12 MARKET POWER MONOPOLY AND OLIGOPOLY
P. 191-209
Section 1: Microeconomics
HL only
INTRODUCTION
It is now time to look at the market forms where firms may have
a much greater degree of market power. These are market
forms of monopoly and oligopoly.
In both of these market forms, there is the possibility of
significant market power existing. Indeed, in monopoly, the
potential market power may be so great that the term
monopoly power is often used in its place.
It is the abuse of such market power that generates government
intervention.
MONOPOLY
What is monopoly?
“If you’ve got a good enough business, if you have a monopoly
newspaper… you know, your idiot nephew could run it.”
Warren Buffet
https://www.businessinsider.com/warren-buffett-good-business-could-be-run-by-idiot2016-3?r=US&IR=T
MONOPOLY
What is monopoly?
Warren Buffet: “Competition is for losers” and “Competition is a
relic of history”
Source: Tepper Hern (2019), The myth of capitalism, p. 4
MONOPOLY
What is monopoly?
Monopoly is a market structure characterized by the following
assumptions:
• There is only one firm producing the product so the firm is the
industry;
• Barriers to entry exist, which stop new firms from entering the
industry and maintains the monopoly;
• As a consequence of barriers to entry the monopolist may be
able to make abnormal profits in the long run.
MONOPOLY
Milton Friedman wrote, a monopoly is any concentration of
power by a firm that “has sufficient control over a particular
product or service to determine significantly the terms on which
other individuals shall have access to it.”
Source: Tepper Hern (2019), The myth of capitalism, p. 7
The Economist found that over the 15-year period from 1997 to
2012 two-thirds of American industries were concentrated in the
hands of a few firms.
www.economist.com/briefing/2016/03/26/too-much-of-a-good-thing
MONOPOLY
The power of the few (Taken from The Myth of Capitalism)
Almost all big companies are not bad. The paradox is that what
is good, right and logical for the corporation is not good, right ,
or logical for the economy as a whole.
The growth of monopolies does not lead to growth for the
economy.
Every company tries to increase its dominance and market share.
This drive to monopoly works as the micro level, but not at the
macro level.
MONOPOLY
It is logical for the companies to to try to seek efficiencies,
acquire competitors, pay lower wages, and increase their own
income, but when all compagnies try to do this at the same time,
everyone is worse off.
The paradox is that as every company, it leads to lower wages,
higher inequality, lower growth, less investment, and we are all
worse off. Growth for the monopolist does not mean growth for
the economy.
MONOPOLY
However, whether a firm really is a monopoly depends upon
how narrowly we define the industry. For example, Microsoft
may be the only producer of a particular kind of software, but it
does not have a monopoly of all software.
The vegetable shop in your area may have a monopoly of the
sale of vegetables in that area, but is not the only seller of
vegetables and if the area is widened then the shop loses its
monopoly.
The question is not whether a firm is a monopoly but….
how much monopoly power the firm has.
MONOPOLY
To what extent is the firm able to set its own prices without
worrying about other firms and to what extend can it keep
people out of the industry?
The strength of monopoly power possessed by a firm will really
depend upon how many competing substitutes are available.
For example, the underground railway in a city may have the
monopoly of underground travel, but it will face competition
from other industries, such as buses, taxis, and private transport.
MONOPOLY
Other monopoly examples:
Social Networks
Facebook has over 71% market share in all global social media,
far surpassing any rivals like Twitter, or Pinterest.
https://gs.statcounter.com/social-media-stats
It also has an almost 45% share of all display advertising
online.
https://martech.org/emarketer-facebook-dominate-15-9-pct-digital-ad-spend-growth2017
MONOPOLY
Search
Google has an almost 90% market share in search advertising.
Tepper Hern (2019), The myth of capitalism, p. 118
Microprocessors
Intel dominates the market with around 80% market share, and
AMD has hovered around 20%.
Tepper Hern (2019), The myth of capitalism, p. 121
MONOPOLY
What gives a monopoly the ability to maintain its position
and so its market power?
A monopoly may continue to be the only producer in an industry.
If it is able to stop other firms from entering the industry in some
way. What are the factors which may encourage the formation
of a monopoly?
1. Economies of scale
Firms gain average cost advantages as their seize increases.
Their unit costs of production may fall as they grow larger. These
advantages are known as economies of scale.
MONOPOLY
Economies of scale are any decreases in average costs, in the
long run, that come about when a firms alters all of its factors of
production in order to increase its scale of output.
There are a number of different economies of scale that may
benefit a firm as it increases the scale of its output.
a. Specialization : In small firms there are few, if any, managers
and they have to take on many different roles, often roles for
which they are not the best candidates. This may lead to higher
unit costs. As firms grow they are able to have their management
specialize in individual areas of expertise, such as production,
finance, or marketing, and thus be more efficient.
MONOPOLY
b. Division of labour: This is breaking a production process down
into small activities that workers can perform repeatedly and
efficiently. As firms get bigger and demand increases, they are
often able to start to break down their production process, use
division of labour, and reduce unit costs.
c. Bulk buying: As firms increase in scale they are often able to
negotiate discounts with their suppliers that they would not have
received when they were smaller. The cost of their inputs is then
reduced, which will reduce their unit costs of production.
MONOPOLY
d. Financial economies: Large firms can raise financial capital
(money) more cheaply than small firms. Banks tend to charge a
lower interest to larger firms, since the larger firms are
considered to be less of a risk than the smaller firms, and are
less likely to fail to repay their loans.
e. Transport economies: Large firms making bulk orders may be
charged less for delivery costs than smaller firms. Also, as firms
grow they may be able to have their own transport fleet, which
will then cost less because they will not be paying other firms,
who will include a profit margin, to transport their products.
MONOPOLY
f. Large machines: Some machinery is too large to be owned and
used by a small producer – for example, a combine harvester
for a small farmer. In this case, small farmers have to hire the
use the equipment from suppliers who will then charge a price
that includes a profit margin for the supplier. However, once a
farm can increase to a certain size it becomes feasible to have
its own combine harvester, reducing the unit costs of production.
MONOPOLY
g. Promotional economies: Almost all firms attempt to promote
their products by using advertising or sales promotion or
personal selling or publicity or a combination of the above. The
costs of promotion tend not to increase by the same proportion
as output. If a firm doubles its output, it is unlikely that it will
double its expenditure on promotion methods, such as sales
promotion and advertising. Thus, the cost of promotion per unit
of output falls. This situation also applies to other fixed costs,
such as insurance costs or the costs of providing security for the
production unit.
MONOPOLY
If a monopoly is large, then they will be experiencing economies
of scale. Any firm whishing to enter the industry will probably
have to start up in a relatively small way and so will not have
the economies of scale that are enjoyed by the monopolist.
Even if the new firm was able to start up with the same size as
the monopolist, it would still not have the economies that come
from expertise in the industry, such as managerial economies,
promotional economies, and research and development.
The new entrant, in order to gain a market share, is forced to
lower its prices and henceforth is making losses because its
average costs are higher. So the lack of economies of scale acts
as a deterrent to firms that might want to enter a monopoly
industry.
MONOPOLY
2. Natural monopoly
Somme industries are classified as natural monopolies. An
industry is a natural monopoly if there are only enough
economies of scale available in the market to support one firm.
Natural monopolies arise when there are extremely high fixed
costs of distribution, such as exist when large-scale infrastructure
is required to ensure supply.
In that industry the first (natural) supplier has an overwhelming
cost advantage over other actual or potential competitors.
MONOPOLY
Example: Railway companies that have very high costs of laying
track and building a network, as well as the costs of buying or
leasing the trains, would prohibit, or deter, the entry of a
competitor.
Examples of high fixed costs include cables and grids for
electricity supply, pipelines for gas and water supply, and
networks for rail and underground. These costs deter entry and
exit.
MONOPOLY
The monopolist = industry and has the demand curve D1. The
long-run average cost curve faced by the monopolist is LRAC
and its position and shape are set by the economies of scale
that the firm is experiencing. The monopolist is able to make
abnormal profits by producing an output between q1 and q2,
because the AR > AC for that range of output.
MONOPOLY
If another firm were to enter the industry, then the firm would
take demand from the monopolist and the monopolist’s demand
curve would shift to the left, in this case to D2. Since we can
assume that the situation will be the same for both firms, the two
firms would now be in a position where it is impossible for them
to make even normal profits. Their LRACs would be above AR at
every level of output.
MONOPOLY
3. Legal barriers
In certain situations, a firm may have been given a legal right to
be the only producer in an industry, i.e. the legal right to be a
monopoly.
This is the case with patents, which give a firm the right to be the
only producer of a product for a certain number of years after
it has been invented. Patents are usually valid for approximately
20 years. When a patent expires other producers will then be
allowed to produce and sell the product.
Patents exist to encourage invention. If firms put money into
inventions, they would like to see their invention protected and
not copied.
MONOPOLY
If a firm knows that, if its invention is successful, it will have a
protected monopoly over years, then it is more likely to invest in
research and development.
Patents, along with copyrights and trademarks, are examples of
intellectual property rights. They guarantee the creators of
ideas the rights to own the ideas.
A good example is the pharmaceutical industry. When a drug
patent expires, other drug companies can start to produce an
equivalent drug under the name of generics.
Ex. Aspirin (Brand name used by Bayer) à generic Aspirin
MONOPOLY
Another example of legal barriers is where the government of a
country grants the right to produce a product to a single firm. It
may do this by setting up a nationalized industry, such as a state
postal service, and then banning other firms from entering that
industry, or it may simply sell the right to be a sole supplier to a
private firm, such as the right to be the only network provider
for mobile phones, once again banning other firms.
Breaking the Monopoly (Handelsblatt - 10/20/2016 )
https://www.handelsblatt.com/today/companies/prescription-drugs-breaking-themonopoly/23541766.html?ticket=ST-1445760-UoxjaeKG3TkdqnUR4wCS-ap6
MONOPOLY
4. Brand loyalty
It may be that a monopolist produces a product that has gained
huge brand loyalty. The consumers think of the product as the
brand.
Brand name
=
Product name
MONOPOLY
If the brand loyalty is so strong then the new firms may be put
off from entering the industry, since they will feel that they are
not able to produce a product that will be sufficiently different
in order to generate such strong brand loyalty.
5. Anti-competitive behaviour
A monopolist may also attempt to stop competition by adopting
restrictive practices, which may be legal or illegal.
An established monopoly is in a strong position to start a price
war if another firm enters the industry. The monopoly can lower
its price to a loss-making level and should be able to sustain the
losses for a longer time than the new entrant, thus forcing the
new firm out of the industry.
MONOPOLY
The European Commission has fined Google 2.42 billion euros
($2.72 billion) after finding that the company used its dominant
search engine to drive people toward another Google product,
its shopping service.
https://www.npr.org/sections/thetwo-way/2017/06/27/534524024/google-hit-with2-7-billion-fine-by-european-antitrust-monitor?t=1622488088528
In their decision, the EU noted the essential nature of platforms.
The more people search on Google, the better the company
gets at understanding what users are searching for and the
better searching becomes.
MONOPOLY
The more people search, the more likely advisers will flock to
Google, and the more revenue that is generated. The more
advertisers there are, the more efficient ad auctions become.
Most of the tech monopolies are known as “platform” companies
with strong network effects: They all connect members of one
group, like vacationers, looking for rooms to rent, with another
group, like landlords with spare rooms.
Seller want to go where all the buyers are, and buyers want to
be where all the sellers are. The more buyers and sellers there
are, the greater the value of Uber as a platform. This is known
as the platform effect.
MONOPOLY
How much market power exists in monopoly?
As monopolist = industry, the monopolist’s demand curve =
industry demand curve and is downward sloping. The monopolist
can therefore control either the level of output or the price of
the product, but not both. à In order to sell more they must
lower their price.
MONOPOLY
The monopolist has a normal
demand curve, with marginal
revenue
below
it,
and
maximizes profit by producing
at the level of output where
MR = MC
The monopolist sells a quantity
q at a price per unit of P.
MONOPOLY
What are the possible profit
situations in monopoly?
If a monopolist is able to make
abnormal profits in the short run,
and if the monopolist has effective
barriers to entry, then other firms
cannot enter the industry and
compete away the profits that are
being earned.
In this situation, the monopolist is
able to make abnormal profits in
the long run, for as long as the
barriers to entry hold out.
MONOPOLY
Abnormal profits is the short run: perfect competition vs
monopoly
MONOPOLY
It is sometimes assumed that a monopolist will always earn
abnormal profits, but this not true. If the monopolist produces
something for which there is little demand, then it will not earn
abnormal profits.
If a monopolist were making losses in the short run, then it would
have the option of closing down temporarily (if it was not
covering its variable costs) or continuing production for the time
being.
However, it could plan ahead in the long run to see whether
changes could be made so that normal profits, at least, could be
earned. If this were not possible, then the monopolist would close
down the firm and so the industry would cease to exist.
MONOPOLY
The firm is not able to cover
costs in the long run, since the
average cost is greater than
the average revenue at all
levels of output.
Since there is nothing than can
be done to rectify the situation,
this will be an industry in which
no firm will be willing to
produce. There will be no
industry.
MONOPOLY
How efficient is a monopoly?
Unlike perfect competition, the monopolist produces at the level
of output where there is neither productive efficiency nor
allocative efficiency.
The monopolist is producing at the profit-maximizing level of
output, q. Output is being restricted in order to force up the
price and to maximize profit. The most efficient level of output,
q1 and the allocatively efficient level of output, q2, are not
being achieved.
MONOPOLY
Is there a market failure that needs to be rectified in
monopoly?
There is no doubt that market failure can exist in monopoly.
Allocative efficiency is not achieved by a profit-maximising
monopolist and so there is clearly a market failure if firms
follow the profit maximization route.
However, are there advantages of monopoly in comparison with
perfect competition?
MONOPOLY
Advantages and disadvantages of monopoly in comparison
with perfect competition
Although they are both theoretical market forms, there has
always been much debate about the relative merits and
demerits of perfect competition and monopolies.
a. What are the advantages of monopoly in comparison with
perfect competition?
Monopolies may be able to achieve large economies of scale
simple because of their seize. Monopolies do not have to be big,
but if the industry is big, then the monopolist should gain
substantial economies.
MONOPOLY
Economies of scale may push
the MC curve down so that
the monopolist may produce
at a higher output and at a
lower price than in perfect
competition. The idea of
relative price and output in
monopoly is very debateable.
MONOPOLY
In perfect competition, the
equilibrium
price
and
quantity will be where
demand is equal to supply.
This means that the price will
be P1 and that total output
of Q1 will be produced.
However, if the industry is a
monopoly, with significant
economies of scale, then the
MC
curve
may
be
substantially below the MC
curve in perfect competition,
which is the industry supply
curve.
MONOPOLY
If this is the case, then the
monopolist will produce
where MC = MR, maximizing
profits and producing a
greater
quantity
than
perfect competition, Q2, at a
lower price P2.
A second advantage may be
that there will be higher
levels of investment in
research and development in
monopolies
MONOPOLY
Firms in perfect competition
are, by definition, relatively
small, and so may find it
difficult to invest in research
and development. However,
a
monopolist
making
abnormal profits is in a
better situation to use some
of those profits to fund
research and development.
In the long, this will benefit
consumers, who will have
better products and even
more choice.
MONOPOLY
b. What are the disadvantages of monopoly in comparison
with perfect competition?
If significant economies of scale do not exist in a monopoly then
the monopoly may restrict output and charge a higher price than
under perfect competition.
MONOPOLY
There are no differences in
costs for the monopolist and
the perfectly competitive
market. If this is the case,
then the monopolist will
produce Q2 at a price of P2,
where MC = MR.
The perfectly competitive
market will however, produce
Q1 at a price of P1, where
the industry supply meets
industry demand.
MONOPOLY
The high profits of monopolists may be considered as unfair,
especially by competitive firms, or those on low incomes. The
scale of the problem depends upon the size and power of the
monopoly. The monopoly profits of your local post may seem of
little consequence when compared to the profits of a giant
national company.
To summarize, there are three possible problems associated with
monopolies in comparison with perfect competition:
• They are productively and allocatively inefficient;
• They can charge a higher price for a lower level of output;
• They can exercise anti-competitive behaviour to keep their
monopoly power.
à Act against public interest.
OLIGOPOLY
What is oligopoly?
What are the assumptions of oligopoly
Oligopoly is where a few firms dominate the industry. The
industry may have quite a few firms or not very many, but the
key thing is that a large proportion of the industry’s output is
shared by just a small number of firms.
What constitutes a small number varies, but a common indicator
of concentration in an industry is known as the concentration
ratio.
OLIGOPOLY
The CR is a measure used to determine the degree of
competition in an industry, and whether firms have too much
monopoly power; it measures the percentage of output
produced by the largest firms in the industry. Concentration
ratios are expressed in the form CRX where X represents the
number of the largest firms.
OLIGOPOLY
For example, a CR5 (five firm concentration ratio) of 45%
means that the largest five firms produce 45% of industry
output; a CR7 of 80% means that the top seven firms are
responsible for 80% of output.
à The higher the concentration ratio, the lower the degree of
competition in the industry and the higher the degree of
monopoly power.
OLIGOPOLY
While other concentration ratios such as CR8 are measured, it is
the CR4 that is most commonly used to make a link to a given
market structure.
OLIGOPOLY
For example in the US malt beverages industry, there are 160
firms, and the CR4 is 90%. The four largest firms produce 90%
of the industry’s output and it is in an industry with a high
concentration of market power among the largest four
companies.
OLIGOPOLY
In the frozen fish and seafood industry, there are 600 firms and
the CR4 is 19, suggesting low concentration. We may conclude
that the malt industry is an oligopoly and the frozen fish and
seafood industry is in monopolistic competition.
OLIGOPOLY
CR4 tells us how the market share in the industry is concentrated
among the four largest firms, but it doesn’t necessarily reveal the
extent of the competition in the industry.
A CR4 of 80% would suggest high concentration, but it doesn't
tell you anything how this concentration among the four largest
firms is divided up.
Case 1: Four firms, each having a market share of 20%
Case 2: Four firms, one having a market share of 65% and the
other three a market share of 5% each.
Alternative indicator of concentration: Herfindahl-Herschann
index.
OLIGOPOLY
Research task: What is the Herfindahl-Herschmann index? How
might it be a better indicator of concentration than the CR4?
The HHI is a commonly accepted measure of market
concentration. The U.S. Department of Justice, the Federal Trade
Commission, and state attorneys general have used the
Herfindahl-Hirschman Index (HHI) to measure market
concentration for purposes of antitrust enforcement.
OLIGOPOLY
The HHI of a market is calculated by summing the squares of the
percentage market shares held by the respective firms. For
example, an industry consisting of two firms with market shares
of 70% and 30% has an HHI of 70²+30², or 5800. The HHI
number can range from close to zero to 10,000.
The market can be classified into three types:
• Unconcentrated markets: HHI below 1500
• Moderately concentrated markets: HHI between 1500 and
2500
• Highly concentrated markets: HHI above 2500
OLIGOPOLY
Oligopolistic industries may be very different in nature. Some
produce almost identical products, e.g. petrol, where the product
is almost exactly the same and only the names of the oil
companies are different. Some produce highly differentiated
products, e.g. motor cars. Some produce slightly differentiated
products, e.g. shampoo, but spend huge budgets on marketing to
persuade people that their product is better.
OLIGOPOLY
In most examples of oligopoly, there are distinct barriers to
entry, usually the large-scale production of the strong branding
(e.g. Coca-Cola, Nutella, iPhone,…) of the dominant firms, but
this is not always the case. In some oligopolies, there may be low
barriers to entry.
However, the key feature that is common in all oligopolies is that
there is interdependence. Whereas in perfect competition and
monopolistic competition the firms are all too small to the size of
the market to be able to influence the market, in oligopoly there
is a small number of large firms dominating the industry.
As there are just a few firms, each needs to take careful notice
of each other’s actions.
OLIGOPOLY
Interdependence tends to make firms want to collude and so
avoid surprises and unexpected outcomes. If they can collude
and act as a monopoly, then they can maximize industry profits.
However, there is also a tendency for firms to want to compete
vigorously with each other in order to gain a greater market
share.
Oligopoly tends to be characterized by price rigidity. Prices in
oligopoly tend to change much less than in more competitive
markets. Even when there are production-cost changes,
oligopolistic firms often leave their prices unchanged.
OLIGOPOLY
Summary of the oligopoly assumptions
• There is a small number of large firms, each of which is
aware of the presence of the others.
• There are high barriers to entry, making it difficult to new
firms to enter the industry.
• Firms sell either homogeneous products (ex. oil) or
differentiated products (ex. cars)
• There is interdependence among the firms, due to their small
number; the actions of each one affect all of the others.
OLIGOPOLY
What is the difference between a collusive and a noncollusive oligopoly?
The interdependence of firms in oligopoly makes them have
strategic behaviour, so that each firm tries to predict the actions
of rival firms, and to base its own actions on how it expects its
rivals to behave (like a game of chess). Their strategic behaviour
leads them to conflicting incentives:
• The incentive to collude (collusive oligopoly)
• The incentive to compete (non-collusive oligopoly)
OLIGOPOLY
Collusive oligopoly
Collusive oligopoly exists when the firms in an oligopolistic
market collude to charge the same prices for their products, in
effect acting as a monopoly, and so divide up any monopoly
profits that may be made.
There are two types of collusion: formal collusion and tacit
collusion.
Formal collusion takes place when firms openly agree on the
price that they will charge, although sometimes it may be
agreement on market share or on marketing expenditure
instead. Objective = maximize profits by behaving like
monopolist.
OLIGOPOLY
Such a collusive oligopoly is often called a cartel. Since this
results in higher prices and less output for consumers, this is
usually deemed to be against the interest of consumers and so
collusion is generally banned by governments and is against the
law in the law in the majority of countries. If a country’s anti-trust
authority (Conseil de la concurrence) finds that firms have
engaged in anti competitive behaviour such a price-fixing
agreements, then the firms will be penalized with fines or other
punishments.
Formal collusion between governments may be permitted. The
prime example is the OPEC (the Organisation for Petroleum
Exporting Countries), which sets production quotas and prices for
the world oil markets.
OLIGOPOLY
Tacit collusion exists when firms in an oligopoly charge the
same prices without any formal agreement. This is not as difficult
as it sounds. A firm may charge the same price as another by
looking at the prices of a dominant firm in the industry, or at the
prices of the main competitors. It is not necessary to
communicate to be able to charge the same prices.
OLIGOPOLY
In both formal and tacit
collusion, the process is the
same. The firms behave like
monopolist,
charge
the
monopoly
price,
make
monopoly profits, and share
them according to market
share.
OLIGOPOLY
Collusive oligopoly offers one explanation of price rigidity in
oligopoly. If firms are colluding, either formally or tacitly, and
they are making their share of long-run monopoly profits, then
they may try to keep prices stable in order that the situation
continues.
Non-collusive oligopoly exists when the firms in an oligopoly do
not collude and so have the be very aware of the reactions of
other firms when making pricing decisions.
The strategic behaviour the develop to take into account all
possible actions for rivals is explained by what economists call
the “game theory”
OLIGOPOLY
The game theory is a mathematical technique used to analyse
the behaviour of interdependent decision-makers who use
strategic behaviour; one such game is based on the prisoner’s
dilemma. It uses the example of two men being arrested by the
police. The police require more evidence and so separate the
men and offer each of them the following conditions:
1. Testify for the prosecution. If you do, you go free and your
partner in crime gets 3 years in prison. Only the first on to
confess gets the offer.
2. Say nothing an you get 1 year in prison.
3. If both testify, each of you gets 2 years in prison.
OLIGOPOLY
Prisoner’s dilemma table
Each prisoner has the choice of cooperating with the other and
saying nothing or betraying the other, and so it raises issues of
trust, cooperation, and betrayal.
OLIGOPOLY
The principle of the prisoner’s dilemma can be applied to real
world situations, such as cycling. Sometimes, two riders get away
from the main group of riders (known as the peleton). If the two
riders cooperate (french: alliés de circonstance), each taking a
share of the lead so that the other can shelter from wind, they
will finish first and second. If they don’t cooperate, the peleton
will catch them up.
OLIGOPOLY
What sometimes happens is that one rider (the cooperater) does
all the hard work at the front, while the other rider (the
betrayer) sits in the slipstream of the first rider (just behind the
leader). The betrayer almost always wins.
Game theory is very useful in economics to demonstrate
important features of the behaviour of oligopolistic firms.
For simplicity we will look at a situation where only two firms
making up a market. This is known as a duopoly. We assume
that the firms have equal costs, identical products and share the
market evenly, so the initial demand for their goods is the same.
OLIGOPOLY
Firms A’s price choices
Firms B’s
price
choices
$5.50
$5.00
$5.50
A & B both high prices
A gets $6m
A gets $6m
A low price; B high price
A gets $8m
A gets $2m
$5.00
B low price; A high price
B gets $8m
A gets $2m
A & B both low prices
A gets $4m
B gets $4m
Let us start assuming that both firms are currently charging a price of
$5.50 for their products and so they are both making profits of $6 million.
Now let us assume that they are not colluding, but they are both separately
considering lowering their prices to $5.00 for their products and so they
are both making profits of $4 million.
OLIGOPOLY
Two scenarios are offered to the firms: pessimistic or cautious
scenario or a optimistic scenario.
What is the best strategy?
A price cutting
exercise is actually
harmful to both firms.
They would have been
better leaving their
prices where they were.
They would have
benefitted from the
ability to collude, if
they could have done
so.
OLIGOPOLY
Game theory is useful for firms if they are able to predict,
relatively accurately, the outcomes that will follow any set of
decisions. However, this is not necessarily easy to do.
The more firms there are in an industry the more difficult it will
be to estimate all the possible combinations of decisions and
also outcomes.
So, game theory is mostly useful when there are only a few firms
in an industry, there are only a small number of possible options,
and the outcomes can be accurately predicted.
OLIGOPOLY
How do firms compete in oligopoly?
Because firms in oligopoly tend not to compete in terms of price,
the concept of non-price competition becomes important. There
are many kinds of non-price competition, such as the use of
brand names, packaging, special features, advertising, sales
promotion, personal selling, publicity, etc.
Oligopoly is characterized by very large advertising and
marketing expenditures as firms try to develop brand loyalty
and make abnormal demand for their products less elastic.
OLIGOPOLY
Firms undertake all kinds of behaviour to guard and extend
their market share. This serves to increase the barriers to entry
the new firms. Many rivalries among firms in oligopolies are well
known nationally and internationally, for example, Coke and
Pepsi, Nike and Adidas.
However, many of the branded consumer goods that we
purchase are produced in oligopolies and we might have no
idea that there are actually just a few companies dominating
the market. The majority of the brands are often produced by
just a few companies.
OLIGOPOLY
OLIGOPOLY
OLIGOPOLY
Is there a market failure that needs to be rectified in
oligopoly?
As with firms that faces a downward-sloping demand curve,
firms in oligopoly will not be producing at the allocatively
efficient level of output, if they are maximizing profits, and so
there will be a market failure. The existence of market power
will always create risks in terms of output, price and consumer
choice.
OLIGOPOLY
If there is a collusive oligopoly, with formal or tacit collusion, and
if there are barriers to entry, then firms will behave like a
monopolist, by charging the monopoly price and splitting the
monopoly abnormal profits based upon their market share.
OLIGOPOLY
So when will governments intervene to restrict significant
market power in monopoly or oligopoly?
We have already identified a number of situations that may
lead to government intervention to restrict the abuse of market
power. They are summarized in the list below:
1. Restrictions of output, higher prices and distorted resource
allocation
Firms with market power control output to force up market
prices, and there will be a loss of consumer surplus.
OLIGOPOLY
In some oligopolistic markets, firms will spend large amounts of
money on marketing in order to make the demand for their
product more inelastic and so to create a significant barrier to
entry. This is a form of non-price competition.
2. Lower consumer choice
The existence of fewer, or single, firms in an industry may lead
to the production of fewer brands, leading to a lack of
consumer choice.
3. Productive inefficiency
Production does not take place at the lowest possible unit cost.
OLIGOPOLY
4. Allocative inefficiency
There will be an underallocation of resources to the product in
question, since the value put on it by consumers is greater than
the cost of producing it to producers.
5. Abnormal profits and inequity
The higher prices in an oligopoly or monopoly may exploit low
income consumers and their purchasing power might be
transferred to the owners of firms, entrepreneurs or
shareholders, in the form of higher profits leading to more
unequal distribution of income. There may be a reduction in
equity.
OLIGOPOLY
How might governments intervene in response to abuse of
significant market power in monopoly or oligopoly?
The existence of significant market power in monopoly or
oligopoly is considered to be socially unacceptable, if firms
abuse the power. Obviously, the existence/definition of what
constitutes abuse is a subjective matter and will vary from
country to country. However, if abuse is in existence, the
government intervention should take place.
OLIGOPOLY
Governments have agencies to promote competition and prevent
the abuse of monopoly power. à Competition Commission or
Commerce Department: Monopoly watchdogs.
The actions of a competition authority could include the
following:
Governments usually pass laws to restrict the ability of firms to
grow through mergers or takeovers. A merger is where two
companies, often of similar size, agree to combine and become
one larger firm. A takeover is the acquisition of a company by
another company. Takeovers are mostly ”hostile”, ie without the
consent of the company being taken over.
OLIGOPOLY
The laws may not permit mergers or takeovers that would give
an individual firm more than a certain percentage of the market
– for example, 25 %.
Governments pass laws against price fixing, making it illegal
for firms to collude over prices, thus making collusive oligopolies
illegal. This is the case in the majority of the countries in the
world.
If firms are insisting that retailers charge a certain price for their
product, or if firms are refusing to supply their products to
certain retailers, then governments may also legislate to stop the
practice.
OLIGOPOLY
Such bodies are then empowered to take action, or to
recommend that the government should take some action, if it
can be shown that the public interest is being harmed.
Governments may also set up regulatory bodies for certain
industries that have a duty to represent the interests of
consumers, where possible by promoting competition.
An example of this might be the Office of Gas and Electricity
Markets in the UK.
OLIGOPOLY
Regulatory bodies may have a number of different powers, such
as:
• The ability to set price controls (price capping).
• The ability to impose fines for anti-competitive behaviour.
• The ability to insist on average price levels that set a “fair
trade of return” based upon profit levels which might be
expected in a competitive market.
• The ability of make firms “unbundle” their products, thus
making it easier for other firms to enter the market and
compete. Bundling is where firms sell a number of products
together in a ‘bundle’.
OLIGOPOLY
• The ability to break up a monopoly into separate businesses,
thus promoting competition. However, this rarely happens and is
considered to be an extreme action.
• The ability to set standards for the quality of service in an
industry.
In an extreme situation, the government may take the industry
into public (government) ownership. In this case, the goods and
services are sold in the market would be produced in
nationalized industry, owned by the state.