OLIGOPOLY, BEHAVIOR: Interdependence

Transcription

1 OLIGOPOLY, BEHAVIOR: Oligopolistic industries share several behavioral tendencies, including: (1) interdependence, (2) rigid prices, (3) nonprice competition, (4) mergers, and (5) collusion. In other words, each oligopolistic firm keeps a close eye on the decisions made by other firms in the industry (interdependence), are reluctant to change prices (rigid prices), but instead try to attract customers from the competition using incentives other than prices (nonprice competition), and when they get tired of competing with their competitors they are inclined to cooperate formally and legally (mergers) or informally and illegally (collusion). Oligopolistic industries are nothing if not diverse. Some sell identical products, others differentiated products. Some have three or four firms of nearly equal size, others have one large dominate firm (a clear industry leader) and a handful of smaller firms (that follow the leader). Some sell intermediate goods to other producers others sell consumer goods directly to the public. However, through this diversity, all oligopolistic industries engage in similar types of behavior. The most noted behavior tendencies are: (1) interdependent decision making, (2) relatively constant prices, (3) competition in ways that do not involve prices, (4) the legal merger of two or more firms, and (5) the illegal collusion among firms to control price and production. Interdependence Each firm in an oligopolistic industry keeps a close eye on the activities of other firms in the industry. Because oligopolistic firms engage in competition among the few, decisions made by one firm invariably affect others. Competition among interdependent oligopoly firms is comparable to a game or an athletic contest. One team's success depends not only on its own actions but the actions of its competitors. Chip Merthington might win a foot race not just because he runs really fast, but because his competition (Edgar Millbottom) runs really slow. In a game of chess, Chip captures Edgar's knight with his rook. Edgar then counters by capturing Chip's rook with his queen. The key point is that Edgar would not have taken Chip's rook if Chip had not captured Edgar's knight. This is how oligopolies behave. An action by one firm motivates a counter action by another firm. Consider, for example, the hypothetical oligopolistic athletic footwear industry, dominated by two companies OmniRun, Inc. and The Master Foot Company. If OmniRun introduces the OmniFast 9000, a new running shoe with ankle stabilizers and an extra thick cushioned insole, then The Master Foot Company needs to introduce a comparable shoe to keep pace with the competition because its existing model, the Fleet Foot 30, does not have ankle stabilizers nor an extra thick cushioned insole. If The Master Foot Company does not counter the action by OmniRun, then buyers will likely choose the new OmniFast 9000 over the older Fleet Foot 30. As such, The Master Foot Company will probably introduce something like the Fleet Foot 40 with flexible ankle stabilizers, a double extra thick cushioned insole, and metallic heal reflectors. And when it does, it is also likely to launch a massive advertising campaign to promote the new shoe, using the well-known, and wildly popular baseball superstar, Harold "Hair Doo" Dueterman as a spokesperson. This is likely to prompt OmniRun, Inc. to launch its own advertising blitz for the

2 OmniFast 9000 featuring motion picture box office mega-star, Brace Brickhead. And on it goes... each firm taking action to counter that of the other firm, which then takes further action, which then prompts more action. Rigid Prices Oligopolistic industries tend to keep prices relatively constant, preferring to compete in ways that do not involve changing the price. The prime reason for rigid prices rests with the interdependence among oligopolistic firms. Because competing firms ARE NOT likely to match the price increases of an oligopolistic firm, the firm is likely to loose customers and market share to the competition should it charge a higher price. As such, it has little motive to increase its price. Because competing firms ARE likely to match the price decreases of an oligopolistic firm, the firm is unlikely to gain customers and market share from the competition should it charge a lower price. As such, it has little motive to decrease its price. Consider, once again, the oligopolistic athlete shoe industry. OmniRun, Inc. sells its OmniFast 9000 shoe for $100. Likewise, The Master Foot Company sells its Fleet Foot 40 running shoe for $100. OmniRun could reduce the price of its OmniFast 9000 to $95, thinking buyers will select it over the more expensive Fleet Foot 40. But Master Foot is not likely to sit idly by as OmniRun dominates the market by virtue of a lower price. Master Foot will reduce the price of the Fleet Foot 40 to $95 as well. The net result of this joint price reduction is that each firm retains the same market share, but sells its shoe for $5 less. While the lower overall shoe price might increase the overall quantity demanded in the market (due to the law of demand), neither firm gains a competitive advantage over the other. Both maintain the same market share at the $95 price as they had with the $100 price. To the extent that OmniRun realizes Master Foot will match any price reduction, it has little motivation to reduce prices. Master Foot also has little motivation to pursue a price increase of its Fleet Foot 40 to $105. OmniRun is unlikely to match this higher price. If the higher Fleet Foot 40 price is $5 more, the OmniFast 9000 is $5 cheaper. Buyers will select the less expensive OmniFast 9000 over the now more expensive Fleet Foot 40. As such, The Master Foot Company has nothing to gain with a higher price, but it is likely to lose market share to OmniRun. The net result is that neither firm can gain a competitive advantage by changing the price. As such, the seek to compete in ways that do not involve price changes. However, this does not mean prices in oligopolistic industries NEVER change. Should industrywide conditions change, such as higher input prices, regulatory changes, or technological

3 advances, conditions that affect all firms, then all firms are likely respond in the same manner. They are likely to raise or lower prices together. Should the Athletic Shoe Workers Union negotiate an across-the-board 10 percent wage increase, then OmniRun and Master Foot are both inclined to raise shoe prices to the same degree. Should Professor Magnaminious, the leading expert on athletic shoe fabrication, design a new athletic shoe assembly machine that is twice as productive as the old assembly method, then OmniRun and Master Foot are both inclined to reduce shoe prices to the same degree. Nonprice Competition Because oligopolistic firms realize that price competition is ineffective, they generally rely on nonprice methods of competition. Three of the more common methods of nonprice competition are: (1) advertising, (2) product differentiation, and (3) barriers to entry. The key for a firm is to attract buyers and increase market share, while holding the line on price. Advertising: A large share of commercial advertising, especially at the national level, is designed as nonprice competition among oligopolistic firms. The Master Foot Company, as a hypothetical example, promotes its Fleet Foot 40 running shoe using the baseball superstar, Harold "Hair Doo" Dueterman, as a spokesperson. OmniRun, Inc. counters with advertising for the OmniFast 9000 featuring motion picture mega-star, Brace Brickhead. Each firm engages in advertising is an attempt either: (a) to attract customers from its competition or (b) to prevent the competition from attracting its customers. Production Differentiation: Another common method of nonprice competition among oligopolistic firms is product differentiation. Such firms often compete by offering a bigger, better, faster, cleaner, and newer product--and especially one that is different from the competition. This is the reason why OmniRun might introduce its OmniFast 9000, with ankle stabilizers and an extra thick cushioned insole. This is also the reason why The Master Foot Company might introduce its Fleet Foot 40 with flexible ankle stabilizers, a double extra thick cushioned insole, and metallic heal reflectors. Each firm seeks to differentiate its product and to give customers a reason (other than price differences) to select its product over the competition. Barriers to Entry: Oligopolistic firms also frequently "compete" by preventing the competition from entering the industry. Master Foot, for example, has a patent on the design of its innovative Fleet Foot 40 shoe which, for obvious reasons, it does not care to share with any potential competitors. Alternatively, OmniRun has acquired exclusive ownership of the world's supply of plaviminium (the material used to make the extra thick cushioned insole of the OmniFast 9000), which it is not inclined to sell to potential competitors. While assorted entry barriers exist, a popular form is government restrictions, especially if the competition happens to reside in another country.

4 Mergers Interdependence means that oligopolistic firms perpetually balance the need for competition against the benefits of cooperation. OmniRun and Master Foot are competitors in the market for athletic shoes. The profitability of OmniRun depends on the actions of Master Foot and vice versa. Such competition is inherent in an industry with a small number of large firms. However, oligopolistic firms also realize that cooperation is often more beneficial than competition. One common method of cooperation is through a merger, that is, the legally combination of two firms into a single firm. OmniRun, for example, can eliminate its number one competitor, Master Foot, by merging with it and forming a new, larger company (MasterRun or perhaps OmniFoot). With such a merger, OmniRun now has one less competitor to worry about. If Master Foot is OmniRun's only competitor, then this merger gives OmniRun a monopoly in the athletic shoe market. In general, as the number of competitors in an industry declines, then market control of the remaining firms is enhanced. Because oligopoly has a small number of firms, the incentive to cooperate through mergers is quite high. The large number of firms in monopolistic competition, by contrast, provides very few merger benefits. The merger of two monopolistically competitive firms, each with one-thousandth of the overall market, does not enhanced market control much at all. However, the merger of two oligopolistic firms, each with one-third of the market, greatly enhances the market control of the new firm. Collusion The incentive among oligopolistic firms to cooperate also takes the form of collusion. With collusion, oligopolistic firms remain legally independent and autonomous, but they enjoy the benefits of cooperation. Collusion occurs when two or more firms secretly agree to control prices, production, or other aspects of the market. For example, OmniRun and Master Foot might secretly agree to raise their shoe prices to $150 a pair. If these are the only two firms in the market for athletic shoes, then buyers have no choice but to pay the $150 price. In effect, the two firms operate as if they were one firm, a monopoly. By acting like a monopoly, the colluding firms can set a monopoly price, produce a monopoly quantity, generate monopoly profit; and allocate resources as inefficiently as a monopoly. Collusion can take one of two forms. Explicit collusion results when two or more firms reach a formal agreement. Implicit collusion results when two or more firms informally control the market with necessarily reaching a formal agreement. Given that collusion is usually illegal, especially within the United States, it is invariably kept secret. Some collusive agreements, however, are anything but secret. The most well-known example is the Organization of Petroleum Exporting Countries (OPEC). OPEC is an open, formal collusive agreement among petroleum producing countries to control prices and production.

5 OLIGOPOLY, CHARACTERISTICS: The three most important characteristics of oligopoly are: (1) an industry dominated by a small number of large firms, (2) firms sell either identical or differentiated products, and (3) the industry has significant barriers to entry. These three characteristics underlie common oligopolistic behavior, including interdependent actions and decision making, the inclination to keep prices rigid, the pursuit of nonprice competition rather than price competition, the tendency for firms to merge, and the incentive to form collusive arrangements. Small Number of Large Firms The most important characteristic of oligopoly is an industry dominated by a small number of large firms, each of which is relatively large compared to the overall size of the market. This characteristics gives each of the relatively large firms substantial market control. While each firm does not have as much market control as monopoly, it definitely has more than a monopolistically competitive firm. The total number of firms in an oligopolistic industry is not the key consideration. A oligopoly firm actually can have a large number of firms, approaching that of any monopolistically competitive industry. However, the distinguishing feature is that a few of the firms are relatively large compared to the overall market. A given industry with a thousand firms, for example, is considered oligopolistic if the top five firms produce half of the industry's total output. The hypothetical Shady Valley soft drink market contains 20 firms, but it is oligopolistic because the four largest firms account for over 60 percent of total industry sales and the top eight firms account for almost 80 percent. Identical or Differentiate Products Some oligopolistic industries produce identical products, like perfect competition in this regard, while others produce differentiated products, more like monopolistic competition. This characteristic might seem to be a bit wishy-washy, taking both sides of product differentiation issue. In actuality it points out that oligopolistic industries general come in two varieties. Identical Product Oligopoly: This type of oligopoly tends to process raw materials or produce intermediate goods that are used as inputs by other industries. Notable examples are petroleum, steel, and aluminum. Differentiate Product Oligopoly: This type of oligopoly tends to focus on goods sold for personal consumption. The key is that people have different wants and needs and thus enjoy variety. A few examples of differentiated oligopolistic industries include automobiles, household detergents, and computers.

6 Barriers to Entry Firms in an oligopolistic industry attain and retain market control through barriers to entry. The most noted entry barriers are: (1) exclusive resource ownership, (2) patents and copyrights, (3) other government restrictions, and (4) high start-up cost. Barriers to entry are the key characteristic that separates oligopoly from monopolistic competition on the continuum of market structures. With few if any barriers to entry, firms can enter a monopolistically competitive industry when existing firms receive economic profit. This diminishes the market control of any given firm. However, with substantial entry barriers found in oligopoly, firms cannot enter the industry as easily and thus existing firms maintain greater market control. Consider the hypothetical oligopolistic Shady Valley athletic shoe market dominated by OmniRun, Inc. and The Master Foot Company. Each of these firms has produced athletic shoes for several years. They have well-known brand names, state-of-the-art factories that provide economies of scale for large volumes of production, and a few patents on how their shoes are made. Any firm seeking to enter this market is faced with significant barriers. First, a new firm must compete with the established Fleet Foot and OmniFast brand names. At the very least, this requires a substantial amount of expensive upfront advertising and promotion. Second, a new entry has to construct a new factory. With limited initial sales, this new firm in the market will be unable to take full advantage of decreasing short-run average cost or long-run economies of scale. Third, any new firm has to devise its own production techniques to compete with the patented techniques used by OmniRun and Master Foot. While a new firm could enter this oligopolistic market, such a task is significantly more difficult than entering an industry with fewer barriers. OLIGOPOLY, CONCENTRATION: Oligopoly is a market structure that contains a small number of relatively large firms, meaning oligopoly markets tend to be concentrated. A small number of large firms account for a majority of total output. Concentration unto itself is not necessarily bad, but it often leads to inefficient behavior, such as collusion and nonprice competition. Concentration is measured in three ways-- market share, concentration ratio, Herfindahl index. Concentration is a primary feature of oligopoly. In fact, oligopoly is the only one of the four market structures where concentration is really an issue. Because monopoly is the only supplier in a market, concentration is not particularly relevant. The monopoly IS the market. Because monopolistic competition and perfect competition contain large numbers of small firms, concentration is barely measurable.

7 Oligopoly has a small number of large firms producing a majority of the total industry output. This means that production and sales tend to be concentrated in the hands of a relatively few firms. For many oligopoly markets, the ten largest firms often account for over 75 percent of total sales. For some oligopoly industries, the three to four largest firms account for over 90 percent of the market. Such concentration is what leads to some of the more interesting behavior of oligopoly, like collusion and nonprice competition. The identification and measurement of concentration in an oligopoly market quite useful. Concentration measurement is generally accomplished in one of three ways. Market Share: The simplest measure of concentration is the share of the market held by one or more firms in the industry. This is typically computed as the fraction of total sales or total production accounted for by one or more firms. For example, OmniCola sells $460 million of soft drinks each year. Total soft drink sales in the Shady Valley market are $2,000 million. As such, OmniCola has a market share of 23 percent. Concentration Ratio: This measure of concentration combines the market shares for the largest number of firms in an industry to indicate the degree of market concentration. The two most popular concentration ratios are for the four or eight largest firms in an industry. More specifically a concentration ratio is the fraction of total industry activity accounted for by the four or eight largest firms in the market. For example, the top four firms in the $2- billion Shady Valley soft drink market account for $460 million, $350 million, $225 million, and $190 million worth of sales. This gives a four-firm concentration ratio of about 61 percent. Concentration ratios fall somewhere in the range of 0 to 100 percent. Herfindahl Index: This measure was developed to compensate for a few problems associated with concentration ratios. In particular, the standard four-firm and eight-firm concentration ratios ignore the activity of firms not included in the calculation. The Herfindahl index includes the market shares of all firms in the market. Moreover, rather than simply adding the market shares, the Herfindahl index squares each market share before adding. This little trick has the added feature of placing greater weight on larger market shares. The Herfindahl index generates values between 0 and 10,000. Measures of concentration are the first bits of information that government officials consider when questions arise about the possible violation of antitrust laws. While concentration itself is not bad or inefficient, abuse of market control is easier and more likely with greater concentration. OLIGOPOLY, REALISM: Real world markets are heavily populated by oligopoly. About half of all output produced in the U.S. economy each year is done so by oligopoly firms. Other industrialized nations can make a similar claim. Oligopoly markets arise in a wide assortment different industries, ranging from manufacturing to retail trade to resource extraction to financial services. Oligopoly markets provide a veritable who's who of business firms in the United States and throughout the global economy. Any listing of oligopolistic industries, let alone specific oligopolistic firms, is bound to be incomplete. However, here is a partial list.

8 Automobiles At the top of the list is the market for cars, which has been one of the most important industries in this country for decades. A handful of firms--especially General Motors, Ford, Chrysler, Honda, and Toyota--account for over 90 percent of the cars, trucks, vans, and sport utility vehicles sold in the United States. The need for large factories, a nation-wide network of dealerships, and brand name recognition create entry barriers that limit production to a few large firms. Petroleum An industry closely tied to the market for cars is the extraction and refinement of petroleum. A few representatives in this market include ExxonMobile, ConocoPhillips, Gulf, and Shell. While the petroleum industry contains hundreds, if not thousands, of smaller firms, the biggest ones tend to dominate the market. In addition, another major player on the international scene is the Organization of Petroleum Exporting Countries (OPEC), which is an international cartel representing several petroleum-rich countries especially in the Middle East. Ownership and control of petroleum resources is a prime factor in the creation of an oligopolistic industry. Tires Another industry closely connected to the automobile industry is the manufacture of tires. Every car needs tires. This industry is also dominated by a small number of familiar firms as well, including Goodyear, Firestone, Goodrich, Uniroyal, and Michelin. The number of firms in this industry is also limited by the need for large factories. Computers An increasingly important market is that for personal computers. The manufacture of computers tends to be dominated by a small number of firms, including Dell, Hewlett-Packard, Gateway, Apple, and IBM. In the early years of the computer revolution (1970s and 1980s), numerous firms entered the market (Kaypro, Osborne, Packard Bell, Compaq, Texas Instruments), then went bankrupt, merged with other firms, or simply stopped offering personal computers. Although entry barriers are not insurmountable, brand name recognition and the need for manufacturing facilities tend to limit the entry of other firms. Banking A market that is becoming increasingly oligopolistic is banking. While the United States has a total of approximately 20,000 banks, a small contingent of firms tends to dominate the national market. Names include Citibank, Bank of America, Wells Fargo, Bank One, and MBNA. Moreover, most banking is done at the local level and most cities generally have no more than a handful of firms, including these national firms, that provide banking services. The key entry barrier that limits the number of firms in the banking industry is government authorization. Before a firm can provide banking services, it must obtain a government charter.

9 Wireless Telephone Throughout much of the 1900s, the only company providing telephone services was AT&T. Technological advances and regulatory changes enabled the development of an oligopolistic market for wireless telephone services (cell phones). AT&T has been joined by a small number of other companies, including Verizon, Cingular, Sprint, T-Mobile. The need for a nation-wide network of relay towers makes this industry well suited for a small number of large companies. Television While television sets are filled with hundreds of television channels, only a handful of companies dominate the market. The big players, including Disney (ABC, ESPN, Disney), Viacom (CBS, UPN, MTV), General Electric (NBC, Bravo, CNBC), Time-Warner (HBO, WB, CNN, TBS), and News Corp. (Fox, FX, Fox News), own and control many of the channels. (These companies also play major roles in related markets--including motion pictures, cable systems, radio and television stations, and newspapers.) Domination by a few firms arises due to the upfront costs of producing programming and acquiring satellite relay access. Airlines The airline industry has long been dominated by a small number of firms. Throughout the middle part of the 1900s, seven firms dominated the U.S. market--american, United, TWA, PanAm, Continental, Braniff, and Eastern. However, deregulation in the 1980s lead to decades of changes. Some airlines folded. New airlines emerged. Even though changes continue, the industry remains dominated by a small number of competitors--american, United, Southwest, Delta. Heavy expenses needed to purchase planes, establish flight routes, and acquire terminal space tends to limit the entry of new firms.