Full version Market Structure Of Oligopoly

Market Structure Of Oligopoly

This print version free essay Market Structure Of Oligopoly.

Category: Business

Autor: reviewessays 18 February 2011

Words: 1648 | Pages: 7

Analyse The Structure Of The Market Structure Of Oligopoly And The Difficulty In Predicting Output And Profits

Market structure of oligopoly

Oligopoly is a market structure where there are a few firms producing all or most of the market supply of a particular good or service and whose decisions about the industry’s output can affect competitors. Examples of oligopolistic structures are supermarket, banking industry and pharmaceutical industry.

The characteristics of the oligopoly are:

• Small number of large firms dominate the industry

• High degree of interdependence: the behaviour of firms are affected by what they believe other rivalry firms might do

• High barriers to entry that restrict new firms to enter the industry e.g. control of technology

• Price stability within the markets

• Goods are highly differentiated or standardized

• Non –price competitive e.g. free deliveries and installation, extended warranties

• Restricted information.

Oligopolies do not compete on prices. Price wars tend to lead to lower profits, leaving a little change to market shares. However, Oligopolies firms tend to charge reasonably premium prices but they compete through advertising and other promotional means. Existing companies are safe from new companies entering the market because barriers to entry to the market are high. For example, if products are heavily promoted and producers have a number of existing successful brands, it will be very costly and difficult for new firms to establish their own new brand in an oligopoly market.

Because there are few firms in an oligopoly industry, each firms output is a large share of the market. As a result, each firm’s pricing and output decisions have a substantial effect on the profitability of other firms. In addition, when making decisions relating to price or output, each firm has to take into consideration the likely reaction of rival firms. Because of this interdependence, oligopoly firms engage in strategic behaviour. Strategic behaviour means when the best outcome of a firm is determined by the actions of other firms.

Oligopolists are drawn in two different directions, either to compete with each other or to collude with each other. If they collude, they end up acting as monopoly and thereby maximising the industry’s profits. However they are often tempted to compete with each other inorder to gain a bigger share of the profit of the industry.

There are two ways in which firms collude in oligopoly. These are:

Collusive oligopoly:

This is an explicit or implicit agreement between existing firms to avoid or limit competition with one another.

Because the actions and profits of oligopolists are controlled by mutual interdependence, there is a great temptation for firms to collude; to get together and agree to act jointly in pricing and other matters. Firms are tempted to collude because they believe that they can increase their prices by organizing their actions. There are two types of collusive oligopoly.

• Open (cartel)

• Tacit

Open (cartel) collusion

Firms under oligopoly engage in collusion, when they do this, they agree on sale, pricing, market share, advertising and other decisions. This type of collusion reduces uncertainty they face and increase the potential for monopoly profits.

When this happens the existing businesses decide to engage in price fixing agreements or cartels. The aim of forming cartels, is to maximize joint profits and allows firms to act as if they were in a pure monopoly.

Source: www.bized.ac.uk/educators/he/pearson/lectures

If the cartel sets the price at the industry profit maximising price of P1, this will give an industry output of Q1. Once the cartel price has been set, members may decide to compete against each other using the non-price competition (advertising) to gain as much share of resulting sales as they can.

Once the profit maximization price is determined, they can agree on how much output each firm in the group will offer for sale. Each member is given a quota and the sum of all quota must add up to Q1, however if the quota exceeds Q1, there would be unsold output or price will fall.

Like monopoly, if the oligopoly is maintained in the long run, it charges a high price, produces less output and fails to maximise social welfare relative to perfect competition.

Cartel is seen by the government as a means of driving up prices and profits which is against the public interest. As a result it is illegal to operate the cartel in many countries.

Tacit collusion

Tacit Collusion is collusion that is not organized through a formal, open contract between colluding parties. Tacit collusion is when firms abide to the price that has been set by a recognized leader. The leader is usually the largest firm i.e. the firm that controls the industry known as dominant firm price leadership. On the other hand, the leader may be the firm that is most reliable to follow, known as barometric firm price leader.

Dominant firm price leadership

This is when smaller firm chooses the same price as the price set by the large firms in the industry.

Source: www.bized.ac.uk/educators/he/pearson/lectures

The leader tends to maximise profits where marginal revenue is equal to marginal the marginal cost, then produces at QL and sell goods at PL on its demand curve where marginal cost equal marginal revenue. At this stage other firms in the industry will follow the price. Therefore, the market produces at Qt, with other firms producing the output not supplied by the leader i.e. Qt-Ql.

Barometric firm price leadership.

Where the price leader is the one whose prices are believed to reflect market conditions in the most satisfactory way.The barometric firm does not dominate the industry, instead, its price is followed by other because they believe they can rely on it. A barometric firm estimates its demand and MR curves by assuming a constant market share and it then produces where MR=MC and set price accordingly.

Non-collusive oligopoly

This can be defined as a situation where firms have no agreement between themselves, be it formal, informal or tacit. Oligopolists are not able to communicate with themselves and they behave as competitors.

• Game theory

• The kinked demand curve.

The game theory

The game theory is a method of analysing strategic behaviour. The behaviour of a firm depends on how it thinks its competitors will react to its policies. The game theory is usually effective where there are just two firms whose costs, products and demand are identical.

Source: www.bized.ac.uk/educators/he/pearson/lectures

In the table above, X and Y are charging Ј2 for their products and making a profit of Ј10million each, giving a total industry profits if Ј20million. If both firms independently consider reducing their price to Ј1.80, they need to take into account what the other firm will do and how this might have an effect on them.

Firms can opt for the cautious approach and imagine the worst thing that its rival can do. For example, if X retains its price at Ј2, the worst thing for X would be if Y decides to cut its price, then X profit will fall to Ј5million.

On the other hand, if X cuts its price to Ј1.80, the worst outcome for X would be for Y to cut its price, but this time X profit will fall to Ј8million. In this situation, if X wants to be cautious, it will be wise to cut price to Ј1.80. Y ill also want to be cautious and will cut price to Ј1.80.

Otherwise, firms can opt for the optimistic approach and assume competitors will respond in a favourable way. For example if X cut prices on believing that Y will not change its price and Y doesn’t change its price, X will realise a maximum profit of Ј12million.

If both firms lower their prices from the joint-profit-maximization level, both will be worse off than if they had colluded, but at least each will have minimized its potential loss if it cannot trust its competitor. Each firms profit depends both on its own pricing strategy and that of its rival.

The game theory is of use to firm because they do not need to worry about the response their competitors will make. Instead, firm need to measure the effect that the response of each competitors will have on them.

The kinked demand curve

The kinked demand curve model is based on the idea that there is price inflexibility in oligopoly. Each firm in the oligopoly faces a demand curve that is kinked at the market price because there is a greater tendency for competitors to follow price reductions instead of price increases.

With the kinked demand curve, if demand or cost were to increase, firms will be tempted to increase their prices , but they will not because of the fear that competitors will not raise their prices and they will end up losing customer sales.

A price reduction by a firm forces other firms to cut prices inorder to protect their sales, while an increase does not require a readjustment, since other gain customers if one increases its price.

Source: www.bized.ac.uk/educators/he/pearson/lectures

In the kinked demand curve model, the MR curve is discontinuous at the point of the kink. The point at which the demand curve changes slopes indicates the profit maximizing price.

For higher prices, the demand curve is elastic above P1, the firm will thereby lose its sales and market share to others who fail to follow the price increase. While for lower prices, the demand curve is relatively inelastic and rival firms match the price reduction to maintain their market share.

Conclusion

In oligopoly, there is always tension between co-operation and self-interest. The group of oligopoly is better off cooperating and acting like the monopoly. However, because the oligopolist cares about their own personal profit, there is an incentive for them to act on their won. This will therefore limit the ability of the group to act as a monopoly.

Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. However, if they make decisions about production levels individually, there would be a greater quantity and a lower price compared to operating as a monopoly.

For these reasons, Oligopoly prices and output are indeterminate; they may be anything within the range and are unpredictable.