MIC ECON Lec 07 – Oligopoly

CHAPTER 7:

 OLIGOPOLY

INTRODUCTION In this topic the oligopoly form of market is studied. You will learn that fewness of firms in a market results in mutual interdependence. The fear of price wars is verified with the help of the kinked demand curve. Collusive forms and non-collusive forms of market are analyzed. The economic effect of the oligopoly form of market is presented.

OLIGOPOLY CHARACTERISTICS The oligopoly form of market is characterized by

– a few large dominant firms, with many 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 nonprice competition because of the fear of price wars.

 All “big” business is in the oligopoly form of market. Being a major corporation almost automatically implies that the company has means of controlling its market.

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 gasoline industry is an oligopoly in the United States: it is dominated by a few giant firms such as Exxon, Mobil, Chevron and Texaco. Note, however, that many small firms exist in the market: small independent gas stations which sell in just one city or just a limited region.

 

 

 

OLIGOPOLY CONCENTRATION CAUSES 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 advertising.

 The history of the U.S. automobile manufacturing shows a continuous process of increasing concentration of the market in the hands of the big 3: G.M., Ford and Chrysler. Not long ago, Chrysler acquired the failing American Motors. In the beginning of this century, a new round of concentration is now taking place on a global scale as Daimler acquired Chrysler, Renault acquired Honda and GM seeks to acquire Daewoo. The needed volume of production to be profitable (100,000 vehicles) is a major barrier for any new firm wishing to start producing cars.

OLIGOPOLY KINKED DEMAND 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 market share.

oligopoly-kinked-demand

 Several gas stations are often found next to each other at major highway intersections. They also often have same or similar prices. If one gas station tries to increase its price from the prevailing 125.9 to 127.9, customers will go across the street and the gas station will lose revenues. If the same gas station lowers is price to 123.9, it will attract new customers only until the other also drop their prices; then all will lose revenues.

OLIGOPOLY PRICE STABILITY The lesson from the kinked demand is that a strategy of increasing its price will cause a firm to lose revenue, but so will decreasing price. Thus, firms will tend not to change prices. Furthermore, as a result of the kinked demand curve, marginal revenue has a gap or break, and any marginal cost curve would lead to the same optimum quantity. Thus the same price is optimum for many different cost structures.

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.

 All businesses tend to watch each other, as in the case of the gas stations. Their actions are however independent. Collusion would occur if all gas stations decided simultaneously to raise their prices in order to increase their revenues. Such a concerted and deliberate action is the form of collusion which is prohibited.

OLIGOPOLY PROFIT The profit of firms in oligopoly is determined exactly in the same fashion as in other forms of markets: from optimum quantity where marginal revenue equals marginal cost, price is determined on the demand curve and unit cost on the average total cost curve. However, this determination may be affected by the kinked demand curve. Furthermore, in a collusive oligopoly, all the firms act as if they constituted one monopoly and the output is divided up among firms.

 OPEC acts as a monopoly by restricting output of its members with quotas. Each member shares in the profits of the would-be monopoly, but does not set price and output independently.

 

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). Recent OPEC difficulties are also characteristic of cartels: new producers, difficulty to enforce quotas and maintaining prices.

CARTEL BREAKDOWN Cartels and other forms of collusion tend to break down because – an incentive exists for each firm to undersell, – firms may have different cost structures causing hardship for some, – recessions put additional strains on firms, – new firms entering the market do not abide by the agreement, – when many firms join in, discipline is difficult.

 Many producers of basic commodities tried to duplicate the success of OPEC during the 1970’s. Agreements on quotas were reached for coffee, cocoa, tin and copper, for instance. Within a few years the quotas were not obeyed and the cartels broke down.

OLIGOPOLY MUTUAL INTERDEPENDENCE The mutual interdependence of firms in oligopoly 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 have the same profit or markup margin on similar costs.

 The prime rate (i.e. the interest rate charged by commercial banks to their best customers) is usually very similar among major banks. Changes in the prime also take place within a very short period of time (less than one day), at the initiative of one of the banks. It has been established that no outright collusion exists in this simultaneous changes, but a high degree of interdependence.

OLIGOPOLY NONPRICE ACTION Both product development and advertising are extensively used in the oligopoly form of market because of the fear of price wars. Furthermore, these strategies are essential to maintain the dominant positions of the firms.

 Car manufacturers use extensive product development and advertisement. Oil companies (Exxon, Mobil, Chevron) are also in an oligopoly form of market and advertise extensively. They advertise their names more than their product because their product is identical to that of competitors.

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 nonprice 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 products.

OLIGOPOLY TECHNOLOGICAL PROGRESS The oligopoly form of market is seen as a necessary framework in which profit and competition are present to stimulate technological progress and make it rewarding. However, studies show that most technological breakthroughs are generated by small rather than dominant firms.

The computer industry is dominated by a few companies, IBM most notably. While all companies depend heavily on new technology, it is often small companies which come up with the most far reaching breakthroughs. Supercomputers are produced by Cray. A new generation of microcomputers was recently introduced by Next.

 

 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 products.

 

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