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. Most recently,
Chrysler acquired the failing American Motors. 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.

Graph G-MIC7.1

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 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.

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