Oligopoly and Marginal Cost Firms free essay sample

An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce competition and lead to higher costs for consumers. [1] With few sellers, each oligopolist is likely to be aware of the actions of the others. 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. Oligopoly is a common market form where a small number of firms are in competition. As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. For example, as of fourth quarter 2008, Verizon, ATT, Sprint, and T-Mobile together control 89% of the US cellular phone market. Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil. Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development. [citation needed] There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual 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. 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 firms in an industry than if, for example, the firms were only regionally based and did not compete directly with each other. Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the markets structure. In particular, the level of dead weight loss is hard to measure. The study ofproduct differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition. Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies: Stackelbergs duopoly. In this model the firms move sequentially (see Stackelberg competition). Cournots duopoly. In this model the firms simultaneously choose quantities (see Cournot competition). Bertrands oligopoly. In this model the firms simultaneously choose prices (see Bertrand competition). Characteristics[edit] Profit maximization conditions An oligopoly maximizes profits . Ability to set price Oligopolies are price setters rather than price takers. [2] Entry and exit Barriers to entry are high. The most important barriers are 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. [4] Number of firms Few – a handful of sellers. [3] There are so few firms that the actions of one firm can influence the actions of the other firms. [5] Long run profits Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits. Product differentiation Product may be homogeneous (steel) or differentiated (automobiles). [4] 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, cost and product quality. Interdependence The distinctive feature of an oligopoly is interdependence. 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 firms 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. [7] It is very much like a game of chess or pool in which a player must anticipate a whole sequence of moves and countermoves in determining how to achieve his or her objectives. For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices 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 high degree of interdependence and need to be aware of what other firms are doing or might do is to be contrasted with 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 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 firms 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. Modeling[edit] There is no single model describing the operation of an oligopolistic market. The variety and complexity of the models is because you can have two to 10 firms competing on the basis of price, quantity, technological innovations, marketing, advertising and reputation. Fortunately, 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 dominant firm model, the Cournot-Nash model, the Bertrand model and the kinked demand model. Cournot-Nash model[edit] Main article: Cournot competition The Cournot-Nash model is the simplest oligopoly model. The model assumes that there are two â€Å"equally positioned firms†; the firms compete on the basis of quantity rather than price and each firm makes an â€Å"output decision assuming that the other firm’s behavior is fixed. †[8] The market demand curve is assumed to be linear and marginal costs are constant. To find the Cournot-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 â€Å"to change what it is doing, given how it believes the other firm will react to any change. 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. [10] 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,[11] and M=60 is the market. Assume that marginal cost is CM=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 RT = Q1 P= Q1(M Q2 Q1) = M Q1- Q1Q2 Q12. The marginal revenue function is . [note 1] RM = CM M Q2 2Q1 = CM 2Q1 = (M-CM) Q2 Q1 = (M-CM)/2 Q2/2 = 24 0. 5 Q2 [1. 1] Q2 = 2(M-CM) 2Q2 = 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 Cournot-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. [12] The reaction functions are not necessarily symmetric. [13] The firms may face differing cost functions in which case the reaction functions would not be identical nor would the equilibrium quantities. Bertrand model[edit] Main article: Bertrand competition The Bertrand model is essentially the Cournot-Nash model except the strategic variable is price rather than quantity. [14] 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 PA and PB simultaneously Firms outputs are perfect substitutes Sales are split evenly if PA = PB[15] The only Nash equilibrium is PA = PB = 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. [16] The Bertrand equilibrium is the same as the competitive result. [17] Each firm will produce where P = marginal costs and there will be zero profits. [14] A generalization of the Bertrand model is theBertrand-Edgeworth Model that allows for capacity constraints and more general cost functions. Kinked demand curve model[edit] Main article: Kinked demand According to this model, each firm faces a demand curve kinked at the existing price. [18] 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 firms output will increase only marginally. [19] If the assumptions hold then: The firms marginal revenue curve is discontinuous (or rather, not differentiable), and has a gap at the kink[18] For prices above the prevailing price the curve is relatively elastic [20] For prices below the point the curve is relatively inelastic [20] The gap in the marginal revenue curve means that marginal costs can fluctuate without changing equilibrium price and quantity. [18] Thus prices tend to be rigid. Examples[edit] In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. Market shares in an oligopoly are typically determined by product development and advertising. For example, there are now only a small number of manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have participated in the small passenger aircraft market sector. Oligopolies have also arisen in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate. Australia[edit] Most media outlets are owned either by News Corporation, Time Warner, or by Fairfax Media[21] Grocery retailing is dominated by Coles Group and Woolworths. Banking is dominated by ANZ, Westpac, NAB, and Commonwealth Bank. To an extent this oligopoly is enshrined in law in what is known as the Four pillars policy, in order to ensure the stability of Australias banking system. Most of the telecommunications in Australia is delivered by Telstra or Optus. Other brands are virtual network operators (VNO). Canada[edit] Six companies (Royal Bank of Canada, Toronto Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada) control the banking industry. As of 2008, three companies (Rogers Wireless, Bell Mobility and Telus Mobility) share over 94% of Canadas wireless market. [22][23] 4 companies control the internet service provider market, (Rogers), (Bell), (Telus), (Shaw) 8 companies control the oil and gas market, (Husky Energy) (Imperial Oil) (Nexen) (Petro-Canada) (Shell Canada) (Suncor Energy) (Syncrude Canada) (Talisman Energy) India[edit] The petroleum and gas industry is dominated by Indian Oil, Bharat Petroleum, Hindustan Petroleum and Reliance. Most of the telecommunication in India is dominated by Airtel, Vodafone,Idea, Reliance European Union[edit] The VHF Data Link market as air-ground part of aeronautical communications is controlled by ARINC and SITA, commonly known as the organisations providing communication services for the exchange of data between air-ground applications in the Commission Regulation (EC) No 29/2009. United Kingdom[edit] Five banks (Barclays, Halifax, HSBC, Lloyds TSB and Natwest) dominate the UK banking sector, they were accused of being an oligopoly by the relative newcomer Virgin bank. Four companies (Tesco, Sainsburys, Asda and Morrisons) share 74. 4% of the grocery market. The detergent market is dominated by two players, Unilever and Procter Gamble. [26] Six utilities (EDF Energy, Centrica, RWE npower, E. on, Scottish Power and Scottish and Southern Energy) share 99% of the retail electricity market. [27] United States[edit] Many media industries today are essentially oligopolies. Six movie studios receive almost 87% of American film revenues. [28] The television and high speed internet industry is mostly an oligopoly of seven companies: The Walt Disney Company, CBS Corporation, Viacom, Comcast, Hearst Corporation, Time Warner, and News Corporation. See Concentration of media ownership. Four wireless providers (ATT Mobility, Verizon Wireless, T-Mobile, Sprint Nextel) control 89% of the cellular telephone service market. [30] This is not to be confused with cellular telephone manufacturing, an integral portion of the cellular telephone market as a whole. Healthcare insurance in the United States consists of very few insurance companies controlling major market share in most states. For example, Californias insured population of 20 million is the most competitive in the nation and 44% of that market is dominated by two insurance companies, Anthem and Kaiser Permanente. [31] Anheuser-Busch and MillerCoors control about 80% of the beer industry. [32] In March 2012, the United States Department of Justice announced that it would sue six major publishers for price fixing in the sale of electronic books. The accused publishers are Apple, Simon Schuster Inc, Hachette Book Group, Penguin Group, Macmillan, and HarperCollins Publishers. [33][34][35] Worldwide[edit] The accountancy market is controlled by PriceWaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu, and Ernst Young (commonly known as the Big Four)[36] Three leading food processing companies, Kraft Foods, PepsiCo and Nestle, together achieve a large proportion[vague] of global processed food sales. These three companies are often used as an example of Rule of three,[37] which states that markets often become an oligopoly of three large firms. Boeing and Airbus have a duopoly over the airliner market. [38] General Electric, Pratt and Whitney and Rolls-Royce plc own more than 50% of the marketshare in the airliner engine market. Three credit rating agencies (Standard Poors, Moodys, and Fitch Group) dominate their market and extend their crucial importance into the financial sector. See Big Three (credit rating agencies). Nestle, The Hershey Company and Mars, Incorporated together make most of the candy made worldwide. Microsoft, Sony, and Nintendo dominate the video game console market. Demand curve[edit] 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 themarginal 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 costs 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. 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. Firms will often enter the industry in the long run.