Oligopoly

We have all seen products where we can name about 5-10 main brands. Well a market which is contested among a few big firms is Oligopoly(can cover wide varieties of markets ‘imperfect competition amongst the few’). In the extremes PC and Monopoly, the assumptions of how those markets work is fairly certain. Oligopolists are different, there is no certain way of guessing how each firm will compete with one another(or compete at all).

The way you can see an Oligopoly is when there is:

  • Uncertainty: As above, how each firm reacts to each others plans to increase their share is uncertain(Von Neumann’s Game Theory tries to predict outcomes in such cases).
  • Interdependence: Because of dominant few firms, each’s strategy directly affects others. So how rivals will act is thought about when a decision is made(e.g takeovers)
  • Independence: Each firm makes its own decision.

An oligopoly market does have some key assumptions which hold strong in any case. Firstly, there are high barriers to entry for a newcomer, which are further raised by firms when aware of the newcomer threat. Firms deliberately make it harder for an entrant by making strategic barriers to entry, as they do not want another to take their share (such as lower ‘limit’ prices, heavy promo, when entrant threat).  It is not as hard to enter as monopoly, however. To see these barriers in play, lets use a classic oligopoly, games consoles. Say I want to launch a new console Zahacube. It is obvious that a huge amount of brand promo is needed, aswell as seize the networking ties which keep people on PS3, XBOX360 as others use them(net play is useless with one person). Once I have ‘New Zahacube in stores August’ adverts, XBOX may cut the price of their games by half to keep them in. Nintendo may release a blu-ray console which is more powerful than Zahacube. Barriers have been made higher due to the threat of the world conquering Zahacube.

Other assumptions.

Due to the rivalry amongst the giants, brand promo is a priority for each. There is brand loyalty amongst consumers  meaning that each firm faces some inelasticity for it’s product. Nike could raise the price of Airmax by £10 and not everyone will flock to Converse, for instance. This is similar to another, product differentiation. Aswell as people paying big money for a favoured brand(Gucci, Nando’s etc), people also see differences amongst the goods offered. Some products are higher quality than others, or suited to different tastes. Each firm has monopoly power, as it can trade off price/output. Remember, in some, brand loyalty/differences has a smaller effect than in others.

The Kinked Demand Curve Theory

This shows the interdependence of pricing decisions in oligopoly, although it is a theory in practice, remaining so due to it’s general assumptions. One of those is that non price competition (e.g branding, innovation) is unchanged throughout, that rivals will retaliate on price rather than the former. It is also an attempt to explain why each keeps their price stable here.

The theory says the demand curve a firm faces goes like this. Say we are pricing at P with a stable market, with all firms pricing higher having other factors to make up for it and vice versa. If I rise my price, other firms will keep their price the same and demand will go from me to them quickly, but not fully due to brand loyalty for my product, demand is elastic. If instead I decide to cut my price to get customers at the expense of my rivals(even with loyalty etc), they will be thinking ‘not so fast’ and a price war will begin. All big fish in the market will undercut each other again and again and the general market price falls. Market demand will rise but must be shared amongst the firms in there, meaning a small rise for each. Inelastic demand shows price wars are unwanted, as each is left with lower revenues after.

The Theory is Incomplete however as it undermines a main assumption of ‘imperfect competition amongst the few’. It assumes certainty as to firm’s actions, that they are obvious rivals and compete only on price at least in the short term. Oligopolists focus hugely on non price competition, and one can respond by improving it’s product rather than a price cut for a reaction. As we see soon, oligopolists can also collude  (work together and hurt consumer rather than each other, a big issue in real life). In a main example, Cartel, others will follow ones price rise. When we are stable, it shows a disincentive to change price, not explaining predatory and other pricing tactics firms have attempted. Use it in the exam though, it will impress!

Collusion in Oligopoly

Instead of big firms spending huge amounts competing against one another, they could make their lives a lot easier by working together as one. In Oligopoly, there is an incentive to collude, which is also hinted at in Game Theory. The incentive is that working together, firms need not engage in price wars, nor spend hugely on promos, or bidding wars for contracts(saving hugely on time and cost). In collusion, it is usually(but not always) the consumer that suffers and the firms mutually gain. Here are the main methods it can happen……………

Price Ring: Say we have 5 firms in a market competing, and there is an incentive to collude as shown in game theory. One main way firms have colluded in the past is price fixing. Typically, all the firms mark up their prices so they are equal, so that wherever the consumer goes to, he must accept the same very high price. Firms can make huge profits at the expense of the consumer this way(consumer surplus turns into producer surplus). But this only works when the product is similar, so each makes their product similar to one another. If product is differentiated, each firm must increase their price by the same factor.

Joint Profit Maximisation: This is very rare in practice due to it being more obvious for the competition authorities to figure. Basically all firms combine their factors of production, so make in the same production line, making their product exactly the same and exploiting huge economies of scale. It is the same as if there is one producer facing an audience, meaning monopoly, but each keeps their own brand still. Each makes a treaty to split production that is theirs and share profits.

How can the consumer benefit? Well, by working together, firms may be able to make better products. Remember the external economy of scale specialisation by firms? This can cut costs as each firm focuses on one part of the process which can cut prices for the product. Aswell as this, firms can get the benefit of a merger without merging. Specialist knowledge and services of directors can be shared, which can improve customer services etc. Firms can also share their plants in a timeshare scheme, cutting costs and relieving seasonal disuse for example(which is technically collusion). A firm making raincoats and a firm making sunglasses can share one instead of building two, which is costly. Productive efficiency can be improved.

Collusion in popular culture: Tobacconists Gallaher and Imperial and retailers have recently been fined over £200m for price fixing on their products 2001 to 2003(they marked up the same proportion, following each others price rises) by the Office of Fair Trading . A very famous cartel was the Phoebus Cartel in the UK 1920’s-30’s. These were the makers of lightbulbs who converged their product, each lightbulb would go after 1000 hours of use, and charged a high mark up price for them. Off the top of my head I cannot think of an example of Joint proft max. We must also remember OPEC(Oil Producing and Exporting Countries). Though not firms, they are essentially a team of producers working together, and have all cut supply/increasing prices in 1974(leading to Oil Crises) and 2007 about $140 a barrel high, showing a price ring in practice causing trouble to ‘consumers’.

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!

Prisonners 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 each one knows that if they be a traitor and plead guilty, they will get off lightly at the other’s expense.

How does this apply to the Markets? Well, say we 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 deciet, 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 ‘not guilty’. It is simple to apply:).

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 don’t buy you’re rival will get in, if you do buy, even if you’re 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 their best choice, given other’s choices. Can easily be applied to business. Simples!

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6 Responses to Oligopoly

  1. Pingback: My Space. « Zahablog's Economic Page

  2. kenny says:

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  3. Jose says:

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  4. Bill says:

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