Oligopoly

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Competition law
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Anti-competitive practices
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An oligopoly (from Greek ὀλίγος, oligos "few" and πωλεῖν, polein "to sell") is a market form wherein a market or industry is dominated by a small group of large sellers (oligopolists). For example, it has been found out that insulin and the electrical industry are highly oligopolist in the US.^[1]

Description[]

Oligopolies can result from various forms of collusion that reduce market competition which then leads to higher prices for consumers and lower wages for the employees of oligopolies. Under this situation, oligopolists act like a monopoly and ultimately gain a market power. While they still can choose to compete hard instead of colluding together and ending up with a scenario where is similar to perfect competition.^[2] Oligopolists have their own market structure.^[3]

With few sellers, each oligopolist is likely to be aware of the actions of the others. According to game theory, the decisions of one firm therefore influence and are influenced by the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants. Entry barriers include high investment requirements, strong consumer loyalty for existing brands, and economies of scale, and these barriers effectively facilitate the formation and sustainability of collusion.

The fundamental reason is related to future retaliation (deviation). In other words, firms will lose less for deviation and thus have more incentive to undercut collusion price (obtain short-term deviated profit) when future entry continues.^[4] There are other factors that could also facilitate collusion such as market transparency and frequent interaction.^[4] In developed economies oligopolies dominate the economy as the perfectly competitive model is of negligible importance for consumers. Specifically, oligopolists will implement a practice called price fixing to dominate the economy. Taking an example from the US in 2013 that most new prosecuted oligopolist cases were based on price-fixing.^[5] However, this will bring negative impacts since it ends up with less choices and high prices for customers.^[6]

As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized and is the most preferable ratio for analyzing market concentration.^[7] This measure expresses, as a percentage, the market share of the four largest firms in any particular industry. For example, as of fourth quarter 2008, if we combine the total market share of Verizon Wireless, AT&T, Sprint, and T-Mobile, we see that these firms, together, control 97% of the U.S. cellular telephone market.^[8] These four cellular telephone firms have become the top-tier in US carriers and were protected by the US government that acted as an intervention for other firms entering the market.^[9]

Oligopolistic competition can give rise to both wide-ranging and diverse outcomes. In some situations, particular companies may employ restrictive trade practices (collusion, market sharing etc.) in order to inflate prices and restrict production in much the same way that a monopoly does. Whenever there is a formal agreement for such collusion, between companies that usually compete with one another, this practice is known as a cartel. A prime example of such a cartel is OPEC, where oligopolistic countries manipulate the worldwide oil supply and ultimately leaves a profound influence on the international price of oil.^[10]

There are legal restrictions on such collusion in most countries and relevant regulations or enforcements against cartels (anti-competitive behaviours) enacted since the late of 1990s.^[11] For example, EU competition law has prohibited some unreasonable anti-competitive practises such as directly or indirectly fix selling prices, manipulate market supply or control trade among competitors etc, either by means of formal contracts or oral agreements.^[12] In US, Antitrust Division of the Justice Department and Federal Trade Commission are created for banning collusion on cartels.^[13] However, there does not have to be a formal agreement for collusion to take place, which called tacit collusion that less competitive outcome is achieved through mutual understanding among firms (although for the act to be illegal there must be actual and direct communication between companies)–for example, in some industries there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership.^[14] Within the development of anti-trust law on most countries that tacit collusion is becoming more popular.^[15]

In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater when there are more competitors in an industry. Theoretically, it is harder to sustain cartels ( anti-competitive behaviors) in an industry with a larger number of firms in that it will yield less collusive profit for each firm.^[16] Consequently, existing firms may have more incentive to deviate. However, this conclusion is a bit more intuitive and empirical evidence has shown this conclusion or relationship is a bit more ambitious and mixed.^[17]

Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's structure. In particular, the level of dead weight loss is hard to measure. The study of product differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition, as they could gain certain marker power by offering somewhat differentiated products.^[18]

Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies:

• Stackelberg's duopoly. In this model, the firms move sequentially (see Stackelberg competition).
• Cournot's duopoly. In this model, the firms simultaneously choose quantities (see Cournot competition).
• Bertrand's oligopoly. In this model, the firms simultaneously choose prices (see Bertrand competition).

When compared with Cournot and Bertrand's model, it can be seen that price competition is more aggressive and competitive, and also it is easier to sustain collusion under price competition.^[19]

Characteristics[]

Profit maximization conditions

An oligopoly maximizes profits.

Ability to set price

Oligopolies are price setters rather than price takers.^[20]

Entry and exit

Barriers to entry are high.^[21] The most important barriers are government licenses, economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms. Additional sources of barriers to entry often result from government regulation favoring existing firms making it difficult for new firms to enter the market.^[22]

Number of firms

"Few" – a "handful" of sellers.^[21] There are so few firms that the actions of one firm can influence the actions of the other firms.^[23]

Long run profits

Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering the market to capture excess profits.

Product differentiation

Product may be homogeneous (steel) or differentiated (automobiles).^[22]

Perfect knowledge

Assumptions about perfect knowledge vary but the knowledge of various economic factors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions, but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price,^[21] cost, and product quality.

Interdependence

The distinctive feature of an oligopoly is interdependence.^[24] Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore, the competing firms will be aware of a firm's market actions and will respond appropriately. This means that in contemplating a market action, a firm must take into consideration the possible reactions of all competing firms and the firms' countermoves.^[25] It is very much like a game of chess, in which a player must anticipate a whole sequence of moves and countermoves in order to determine how to achieve his or her objectives; this is known as game theory. For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices for retaliation and possibly trigger a ruinous price war. Or if the firm is considering a price increase, it may want to know whether other firms will also increase prices or hold existing prices constant. This anticipation leads to price rigidity, as firms will only be willing to adjust their prices and quantity of output in accordance with a "price leader" in the market. An example for this interdependence among oligopolists such that Texaco needs to take into consideration whether its own price cut will trigger Shell's incentive to match, and so that the benefit or privilege gained by low price would be eliminated.^[26] This high degree of interdependence and need to be aware of what other firms are doing or might do stands in contrast with the lack of interdependence in other market structures. In a perfectly competitive (PC) market there is zero interdependence because no firm is large enough to affect market price. All firms in a PC market are price takers, as the current market selling price can be followed predictably to maximize short-term profits. In a monopoly, there are no competitors to be concerned about. In a monopolistically-competitive market, each firm's effects on market conditions is so negligible as to be safely ignored by competitors.

Non-price competition

Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and product differentiation are all examples of non-price competition, which is perceived less risky and brings less disastrous impacts to business. In other words, oligopolists are able to extract more rents (charge prices above normal competition level without losing large consumers) by offering differentiated products or initiating promotion efforts.^[27] However, collusion among oligopolists is harder or more difficult to sustain along such non-price dimensions such as differentiation, marketing, product design.^[28]

For fighting collusion and cartels in an oligopoly market, competition authorities have taken measures or practices to effectively discover, prosecute and penalize them.^[29] Leniency program and economic analysis (screening) are currently two popular mechanisms.

Leniency program[]

Competition authorities prominently have roles and responsibilities on prosecuting and penalizing existing cartels and desisting new ones. Thus, authorities have created an effective tool called the leniency program, which makes antitrust firms to be more proactive participants in confessing their collusion behaviors in that they will be granted immunity from fines and still have a right to plea bargaining if not receive a full reduction.^[30] Nowadays, leniency program has been implemented by several countries like US, Japan and Canada. However, it causes negative impacts to competition authorities themselves in the wake of abusing of leniency program that there are still many cartels in society and the expected sanctions for colluded firms will experience a sharp drop.^[31] As a result, the total effect of the leniency program is ambiguous and an optimal leniency program is required.^[16]

Economic analysis[]

There are two screening methods that are currently available for competition authorities: structural and behavioral.^[32] In terms of structural screening, it refers to identify industry traits or characteristics, such as homogenous goods, stable demand, less existing participants, which are prone to cartel formation. While regarding behavioral one, is mainly implemented when a cartel formation or agreement has reached and subsequently authorities start to look into firms' data and figure out whether their price variance is low or has a significant price increase or decrease.^[16]

Oligopolies in countries with competition laws[]

Oligopolies become "mature" when competing entities realize they can maximize profits through joint efforts designed to maximize price control by minimizing the influence of competition. As a result of operating in countries with enforced antitrust laws, oligopolists will operate under tacit collusion, which is collusion through a mutual understanding among the competitors of a market without any direct communication or contact that by collectively raising prices, each participating competitor can achieve economic profits comparable to those achieved by a monopolist while avoiding the explicit breach of market regulations.^[33] Hence, the kinked demand curve for a joint profit-maximizing oligopoly industry can model the behaviors of oligopolists' pricing decisions other than that of the price leader (the price leader being the entity that all other entities follow in terms of pricing decisions). This is because if an entity unilaterally raises the prices of their good/service and competing entities do not follow, the entity that raised their price will lose a significant market as they face the elastic upper segment of the demand curve.

As the joint profit-maximizing efforts achieve greater economic profits for all participating entities, there is an incentive for an individual entity to "cheat" by expanding output to gain greater market share and profit. In the case of oligopolist cheating, when the incumbent entity discovers this breach in collusion, competitors in the market will retaliate by matching or dropping prices lower than the original drop. Hence, the market share originally gained by having dropped the price will be minimized or eliminated. This is why on the kinked demand curve model the lower segment of the demand curve is inelastic. As a result, in such markets price rigidity prevails.

Modeling[]

There is no single model describing the operation of an oligopolistic market.^[25] The variety and complexity of the models exist because two to 10 firms can compete on the basis of price, quantity, technological innovations, marketing, and reputation. However, there are a series of simplified models that attempt to describe market behavior by considering certain circumstances. Some of the better-known models are the , the Cournot–Nash model, the Bertrand model and the kinked demand model.

Cournot–Nash model[]

The Cournot–Nash model is the simplest oligopoly model. The model assumes that there are two "equally positioned firms"; the firms compete on the basis of quantity rather than price and each firm makes an "output of decision assuming that the other firm's behavior is fixed."^[34] The market demand curve is assumed to be linear and marginal costs are constant. To find the Nash equilibrium one determines how each firm reacts to a change in the output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a point is reached where neither firm desires "to change what it is doing, given how it believes the other firm will react to any change."^[35] The equilibrium is the intersection of the two firm's reaction functions. The reaction function shows how one firm reacts to the quantity choice of the other firm.^[36] For example, assume that the firm 1's demand function is P = (M − Q₂) − Q₁ where Q₂ is the quantity produced by the other firm and Q₁ is the amount produced by firm 1,^[37] and M=60 is the market. Assume that marginal cost is C_M=12. Firm 1 wants to know its maximizing quantity and price. Firm 1 begins the process by following the profit maximization rule of equating marginal revenue to marginal costs. Firm 1's total revenue function is R_T = Q₁ P = Q₁(M − Q₂ − Q₁) = MQ₁ − Q₁ Q₂ − Q₁². The marginal revenue function is ${\displaystyle R_{M}={\frac {\partial R_{T}}{\partial Q_{1}}}=M-Q_{2}-2Q_{1}}$.^{[note 1]}

R_M = C_M

M − Q₂ − 2Q₁ = C_M

2Q₁ = (M − C_M) − Q₂

Q₁ = (M − C_M)/2 − Q₂/2 = 24 − 0.5 Q₂ [1.1]

Q₂ = 2(M − C_M) − 2Q₁ = 96 − 2 Q₁ [1.2]

Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2.

To determine the Nash equilibrium you can solve the equations simultaneously. The equilibrium quantities can also be determined graphically. The equilibrium solution would be at the intersection of the two reaction functions. Note that if you graph the functions the axes represent quantities.^[38] The reaction functions are not necessarily symmetric.^[39] The firms may face differing cost functions in which case the reaction functions would not be identical nor would the equilibrium quantities.

Bertrand model[]

The Bertrand model is essentially the Cournot–Nash model except the strategic variable is price rather than quantity.^[40]

The model assumptions are:

• There are two firms in the market
• They produce a homogeneous product
• They produce at a constant marginal cost
• Firms choose prices P_A and P_B simultaneously
• Firms outputs are perfect substitutes
• Sales are split evenly if P_A = P_B^[41]

The only Nash equilibrium is P_A = P_B = MC.

Neither firm has any reason to change strategy. If the firm raises prices it will lose all its customers. If the firm lowers price P < MC then it will be losing money on every unit sold.^[42]

The Bertrand equilibrium is the same as the competitive result.^[43] Each firm will produce where P = marginal costs and there will be zero profits.^[40] A generalization of the Bertrand model is the Bertrand–Edgeworth model that allows for capacity constraints and a more general cost function.

Oligopolistic market: Kinked demand curve model[]

According to this model, each firm faces a demand curve kinked at the existing price.^[44] The conjectural assumptions of the model are; if the firm raises its price above the current existing price, competitors will not follow and the acting firm will lose market share and second, if a firm lowers prices below the existing price then their competitors will follow to retain their market share and the firm's output will increase only marginally.^[45] In other words, oligopolist's pricing logic is that competitors will match and respond to any price cut - retaliating to obtain more market share, while they will stick with the current or initial price for any price rising among competitors.^[46]

If the assumptions hold then:

• The firm's marginal revenue curve is discontinuous (or rather, not differentiable), and has a gap at the kink^[44]
• For prices above the prevailing price the curve is relatively elastic^[47]
• For prices below the point the curve is relatively inelastic^[47]

The gap in the marginal revenue curve means that marginal costs can fluctuate without changing equilibrium price and quantity.^[44] Thus prices tend to be rigid.

Examples[]

Many industries have been cited as oligopolistic, including civil aviation,^[48] agricultural pesticides,^[48] electricity,^[49][50] and platinum group metal mining.^[51] In most countries, the telecommunications sector is characterized by an oligopolistic market structure.^[50][52] Rail freight markets in the European Union have an oligopolistic structure.^[53] In the United States, industries that have identified as oligopolistic include food processing,^[54] funeral services,^[55] sugar refining,^[56] beer,^[57] pulp and paper,^[58] , automobiles^[59]

Market power and market concentration can be estimated or quantified using several different tools and measurements, including the Lerner index, stochastic frontier analysis, and New Empirical Industrial Organization (NEIO) modeling,^[54] as well as the Herfindahl-Hirschman index.^[51]

Demand curve[]

Above the kink, demand is relatively elastic because all other firms' prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and the kink point. This is a theoretical model proposed in 1947, which has failed to receive conclusive evidence for support.^[60]

In an oligopoly, firms operate under imperfect competition. With the fierce price competitiveness created by this sticky-upward demand curve, firms use non-price competition in order to accrue greater revenue and market share.

"Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend–"kink". Thus the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal cost, s could change without necessarily changing the price or quantity.

The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices (price rigidity). However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is, therefore, more price-elastic for price increases and less so for price decreases. Theory predicts that firms will enter the industry in the long run since market price for oligopolists is more stable or 'focal' in the long run under this kinked demand curve situation.^[60]

See also[]

Notes[]

References[]

Further reading[]

Wikimedia Commons has media related to Oligopoly.

• Bayer, R. C. (2010). Intertemporal price discrimination and competition. Journal of economic behavior & organization, 73(2), 273–293.
• Harrington, J. (2006). Corporate leniency programs and the role of the antitrust authority in detecting collusion. Competition Policy Research Center Discussion Paper, CPDP-18-E.
• Ivaldi, M., Jullien, B., Rey, P., Seabright, P., & Tirole, J. (2003). The economics of tacit collusion.