extreme case of a successful cartel such as OPEC shows the harm brought on by an oligopoly form of market in reduced availability of a needed product and a much increased price. But even in non cartel situations, some high prices can be observed in many manufactured EFM Faculty P.Uday Shankar 26/09/11 21 products.

Oligopoly- Game Theory

This attempts to predict the likelihood of different

outcomes when we have a game played by few players. It was thought up by the great Mathmetician/ Economist John Von Neumann and developed by academics such as John Nash. It is ideal when we think of Oligopoly. The few firms are the players each with a strategy to win and face a series of results from the decisions they make. For instance, rival decides to stop advertising to save, I have a series of payoffs depending on my action(what is the most likely overall outcome for an action). It can get very complex, but there are simple versions we can use!
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Oligopoly- Game Theory- The Prisoners Dilemma Game

Is a very simple example of Game Theory. It simply

shows that, once firms have made an agreement which is of benefit to each, there is an incentive to break it for a big payoff at the others expense(such as selling for a lower price secretly in a price cartel agreement). It uses two prisoners as an example(lets call them 1 and 2). Each are for questioning, if both plead not guilty then they both get off quite lightly, both pleading guilty will get a slightly worse shared sentence. However, if 1 pleads guilty and 2 not guilty, 1 gets off the hook and lands 2 right in it. This creates a dilemma, hence the name. The incentive is to agree to plead not guilty, but eachFaculty P.Uday Shankarthat if they be a traitor and plead one knows EFM 26/09/11 23 guilty, they will get off lightly at the others

Oligopoly- Game Theory- The Prisoners Dilemma Game

How does this apply to the Markets? Well, say we

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have 2 firms, Boeing and Airbus. Both being rivals, they are self maximising and would plead guilty in the game above(creating a costly outcome as huge promo costs, marketing product etc). The plane giants, if they collude(assuming little regulation etc) find they need not incur so much cost, rather increase their margins, so they may agree to do so. Working together is not guilty plea agreement in the game, creating a better outcome for both. There is now great reward for deceit, however, and Boeing making private contracts with buyers and changing their accounts will make big revenues for them at the expense of Airbus, whom they agreed not to outsource. This is pleading guilty when agreeing for EFM guilty. It is simple to apply:). 26/09/11 not Faculty P.Uday Shankar

Oligopoly- Other Game Theory Terms

Dominant Strategy is whatever anyone else does,

this is the best choice for you in competition. It can be deciding to set up shop in a busy airport for example. If you dont buy youre rival will get in, if you do buy, even if youre rival sets up next store, you still get a good yield. Nash Equilibrium is where each player has made the best decision they can, given the moves made by others. Lets bring back my ice cream vans. 3 children go to a van, 1 gets the last ice cream with flake, the next wants that but gets their next favourite, the mint Feast(one of my favs), the other feels no need to go to van as they have run out, so goes back to the PS3, unpauses the game, and scores a hat trick in a two player. Each has made theirFaculty P.Uday Shankar given others choices. Can easily EFM best choice, 26/09/11 25 be applied to business. Simples!

Thanks
Courtesy:

http://tutor2u.net

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