An analysis of the strategic behavior of an Oligopoly
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An analysis of the strategic behavior of an Oligopoly
Oligopoly, (Greek, 'few sellers') one of the imperfectly competitive market structure where a few large firms dominate the market. This is a basic definition of one of the market structures often called “Big business” market structure because the companies in this type of market structure are the top companies with lots of investments huge labor and big market value. These companies are also best known in the world because they usually compete in worldwide market and not a domestic market and spend a huge amount of their profit on advertising. There are two types of oligopoly1.Impure oligopoly that has a differentiated product
2.Pure oligopoly that has a homogeneous product
Homogenous product means that product the company is producing is identical with any other same product that different company is producing. These products are usually not as many as differential products for example steel, gold, wheat and etc. are all homogenous products because there are very few differences among them.
While homogenous products are almost identical differential products are all the other products any company is producing and even when products are similar in many ways there still can be lots of differences between each product.
Another characteristic of oligopoly is that in this market structure there are few sellers that are in the market. This is mostly because they are using a huge amount of money to run their businesses and usually there are just three of four firms that dominate the market. The question is how many companies are few. The answer in oligopoly is that this market structure is consequence of mutual independence.
Mutual independence means that action of one firm will cause a reaction on the part of other firms are on the market. This means that oligopoly with its few powerful companies makes it easier for a big company to collude. This mutual interdependence basically mean that when one company of “big four“ will change their price the other three will make similar or same decision to keep their market or to have a chance of bigger portion of the market. They are doing this because each company can not afford losing their portion of the market. In other market structures this is impossible, due to luck of monopolistic rules where are lots of companies. Last basic characteristic of an oligopoly is that there is a difficult or almost impossible entry to market for new companies.
This is because these four companies that are dominating the market have enough power and resources not to let new companies to steal their piece of the pie. They are competing among each other and there are huge amounts of money involved in this “fight“. Also it is very hard to exit the market for a company because exit of the company from this market can actually make lots of economic problems for economy in the country where company is situated. There are even other barriers for new companies to enter the market and one of them is legal barrier. This means that government will not grant permissions for new company to enter the market due to safety or other reasons (Water, oil gas companies).
Sometimes these companies that are the oligopoly collude in a cartel, that is a secret (against the law in most countries) cooperation with each other so they can control the market and keep prices high. When cartel is in action producing results are similar that to a monopoly, sometimes they are anti-competitive only by default, because they fear that direct competition would damage all of them. Their actions, therefore, try to take account of the reaction of other oligopolists; this usually happens when cartel is secret. Since it is uncertain, how will each company behave, whether they will cheat on cartel to make bigger profit or they will not, the behavior of an oligopoly is hard to predict. If companies realize that cartel is not working and other companies are breaking the rules of the cartel and cheat a price war breaks out. Oligopolists will produce and price much as a perfectly competitive industry would; at other times they act very like a monopoly.
Homogeneous, or pure, oligopoly involves rivalry among a few producers of products, which are identical with one another. Differentiated oligopoly involves rivalry among a few producers of products, which are similar (in the eyes of the purchasers) but not identical. Monopolist competition is another kind of market which also comprises rivalry among producers of differentiated products, but the market contains a large number of producers rather than just a few.
Oligopoly is considered a common market condition. A localized example of interdependence among a few is the location of three petrol stations on three corners of a rural intersection. If one lowers the price per gallon the others will follow or lose most of their business. Examples in national markets include the automobile industry, the tyre industry, the steel industry and the beer industry.
Some small firms may operate at the periphery in national markets dominated by a few, with their actions failing to elicit any reactions, but a giant firm must anticipate reactions from its fellows when it introduces a change. The other important thing in rivalry among companies in oligopoly is not just the price war, lowering and rising the prices in need of getting larger slice of market, more important in oligopoly is nonprice competition.
Companies are using their profit an unbelievable amount of money on nonprice competition, which is mainly advertising and product differentiation. Advertising is a very common thing in our lives but if we take a closer look at the advertising we realize that it is mainly these big companies that are making most of the advertising through out the world. It is very important for them because the market has its portions already made and it is very difficult for company to maintain that portion or even take a bigger portion of the market. Advertising is mostly the way to get ahead. They also use product differentiation even on products that are not even different for example they can use advertisement “Old foxes steel is better then any other“. Nonprice competition is actually considered among economists as one of the four oligopoly models. The second one is cartel that I already explained so the third model is kinked demand curve.
The kinked demand curve model oligopolists realize that when one company decrease their prices other companies will follow because they don‘t want to loose their portion of the market. But when one company decides to increase the prices other companies will ignore the prices and hope they can again take part of market with lower demand for goods supplied by company that raised its prices. If the firm cuts its price, their rivals will match the price decrease. A relatively large price decrease will, therefore result in a relatively small increase in sales that is called Inelastic Demand as shown on the graph bellow:
If the firm raises its price, their rivals will respond by ignoring the price change. A relatively small price increase will, therefore, result in a relatively large decrease in sales that is Elastic Demand as shown on the graph:
Firms realize their interdependence and that they will benefit if they cooperate in setting prices. The cooperation need not be through secret deals (although this has happened), because Price Leader may emerge.
Another characteristic of this market structure is "price rigidity".
Firms in this market structure use the same decision rule to maximize profit as in all other market structures.
To maximize profit, select the level of out put where Marginal Revenue = Marginal Cost.
You can realize from the graph above that the profit maximizing level of output and price (at the kink in the demand curve) is not going to change even though the costs to the firm change. When marginal cost increase from MC1 to MC2, the profit maximizing level of output does not change. MC1 and MC2 are equal to MR at the same level of output. The result is that prices in an oligopolistic market are less flexible than in other market structures. Costs can change, but prices might not. Firms may wait for the price leader to change the price. Firms in an oligopolistic market structure might have and usually have the goal of maintaining market share, rather than maximizing profit.
The last fourth oligopoly model is called price leadership. Price leadership is something that economists refer as a game of follow-the-leader, it is a pricing strategy that one leading or dominant company perhaps the one that owns the biggest market share sets the price for the whole industry and others will follow. Companies are sometimes matching the prices with the biggest company. This oligopoly model is very common. Oligopoly is a market structure even though is much more difficult to evaluate when compared to other market structures, is very common in today’s society and as we move on in new century and companies are getting bigger and more powerful every day, with the vision of global market it is certain that this market structure is going to be in the future world market a dominant market structure.
References
Tucker, I. B. (2000), Market structures; Monopolistic competition and oligopoly, Economic for Today. South-Western College Publishing.