Analyse the Structure of the Market Structure of Oligopoly and the Difficulty in Predicting Output and Profits

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