economics for managers - session 14

8/3/2019 Economics For Managers - Session 14

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PSG INSTITUTE OF MANAGEMENT

MBA 2011-13 BATCH

I TrimesterSession XIV- For Batch C and D

Markets and Competition- Oligopoly

ECONOMICS FOR MANAGERS


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Oligopoly

We now move away from the fairly straightforward worldof perfect competition and monopoly into the complex

and uncertain world of oligopoly .We find that manymarket structures tend towards being an oligopoly astime progresses. They are frequently fascinating marketsto look at!

An oligopoly is a market dominated by a few

producers, each of which has control over themarket. It is an industry where there is a high level ofmarket concentration. However, oligopoly is bestdefined by the conduct (or behaviour) of firms withina market rather than its market structure.

The concentration ratio measures the extent to whicha market or industry is dominated by a few leadingfirms. Normally an oligopoly exists when the top fivefirms in the market account for more than 60% oftotal market demand/sales.

26/09/112 EFM Faculty P.Uday Shankar


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Oligopoly- Characteristics

26/09/11EFM Faculty P.Uday Shankar3

1. A few large dominant firms, with many

small ones,2. A product either standardized or

differentiated,

3. Power of dominant firms over price, but fearof retaliation,

4. Technological or economic barriers tobecome a dominant firm,

5. Extensive use of non-price competitionbecause of the fear of price wars.


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6) Entry barriers: Significant entry barriers into themarket prevent the dilution of competition in the

long run which maintains supernormal profits forthe dominant firms. It is perfectly possible formany smaller firms to operate on the periphery ofan oligopolistic market, but none of them is large

enough to have any significant effect on marketprices and output.

7) Interdependent decision-making:Interdependence means that firms must take intoaccount likely reactions of their rivals to anychange in price, output or forms of non-pricecompetition. In perfect competition andmonopoly, the producers did not have toconsider a rivals response when choosing


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8) Mergers:

While many oligopolies have emerged through thegrowth of dominant firms in a certain industry, manyhave also emerged through mergers.

Ex.steel, airlines, banking, and entertainment industries

Merging of two or more competing firms is beneficialin that it may increase their market sharesignificantly, and thus achieve greater economies ofscale. In this way, competition can also be reduced.

Firms may also merge hoping to achieve monopoly

power.

The larger firm that results from a merger would havegreater control over market supply and price than afew smaller firms.


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9) Measures of Industry Concentration

Price Leadership is when one firm has a dominant positionin the market.That firm will set a market price and firms

with lower market shares will follow the change.

10) The Four Firm Concentration Ratio

Is the scale that determines whether a industry ismonopolistic competition or oligopoly. If the combination

of market share of the four largest firm in a single industryis equal or greater than 40%, the industry is consider asoligopoly.

A concentration ratio reveals the percentage of totaloutput produced and sold by the industry's largest firms.

11) Herfindahl Index (Herfindahl-Hirschman Index or HHI) The HHI measures of the number and size of firms in ratio

to the industry. It serves as an indicator of the amount ofcompetition within a market. It is defined as the sum of thesquares of the market shares of each individual firm.


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Cartel in Beggary !!!!

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1. Product branding: Each firm in the market isselling a branded (differentiated) product

2. Entry barriers: Significant entry barriers into themarket prevent the dilution of competition in thelong run which maintains supernormal profits forthe dominant firms. It is perfectly possible formany smaller firms to operate on the periphery ofan oligopolistic market, but none of them is largeenough to have any significant effect on marketprices and output

3. Interdependent decision-making: Interdependence

means that firms must take into account likelyreactions of their rivals to any change in price,output or forms of non-price competition. Inperfect competition and monopoly, the producersdid not have to consider a rivals response when

choosing output and price. 26/09/118 EFM Faculty P.Uday Shankar


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4) Non-price competition: Non-price competition sa consistent feature of the competitive strategies

of oligopolistic firms. Examples of non-pricecompetition includes: Free deliveries and installation

Extended warranties for consumers and credit

facilities Longer opening hours (e.g. supermarkets and

petrol stations)

Branding of products and heavy spending onadvertising and marketing

Extensive after-sales service Expanding into new markets + diversification of the

product range


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Oligopoly and the Kinked Demand Curve



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Oligopoly- Kinked Demand Curve


In the above figure the demand of a firm

in oligopoly is made of two segments oftwo separate demand curves.

The upper part is highly elastic because

if the firm raises its price, the otherfirms will not follow, and the firm willlose its market share.

The lower part is inelastic because if thefirm lowers its price, the other firmsfollow, and no firm can expand its

market share.


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The kinked demand curve model developed first by

the economist Paul Sweezy assumes that abusiness might face a dual demand curve for itsproduct based on the likely reactions of otherfirms in the market to a change in its price or

another variable. The common assumption of thetheory is that firms in an oligopoly are looking toprotect and maintain their market share andthat rival firms are unlikely to match anothers

price increase but may match a price fall. I.e.rival firms within an oligopoly react asymmetricallyto a change in the price of another firm.
http://en.wikipedia.org/wiki/Paul_Sweezyhttp://en.wikipedia.org/wiki/Paul_Sweezyhttp://en.wikipedia.org/wiki/Paul_Sweezy


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If a business raises price and others leave their

prices constant, then we can expect quite alarge substitution effect away from this firmmaking demand relatively price elastic. Thebusiness would then lose market share and expect tosee a fall in its total revenue.

If a business reduces price but other firms follow suit,the relative price change is much smaller anddemand would be inelastic in respect of the pricechange. Cutting prices when demand is inelastic also

leads to a fall in total revenue with little or no effecton market share.

The kinked demand curve model therefore makes aprediction that a business might reach a stable

profit-maximising equilibrium at price P1 andoutput Q1 and have little incentive to alter prices.


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Oligopoly



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Oligopoly- Importance of Non-price Competition


The importance of non-price competition underoligopoly

Non-price competition assumes increased importance inoligopolistic markets. Non-price competition involvesadvertising and marketing strategies to increase demandand develop brand loyalty among consumers.Businesses will use other policies to increase market

share:1. Better quality of service including guaranteed delivery

times for consumers and low-cost servicing agreements

2. Longer opening hours for retailers, 24 hour telephoneand online customer support

3. Extended warranties on new products4. Discounts on product upgrades when they become

available in the market

5. Contractual relationships with suppliers - forexample the system of tied houses for pubs and

contractual agreements with franchises (exclusivedistribution a reements


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OLIGOPOLY CONCENTRATION


An oligopoly form of market is characterized by thepresence of a few dominant firms. There may be alarge number of small firms, but only the major firmhave the power to retaliate. This results in a highconcentration of the industry in only 2 to 10 firmswith large market shares.

The most notable causes for the high concentrationin oligopolytype 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 developmentandadvertising.


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Oligopoly- Collusion


All firms benefit from avoiding price wars andseeking to

agree on higher prices and protected salevolumes. Theseagreements are generally illegal. Thus, secretagreements

are sought: these constitute collusion. In the simplest form of collusion, overt collusion,

firms openly agree on price, output, and otherdecisions aimed at achieving monopoly profits.Firms that coordinate their activities throughovert collusion and by forming collusivecoordinating mechanisms make up a cartel.


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Oligopoly- Cartel


CARTELA cartel is an official agreement between several

firms in anoligopoly. The agreement sets the price all firms willchargeand often specifies quotas or market shares of thevariousfirms. Cartels are illegal in most countries of the

world.OPEC is a major example of a cartel. It existsbecause it isbeyond the control of an individual country.

OPEC is naturally the prototype of a successful

cartel. Outputquotas of its members produced staggering priceincreases (from$1.10 to $11.50 per barrel in the early 1970's, and upto $34.00in the late 1970's: an increase of 3400% in ten years).Recent


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Oligopoly- Mutual Interdependence


The mutual interdependence of firms in oligopolyis demonstrated in the necessity to maintain price

stability ahown in the kinked demand. It may leadfirmsto follow strategies which do not constituteoutright collusionbut produce a similar outcome. These strategiesinclude- price leadership where one firm - usually, thedominant or mostdynamic firm - is the first to change its price and

all firmsfollow, and- cost plus pricing where prices are alignedbecause all firmshave the same profit or markup margin on similarcosts.


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Oligopoly- Economic Effect


The oligopoly form of market is harmful tosociety in comparison to perfect competition

because of the loss of productive and allocativeefficiency. In addition, the undesirable effect mayeven be worse than in monopoly becausesupervision is not possible, less economies ofscale are present and more wasteful non-priceactions are used. However, some beneficialeffects are argued to exist from technologyprogress and scale of production.

The extreme case of a successful cartel such as

OPEC shows the harm brought on by anoligopoly form of market in reduced availability ofa needed product and a much increased price.But even in non cartel situations, some high

prices can be observed in many manufacturedroducts.


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Oligopoly- Game Theory


This attempts to predict the likelihood of differentoutcomes when we have a game played by few

players. It was thought up by the greatMathmetician/ Economist John Von Neumann anddeveloped by academics such as John Nash. It isideal when we think of Oligopoly. The few firms

are the players each with a strategy to win andface a series of results from the decisions theymake. For instance, rival decides to stopadvertising to save, I have a series of

payoffs depending on my action(what is the mostlikely overall outcome for an action). It canget very complex, but there are simple versionswe can use!


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Oligopoly- Game Theory- The Prisoners Dilemma Game


Is a very simple example of Game Theory. It simplyshows that, once firms have made an agreement

which is of benefit to each, there is an incentive tobreak it for a big payoff at the others expense(suchas selling for a lower price secretly in a price cartelagreement). It uses two prisoners as an

example(lets call them 1 and 2). Each are forquestioning, if both plead not guilty then they bothget off quite lightly, both pleading guilty will get aslightly worse shared sentence. However, if 1pleads guilty and 2 not guilty, 1 gets off the hookand lands 2 right in it. This creates a dilemma,hence the name.

The incentive is to agree to plead not guilty, buteach one knows that if they be a traitor and pleadguilty, they will get off lightly at the others


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Oligopoly- Game Theory- The Prisoners Dilemma Game


How does this apply to the Markets? Well, say wehave 2 firms, Boeing and Airbus. Both being rivals,

they are self maximising and would plead guilty inthe game above(creating a costly outcome as hugepromo costs, marketing product etc). The planegiants, if they collude(assuming little regulation etc)

find they need not incur so much cost, ratherincrease 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 isnow great reward for deceit, however, and Boeing

making private contracts with buyers and changingtheir accounts will make big revenues for them at theexpense of Airbus, whom they agreed not tooutsource. This is pleading guilty when agreeing for

not guilty. It is simple to apply:).


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Oligopoly- 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 forexample. If you dont buy youre rival will get in, ifyou do buy, even if youre rival sets up next store,you still get a good yield.

Nash Equilibrium is where each player has madethe best decision they can, given the moves madeby others. Lets bring back my ice cream vans. 3children go to a van, 1 gets the last ice cream withflake, the next wants that but gets their next

favourite, the mint Feast(one of my favs), the otherfeels no need to go to van as they have run out, sogoes back to the PS3, unpauses the game, andscores a hat trick in a two player. Each has made

their best choice, given others choices. Can easilybe a lied to business. Sim les!


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Thanks


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economics for managers - session 14

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