Boundless EconomicsOligopoly
Prerequisites of Oligopoly
Few SellersAn oligopoly – a market dominated by a few sellers – is often able to maintainmarket power through increasing returns to scale.
Learning ObjectivesExplain how increasing returns to scale will cause a higher prevalence ofoligopolies
Key TakeawaysKey PointsThe existence of oligopoly requires that a few firms are able to gain significantmarket power, preventing other, smaller competitors from entering the market.Increasing returns to scale is a term that describes an industry in which the rateof increase in output is higher than the rate of increase in inputs. In other words,doubling the number of inputs will more than double the amount of output.Monopolies and oligopolies often form when an industry has increasing returnsto scale at relatively high output levels.
Key Termsoligopoly: An economic condition in which a small number of sellers exertcontrol over the market of a commodity.returns to scale: A term referring to changes in output resulting from aproportional change in all inputs (where all inputs increase by a constant factor).
Oligopoly StructureIn an oligopoly market structure, a few large firms dominate the market, andeach firm recognizes that every time it takes an action it will provoke a responseamong the other firms. These actions, in turn, will affect the original firm. Eachfirm, therefore, recognizes that it is interdependent with the other firms in theindustry. This interdependence is unique to the oligopoly market structure; inperfect and monopolistic competition, we assume that each firm is smallenough that the rest of the market will ignore its actions.
Increasing Returns to ScaleThe existence of oligopoly requires that a few firms are able to gain significantmarket power, preventing other, smaller competitors from entering the market.One source of this power is increasing returns to scale. Increasing returns toscale is a term that describes an industry in which the rate of increase in outputis higher than the rate of increase in inputs. In other words, doubling thenumber of inputs will more than double the amount of output. Increasingreturns to scale implies that larger firms will face lower average costs thansmaller firms because they are able to take advantage of added efficiency athigher levels of production.
Types of Returns to ScaleMost industries exhibit different types of returns to scale in different ranges ofoutput. Typically in competitive markets, there could be increasing returns atrelatively low output levels, decreasing returns at relatively high output levels,and constant returns at one output level between those ranges. Monopolies andoligopolies, however, often form when an industry has increasing returns toscale at relatively high output levels. When a few large firms already exist in thistype of market, any new competitor will be smaller and therefore have higheraverage costs of production. This will make it difficult to compete with thealready-established firms. Therefore, the oligopoly firms have a built-in defense
against new competition.
Take the example of the cell phone industry in the United States. As of thefourth quarter of 2008, Verizon, AT&T, Sprint, and T-Mobile together controlled89% of the U.S. cell phone market. The cell phone industry has increasingreturns to scale: the cost of providing cellular access to 100,000 people is morethan half the cost of providing cellular access to 200,000 people. Any newentrant into the cell phone market will either need to pay one of the largercompanies for access to its already-existing network, or try to build a networkfrom scratch. Both options result in higher costs, higher prices, and difficulty incompeting with the major networks.
Cell Phone Tower: Cell phone companies have increasing returns toscale, which leads to a market dominated by only a few firms.
Product DifferentiationOligopolies can form when product differentiation causes decreasedcompetition within an industry.
Learning ObjectivesExplain the relationship between product differentiation and the existence of anoligopoly
Key TakeawaysKey PointsProduct differentiation is the process of distinguishing a product or service fromothers, to make it more attractive to a particular target market.The objective of differentiation is to develop a position that potential customerssee as unique. This primarily affects performance through reducing competition.Many oligopolies make differentiated products: cigarettes, automobiles,computers, ready-to-eat breakfast cereal, and soft drinks.Although product differentiation is not required for an oligopoly to form, if afirm can successfully differentiate its products it will gain market power andresist competition more easily.
Key Termsproduct differentiation: Perceived differences between the product of one firmand that of its rivals so that some customers value it more.
Product differentiation (or simply differentiation) is the process of distinguishinga product or service from others, to make it more attractive to a particular targetmarket. This involves differentiating it from competitors' products as well as afirm's own products. In economics, successful product differentiation isinconsistent with the conditions for perfect competition, which include therequirement that the products of competing firms should be perfect substitutes.
Differentiation is due to buyers perceiving a difference; hence, causes ofdifferentiation may be functional aspects of the product or service, how it isdistributed and marketed, or who buys it. The major sources of productdifferentiation are as follows:
Differences in quality which are usually accompanied by differences in priceDifferences in functional features or designIgnorance on the part of buyers regarding the essential characteristics andqualities of goods they are purchasingSales promotion activities of sellers and, in particular, advertisingDifferences in availability (e.g. timing and location).
The objective of differentiation is to develop a position that potential customerssee as unique. This primarily affects performance through reducing competition:As the product becomes more differentiated, categorization becomes moredifficult and hence draws fewer comparisons with its competition. A successfulproduct differentiation strategy will move a product from competing basedprimarily on price to competing on non-price factors (such as productcharacteristics, distribution strategy, or promotional variables).
Product Differentiation and OligopoliesWhile some oligopoly industries make standardized products – tools, copper,and steep pipes, for example – others make differentiated products: cars,cigarettes, soda, and cell phone manufacturers. Product differentiation is notnecessary for the existence of an oligopoly, but if a firm can successfully engagein product differentiation it can more easily gain market power and dominate atleast part of the industry.
For example, the soft drink industry in the US is an oligopoly dominated by theCoca-Cola Company, the Dr. Pepper Snapple Group, and PepsiCo. These
companies are able to differentiate their products (e.g. by taste), and aretherefore able to gain market power.
Advertising for Product Differentiation: Some companies are able to usemarketing to achieve product differentiation, encouraging the formation ofoligopolies.Entry BarriersOne important source of oligopoly power are barriers to entry: obstacles thatmake it difficult to enter a given market.
Learning ObjectivesExplain the necessity of entry barriers for the existence of an oligopoly
Key TakeawaysKey Points
Because barriers to entry protect incumbent firms and restrict competition in amarket, they can contribute to distortionary prices.The most important barriers are economies of scale, patents, access toexpensive and complex technology, and strategic actions by incumbent firmsdesigned to discourage or destroy new entrants.In industrialized economies, barriers to entry have resulted in oligopoliesforming in many sectors, with unprecedented levels of competition fueled byincreasing globalization.
Key Termsresearch and development: The process of discovering and creating newknowledge about scientific and technological topics in order to develop newproductsincumbent: A firm that is an established player in the market.patent: A declaration issued by a government agency declaring someone theinventor of a new invention and having the privilege of stopping others frommaking, using, or selling the claimed invention.
One important source of oligopoly power is barriers to entry. Barriers to entryare obstacles that make it difficult to enter a given market. The term can refer tohindrances a firm faces in trying to enter a market or industry—such asgovernment regulation and patents, or a large, established firm takingadvantage of economies of scale—or those an individual faces in trying to gainentrance to a profession—such as education or licensing requirements. Becausebarriers to entry protect incumbent firms and restrict competition in a market,they can contribute to distortionary prices.
The most important barriers are economies of scale, patents, access toexpensive and complex technology, and strategic actions by incumbent firmsdesigned to discourage or destroy new entrants. For example, microprocessing
companies face high research and development costs before possibly making aprofit. This means that new firms cannot enter the market whenever existingfirms are making a positive economic profit, as is the case in perfectcompetition. Pharmaceutical manufacturers are one type of company thatgenerally rely on patents, which makes competition irrelevant for a period oftime after development: competitors can't legally begin manufacturing theproduct until the patent expires.
Additional sources of barriers to entry often result from government regulationfavoring existing firms. For example, requirements for licenses and permits mayraise the investment needed to enter a market, creating an effective barrier toentry.
In industrialized economies, barriers to entry have resulted in oligopoliesforming in many sectors, with unprecedented levels of competition fueled byincreasing globalization. For example, there are now only a small number ofmanufacturers of civil passenger aircraft. Oligopolies have also formed inheavily-regulated markets such as wireless communications: in some areas onlytwo or three providers are licensed to operate.
Oligopoly in Aircraft Manufacturing: Manufacturing commercial airplanestakes a very large initial investment in technology, equipment, and licensing.Consequently, the industry is dominated by two firms.Price LeadershipPrice leadership is a form of tacit collusion that oligopolies may use to achieve amonopoly-like market outcome.
Learning ObjectivesDefine price leadership within the context of an oligopoly
Key TakeawaysKey PointsOligopolies are defined by one firm 's interdependence on other firms withinthe industry. When one firm changes its price or level of output, other firms aredirectly affected.
When firms collude, they use restrictive trade practices to voluntarily loweroutput and raise prices in much the same way as a monopoly, splitting thehigher profits that result.An alternative to overt collusion is tacit collusion, an unwritten, unspokenunderstanding through which firms agree to limit their competition.One strategy is to follow the price leadership of a particular firm, raising orlowering prices when the leader makes such a change. The price leader may bethe largest firm in the industry, or it may be a firm that has been particularlygood at assessing changes in demand or cost.
Key TermsPrice leadership: The action taken by a leader in an oligopolistic industry todetermine prices for the entire industry.collude: To act in concert with; to conspire.Cartel: A group of businesses or nations that collude explicitly to limitcompetition within an industry or market.
OligopolyOligopolies are defined by one firm's interdependence on other firms within theindustry. When one firm changes its price or level of output, other firms aredirectly affected. Unlike perfect competition and monopoly, uncertainty abouthow rival firms interact makes the specification of a single model of oligopolyimpossible. Economists often simplify firm behavior into two strategies: firm cancompete, in which case the market outcome will resemble that in perfectcompetition; or they can collude, in which case the market outcome will moreclosely resemble monopoly. When firms collude, they use restrictive tradepractices to voluntarily lower output and raise prices in much the same way as amonopoly, splitting the higher profits that result.
Price Leadership
Firms can collude explicitly, as in the case of cartels, but this type of behavior isillegal in many parts of the world. An alternative to overt collusion is tacitcollusion, in which firms have an unspoken understanding that limits theircompetition. One way in which firms achieve this is price leadership, in whichone firm serves as an industry leader and sets prices, while other firms raise andlower their prices to match. For example, the steel, cars, and breakfast cerealsindustries have all been accused of engaging in tacit collusion..
Tacit collusion can be difficult to identify. The fact that a price change by onefirm is follwed by similar price changes among other firms doesn't necessarilymean that tacit collusion exists. After all, in a perfectly competitive industry,economists expect prices to move together because all firms face similarchanges in demand and the cost of inputs.
For example, imagine that a town has three gas stations. Without any way tocommunicate, all three will lower their prices in an attempt to capture the entiremarket, stopping only when marginal cost equals marginal revenue. If the firmscould cooperate, however, they would be better off if all set the price of gas at$0.20 above marginal cost. Each would have slightly lower sales but would havemuch higher revenue. Although explicit communication about prices is illegal,the firms might tacitly agree that whenever one station raises its prices, theother two will follow suit. In this way, all three can receive the benefits ofoligopoly. The gas station that first raises its prices, and that the other twofollow, is called the price leader.
Price Leadership and Gas Prices: Although companies cannot legallycommunicate to set prices, some accuse certain industries of using priceleadership to accomplish the same goal.
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