Monday, July 18, 2016

Oligopoly

An Oligopoly is a market structure in which few large firms dominate the market. When a market is shared between a few firms, it is said to be highly concentrated. Although only a few large firms dominate, it is possible that many smaller firms also operate in the market.
Oligopolists may have considerable power to fix prices and output. Oligopolies can result from various forms of collusion between the market participants, which reduce competition and lead to higher prices for consumers. Power is concentrated only in the hands of a few firms, who can dominate the market to gain excessive super normal profits.
Oligopolies may be identified using the Concentration Ratios, which measure the proportion of total market share controlled by a given number of firms. When there is high concentration ratio in an industry, economists tend to identify the industry as an Oligopoly.
With few sellers, each Oligopolist is likely to be aware of the actions of the others. And the decisions taken by one firm therefore can influence the others.
Oligopolistic Competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (Collusion, Market Sharing etc.) to raise prices and restrict production in much the same way as Monopoly. Where there is a formal agreement of such a collusion, this is known as Cartel. A primary example of such a Cartel is OPEC which has a profound influence on the international price of Oil.
Examples of Oligopoly Industries are Airlines, Fuel Retailing, Banking, Supermarkets, Cinema Chains, Cellular Network Companies.

Key Characteristics of Oligopoly Market Structure


Interdependence

The distinctive feature of an Oligopoly is Interdependence. Oligopolies are typically composed of a few firms, and each firm is so large that it's actions can affect the market conditions. Therefore the competing firms have to aware of each firm's market actions and respond appropriately. This means that while contemplating a market action, a firm must also take into consideration the possible reactions of all competing firms or the counter moves of other incumbent firms. it is very much like a game of Chess, in which a player must anticipate the whole sequence of moves and counter moves in order to determine his or her objectives, this is called Game Theory. For example if an Oligopoly considering a price reduction to increase it's market share, it also has to take in account the likelihood of price reduction by other competing firms in retaliation or possibly trigger a ruinous price war. Or if the firm is considering price increase, it may want to know whether other firms will also increase the prices or hold existing prices constant.

Strategy

Strategy is extremely important to the firms that are interdependent. As firms in an Oligopolistic Market cannot act independently, they must anticipate the likely response of a rival to any given change in their price, or non price activity. In other words, they need to plan and work out a range of possible options on how they think the rivals might react.
The critical decisions that Oligopolists have to make are.
  • Whether to compete with the rivals or collude with them.
  • Whether to raise or lower price, or keep prices constant.
  • Whether to be the first to implement a new strategy, or wether to wait and see what rivals do. The advantages of going first or going second is respectively called 1st and 2nd Mover Advantage. Sometimes it pays to go first because a firm can generate head start profits. 2nd Mover Advantage occurs when it pays to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them.

Collusion

Another key feature of the Oligopolistic Market is that the firms may attempt to Collude, rather than compete. Colluding partners act like a monopoly and can enjoy the benefits of higher profits over a long term. Types of Collusion
  • Overt Collusion, is a formal collusion (agreement) among competing firms in an industry intending to raise the market price and act like a monopoly.  Overt Collusion occurs when there is no attempt to hide the agreements, such as when firms form trade associations like the Association of Petroleum Retailers (OPEC).
  • Covert Collusion, occurs when firms try to hide the results of their collusion to avoid detection by the regulators, such as when fixing price.
  • Tacit Collusion, arises when firms act together, called acting in concert, but where there is no formal or informal agreement. For example, it may be accepted that a particular firm is price leader in an industry, and other firms simply have to follow the lead of this firm. all firms may understand this, but there is no formal agreement or record to prove this. If firms Collude their behaviour can be can be checked to prove the reduced competition and they are likely to subject to regulation. In most cases the Tacit Collusion is impossible to prove.

High Barriers to Entry & Exit

Barriers to entry are high, the most important barriers are government licences, economies of scale, patents, access to expensive and complex technology and strategic actions by incumbent firms to discourage or destroy nascent firms. Following are few main barriers to entry that can be faced by the new entrants.
  • Incumbent firms must have already exploited the Economies Of Scale in the market, so new firms deter to enter the market.
  • Owning scarce resources or raw materials that incumbent firms have already access to in large numbers also creates a potential barrier to entry.
  • High Set Up Costs also deter initial market entry, because they increase the Break Even output, and delay the possibility of making profits. Many of these are sunk costs that cannot be recovered when a firm leaves a market including the marketing and advertising costs and other fixed costs.
  • Spending money on Research and Development (R&D) is often a signal to potential entrants that a firm has large financial reserves. New entrants have to match, or exceed this level of spending in order to compete the existing firms in the market. This widely found in Oligopolistic markets such as pharmaceuticals and the chemical industry.
  • Predatory Pricing occurs when a firm deliberately tries to push prices low enough to force rivals out of the market.
  • Limit Pricing means the incumbent firm sets a low price, and a high output, so that new entrants cannot make profits at that price. This is achieved by selling at a price just below the Average Total Cost (ATC) of potential entrants. This signals the potential entrants that profits are impossible to make.
  • An incumbent overtime may have built up a superior level of knowledge of the market, it's customers, and it's production costs or processes. This also deters new entrants into the market.
  • Predatory Acquisition, involves taking over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete buy out.
  • Advertising is another Sunk Cost that incumbent firms can spend on heavily to increase their market share, this also deters the new entrants.
  • A Strong Brand name that has been there for quite some time, wins the trust, creates loyalty and locks in existing customers, which also deters new entrants.

Non Price Competition

When competing, Oligopolists prefer Non Price Competition in order to avoid price wars. Though a price reduction may achieve strategic benefits, such as gaining market share, but the danger is that rivals will simply reduce their prices in response. This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more beneficial strategy is to undertake Non price Competition. Non Price Strategies include.
  • Improving quality or After Sales Services, such as offering Extended Warranties.
  • Spending on Advertising or Sponsorship.
  • Sales promotions, such as giving gifts or Buy One Get One Free.
  • Loyalty Schemes.
These strategies can be evaluated in terms of 
  • How successful it is likely to be ?
  • Will rivals be able to copy the strategy ?
  • Will the firm get a 1st Mover Advantage ?
  • How expensive is it to introduce the strategy ? If the cost of implementation is greater than the pay off, clearly it will be rejected.
  • How long will it take to work ? A strategy that take a long time to generate pay offs may be rejected in favour of a strategy with a quicker pay offs.

Price Stickiness

Oligopolists mostly stick to a price once it has been determined. This is largely because firms cannot pursue independent strategies. For example if an Oligopoly raises the price of it's products, it is unlikely that rivals will follow suit, as it is to their competitive advantage to keep their prices as they are, the firm will start loosing market share to others and will loose revenue. However if a firm lowers it's price, rivals will be forced to follow suit to remain competitive in the market and drop down their prices in response. Again the firm will loose sales revenue and market share.