Concept of Oligopoly 1 CONCEPT OF OLIGOPOLY

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1 Concept of Oligopoly 1 CONCEPT OF OLIGOPOLY By Course Tutor Date

2 Concept of Oligopoly 2 Concept of Oligopoly applying real data and theory An oligopoly can be defined as a market structure in which few firms dominate. Markets that are shared between few firms are observed to be highly concentrated. Despite few firms dominating the market, it is ultimately possible that multiple small firms may also operate within the market. A good example would be that of major airlines like Air France, and British Airways operate their routes which have very few close competitors, but there are many small airlines offering specialist services and catering for holidaymakers. Oligopolies have some characteristics that define them. Interdependence is a key characteristic for firms operating in markets with few close rivals. Most firms operating in environments with few competitors must take up the potential reaction of its closest competitor into account when making its crucial decisions. For example, if a petrol retailer like Caltex wishes to increase its share buy cutting prices, it must realize the possibility that the competitors may reduce their price as a symbol of retaliation. The concept of interdependence can best be appreciated by understanding Prisoner's Dilemma and game theory. Firms that are interdependent should also highly value the impact of strategy. Firms must anticipate the probable response of a rival to changes in non-price activity and change in their prices. In other words, they need to work out and plan a variety of possible options based on how they predict their rivals will react. Strategies such as whether to compete or collude with rivals should initially be set. Price change and movement strategy is also key to maintaining a client base. Usage of already proven strategies such as 1 st and 2 nd mover strategy, where the firm has the option of implementing a new strategy first or wait to see the rival s move.

3 Concept of Oligopoly 3 Oligopolies are well known to maintain largely their dominance in the specific market because it is either difficult or too costly for rivals to infiltrate the market. Most incumbent firms erect barriers to entry deliberately or exploit existing natural barriers. These situations include economies of scale that deter new entrants because incumbents have already exploited. Control and ownership of scarce resources that entrants may require to setup, their firms is also considered a major entry barrier. Initial market entry is deterred by high set-up costs because they swell break-even output. Sunk costs support the oligopolies because they are costs that cannot be recovered when a firm leaves the market which include advertising and marketing costs among other fixed costs. According to Kopel (1996), oligopolies also utilize artificial entrants to bar new entrants into the market. Predatory pricing is a strategy oligopolies use to push deliberately prices to low levels to out rivals. Limit pricing is also very efficient for oligopolies and slightly similar to predatory pricing. The incumbent business implements high low output and low prices so that entrants cannot gain any profits at that price. Prices are set just below the average total costs of the entrants which signal how difficult it is to make profits. Incumbents also have the advantage of having a superior level of knowledge of its customers, market and production costs. Exclusive licenses, patents, and contracts are among the latest artificial strategies oligopolies are using. This strategy favors existing firms who own licenses or who have won contracts; in most cases retailers are barred from entering the market. A strategy that ties up the supply chain makes it very hard for new entrants. For example, electronic manufacturers such as Sony having its retail outlets discourages retail entrants. Cost plus pricing is very common among oligopolies; this is because the precise calculation of marginal revenue and marginal cost is very difficult and hence regarded to as

4 Concept of Oligopoly 4 information failure response. It is also common in the oligopoly market because few firms that dominate share similar costs. With such rigid pricing, there is the risk that rivals could adopt a better-discounting formula to gain market share. Game theory application can explain cost-plus pricing. Where the firm with the greatest market share or the dominant firm uses cost-plus pricing and the others follow-suit so that the strategy acts as the price rule. This rule allows other firms to abide by the price rule hence takes the risk out of pricing decisions. Oligopoly theory states that once the price is determined, it will stick at that level. This can be supported by the fact that the firms cannot pursue independent strategies. For example, an airline raises its ticket prices from New York to London, rivals will not necessarily follow suit, and this leads to the airline losing revenue. The demand curve for the price in this situation is relatively elastic; rivals do not have a tangible reason to follow suit because it is to their advantage to maintain their price level. However, if it lowers its prices, the rest will also be forced to lower their prices. Again, in this situation the airline loses market share and sales revenue since the demand curve here is relatively inelastic. At the end of the day, the main purpose of oligopolies is to maximize profits. If marginal costs and marginal revenue are added it is feasible to prove that profits will be maximized at price P. Whenever MC cuts MR in its vertical portion and MC=MR, profits will always be maximized at P. Price sticks at P even if MC changes within the vertical portion of the MR curve. In cases where MC moves out of the vertical portion, the price effect is minimal. Hence, consumers don't benefit from cost reduction. Common oligopolies in the real life scenario are such as the airline industry, brewing, banking, supermarkets, music and soft drinks. For example, music production, distribution, and manufacture in the USA, UK and within the EU is very concentrated, with a concentration ratio of 75% and is regarded to as an oligopoly. Oligopoly is

5 Concept of Oligopoly 5 significant and will remain relevant to the private enterprise sector. It s correct to state that oligopoly is less homogeneous than what is mostly implied. Concept of Oligopoly problem analysis using theoretical model Parameter indexing in an oligopoly solution is identified using standard econometrics format, even with no profit or cost data available, and even when cost and demand curves require to be estimated. Comparative statics of equilibrium, as quantity and price are shifted by exogenous variables, reveal the extent of market power. The models treated will all contain quantity determined and market prices by the intersection of a supply relation and demand function. Demand function, in this case, utilizes price taking buyers. The supply relation is expressed as a supply function solution of P=MC. A more generalized supply relations occurs when the seller have market power. These are indicated in the form MRp, =MC which means that perceived marginal revenue equals marginal cost. When MR=P, this is an indication that competition is present. In cases when sellers are altering monopoly price, we observe that MRp=MR. When MRp<P, it means that there are some elements of market power. This is the point where it is observed if quantities and prices in the industry can reveal whether some small number or price is set equal marginal cost when the cost function and the demand function are unknown. The model of this can be stated using its statistical theorems and proofs. For example; if buyers possess a typical demand function: Q=D (P, Y, α) +є, where Q is quantity, Y an exogenous variable, P price, є is an econometric error term, and the value α are the parameters of the demand system to be estimated. In the situation where the seller is the price dominants, we can write: P=c (Q, W,β)-Ϡ.h(Q, Y,α)+ɳ, Where marginal revenue is P+h(), marginal revenue as

6 Concept of Oligopoly 6 perceived by the business, exogenous variables, and demand-side parameters are in h() because of their effect on marginal revenue. The new degree indexing market power degree is Ϡ. When there is perfect competition, Ϡ=0, when there are a perfect cartel Ϡ=1 and the value corresponding to other concepts of oligopoly solution is Ϡ s. For example, Ϡ=1/n being the Cournot equilibrium as stated by Kopel 1996,will show that the econometrician will estimate the above formulas simultaneously while treating quantity and price as endogenous. To prove that a cartel and completion are observationally distinct; we let marginal cost and demand be linear which translates the demand function to be Q=α0+ α1p+ α2y+є, the demand has one endogenous variable, and it possesses an excluded exogenous variable. The marginal cost function to be MC=β0+ β1q+ β2w+ɳ, since NR=P-Q/α. Identification of the demand equation is a must no matter the form supply relation takes. When supply relation is identified, and the degree of market power isn t identified, we require to format the first assertion as: P= β0+ϒq+ β2w+ɳ, where ϒ= β1-ϡ/α1. In this case, we can estimate ϒ depending on both β1 and Ϡ but we cannot it is impossible to derive both from the knowledge of ϒ though α1 can be treated as known value since we can estimate the demand curve. If MCm is the supply relation for the cartel with flatter, lower marginal cost MCm or competitor for whom marginal cost is MCc, we conclude that marginal costs here have no observable distinction between monopoly and hypothesis of the competition. This problem may be solved by generalizing of the demand function to achieve exogenous variable movements that do more than shift the intercept vertically. In this scenario, instead of shifting the demand curve up and down to achieve D2-MR2 we now rotate E1 to get D3-MR3. When the supply relation is the supply curve, there is no effect on the equilibrium. Whereby, if marginal cost is MCc and there is perfect competition, then E1 should be the equilibrium point under either D3 or D1. If

7 Concept of Oligopoly 7 supply and marginal cost curve MCm were a monopoly, we observe an equilibrium shift to E3 when MR3= MCm. If we can shift and rotate the demand function, the hypothesis of monopoly and competition are distinct. Consequently, change the demand equation to Q=α0+ α1p+ α2y+ αpz+ α4z+є; Z being the new demand-side exogenous variable. Here, P and Z enter interactively so that when changes occur in Y and Z they combine elements of both vertical and rotational shifts in demand. Z is best viewed as the price of substitute goods and Y interpreted as income to make the interaction natural. At this point, the supply relation is altered to P= [-Ϡ / (α1+ α3z)] Q +β0+ β1q+ β2w+ɳ; here α1 and α3 are treated as known. The logic of this principle holds even when the curves are not linear. Supply relation is always traced out by the demand curve's translation. The revelation of the degree of market power occurs when the demand curve rotates around the equilibrium point. The general assumption is that some rotations will not affect the equilibrium when pricing is competitive but will be affected if there is market power. It is fit to conclude that, the hypothesis of monopoly and competition are distinct. According to Puu (2005), growing and substantial literature presented models of a complex dynamic oligopoly of diverse sorts. Modern mathematics of complexity theory and nonlinear dynamics has beard the burden that has risen yet with many interesting and fruitful results demonstrated. According to Kopel (1996), It has been observed on the occasion when Cournot introduces calculus to economics study rand and duopoly to expound on oligopoly in the chaos theory. In the theory, if the monopolist becomes suspicious about his market behaving like a random number generator, the trend could be because of the exogenous shift in the demand function due to changing business cycle or changing prices of close substitutes. No regular periodic behavior should cause alarm because all economic phenomenon are crowded with

8 Concept of Oligopoly 8 different regular periodic cycles. It occurs even with more complex cases with greater reference and force involving oligopolies and their conduct.

9 Concept of Oligopoly 9 References Kopel, M., Simple and complex adjustment dynamics in Cournot duopoly models. Chaos, Solitons & Fractals, 7(12), pp Puu, T., Complex oligopoly dynamics (pp ). Springer Vienna. Rosser Jr, J.B., The development of complex oligopoly dynamics theory. In Oligopoly Dynamics (pp ). Springer Berlin Heidelberg.