Oligopoly is a market structure in which only few firms are having control over market supply and since there are high barriers of entry and exit from the oligopoly market, the existing firms enjoy the monopoly kind position.( Parkin, 2011) Following are some of the salient features of Oligopoly Market:
Firms operating under oligopoly are interdependent in the decision making process. The reason for the same is that the number of firms operating and competing in the market are very few and any change in price or output level by one firm will have a direct influence on the rival firms and as a result even the rival firms are forced to retaliate by changing in price and output. Thus, under oligopoly a firm not only consider its own demand curve but also of its rivals in the industry. Thus, no firm in oligopolist industry can fail to take into account the reaction of other firms to its price and output policies and therefore there is a strong interdependence among the firms under oligopoly.
2. Importance of advertising and selling costs:
Since the number of firms are very few in oligopoly market, each individual firms face intense competition from its rival firms and thus rely heavily on advertising of their products to lure the customers and enhance the demand of their own product. Thus, each firm employ aggressive and defensive weapons to gain a greater share in the market and to maximize sale. Unlike, perfect competition and monopoly market structure where advertisement and sales promotion are considered unnecessary, such expenditure is an extreme necessity of an oligopolist firm.(Varun, 2012)
3. Group behaviour:
Group behavior is another important feature of oligopolist market. Each firm under this market structure is involved in analysis of group behavior i.e behavior of other firms in the industry. Unlike in perfect competition and other market structures, where firms behave to produce maximum profits, firms under oligopoly are involved in group and thus profit maximization behavior on their part is not valid.
4. Indeterminateness of demand curve:
As already discussed, that a firm under oligopoly market are highly interdependent and this mutual interdependency creates uncertainity for all the firms in the industry. No firm under oligopolist market can predict the consequence of its price-output policy as the other rivals are likely to respond to this price-output change and no firm can judge as what will be the response of other firm. As a result, the demand curve facing an oligopolistic firm losses its determinateness. This is because demand curve can only be definite and determinate when we know the quantity that can be sold at different prices. But since we have uncertain demand, demand curve for a firm under oligopolist is indefinite and indeterminable.
5. Elements of monopoly and monopolistic market:
Oligopoly market structure also reflects some of the features of monopoly and monopolistic market structure. Each firm in the oligopoly industry, just like monopolistic firm, produces differentiated products and rely heavily on advertisement efforts. At the same sphere, each firm controls a large part of the market and thus acts as a monopolist in lining price and output.
6. Price rigidity:
Under oligopoly, price tends to be rigid and sticky. Thus, if any firm makes a price cut it is immediately followed by the rival firm by the same value. Thus, there is an environment of price war in the oligopolist industry Hence under oligopoly no firm resorts to price-cut without making price-output decision with other rival firms. The net result will be price -finite or price-rigidity in the oligopolistic condition.
Why firms under oligopoly collude?
Collusion is yet another characteristic of oligopolist industry and other features of the industry like intense competition and high interdependent decision making process encourages the oligopolist firms to collude. Since the firms within the oligopoly market structure dominate the industry they are characterized by the possible feature of collusion. In other words, since there are few firms operating in the industry, the existing firms has the incentive to collude and set a price level and output for the industry that maximizes their profit. Thus post collusion, prices will be higher than individual firm level while the output will be lower. At an extreme level, the firms entering into collusion may act as a monopoly by reducing their individual output so the colluded output would be equal to that of a monopolist allowing them to earn higher profits.(Amosweb, 2010)
However, it is important to note that collusion is only present in oligopoly market structure because of the very own features of oligopoly. In other words, suppose that there are only two firms dominating a product’s market and thus they are operating under oligopoly market. If both the firms operate individually promoting their own self interest, then they will work with the objective to gain market share and increase their output. Thus, with greater output from each individual firm, the output will be higher than the high profit monopoly quantity, will charge a lower price in comparison to monopoly firm and as a result both the firms will settle at smaller profits. Thus, it is the possibility of higher profits that gives only oligopolists an incentive to collude. However, the collusion itself is a complex term to understand both from definition, features and types and we discuss the same here under:
An illegal type of collusion which is also refered to as tacit collusion. Under this kind of collusion agreement, firms in oligopolist industry agree to control the market in a joint manner through more than interdependent actions. Price leadership is a best example of implicit collusion under which a firm which dominating or ace position holder firm fixes the price with a view to boost the profits of entire industry. Other firms have to follow this price, knowing that they stand to benefit from this price level. Important to note that when firms in the industry decides to follow price leadership, the price leader/dominating firm sets the price high enough so that the low cost efficient firm in the industry also earn some return above the competitive level.(Collusion and Competition, 2012)
This is more kind of a formal collusion among the firms in the oligopoly industry. Also refered to as Overt Collusion, under this agreement, firms under oligopoly industry with a desire to achieve maximum profit, jointly fix a price to prevent price and revenue instability in the industry and enters into price fixing agreement. Under this agreement, suppliers in the indsutry attempt to control the market supply and fix a price close to what a monopolist will fix. Cartels are the perfect examples of explicit collusion.
Whether Implicit or Explicit, collusion is always hard to find for the regulators as since collusion is deemed illegal under anti-trust laws of various countries, firms operating under oligopolist industry, seldom leave any official documentation that could prove that these firms jointly entered into an collusion to maximize the profitability.
Why firm Collude: Economic Analysis
- Higher Profits: The objective behind decision to collude is straightforward- Higher Profits. Total Profit is greater when firms collude than when they compete in the oligopoly industry. Thus, with the objective to earn higher profits, firm decides to collude so they charge a higher price and produce less output and develops a situation of monopoly in the market.
- Ability to drive out smaller firms: Another benefit of colluding is to drive out the small firms so the colluding firms acquire the left over market and then dominate the market collectively. For Example, Pepsi and Coca Cola the two dominating soft drink giants, if disturbed by any smaller firm, can decide to lower their prices in the beginning and when the small firm is driven out from the market, they both share the left over market share of smaller firm. Thus, once the small firms left the market, colluding firm’s becomes more effective. Thus, both Pepsi and Coca-Cola can now go for their main objective of increasing the prices and earn higher profits; by acting as a monopolist.
The above diagram provides insight as what happens to the price and output level when two firms collude in oligopolist industry. Here is a overview of the analysis:
- Two Firms: On individual basis, the cost curves of two oligopolist firms are presented above with cost curve of Pepsi being shown at far left and that of Coca Cola in the middle.
- Industry Marginal Cost: On collusion, the marginal cost curves of these two soft drink companies is combined and represented through industry’s marginal curve, labeled MCm, presented in the far right panel. This curve indicates the change in cost, using the production plants of both firms, that is incurred by producing one more unit of output.
- Demand and Marginal Revenue: Diagram at extreme right represents the combined demand curve of the soft drink market labeled D, while MR is the Marginal Revenue Curve of two firms after colluding.
- Profit Maximization: Just as monopoly, where output is produced at MR=MC, the profit for colluding firms is also maximized by equating MR= Mc and this is achieved at a quantity of 16,000 cans.(Amosweb, 2010)
- Setting Price: After the firms decide to produce output at equilibrium level of MR=MC, they now move ahead to set the price level at $1/can, a price which consumers are ready to pay for equilibrium quantity of 16000 cans
- Dividing Production: Now the equilibrium output production of 16000 cans is divided between Pepsi and Coca-Cola. This decision is based on their individual marginal cost and as a result, Pepsi produces 10000 cans and Coca Cola produces 6000 cans.
- Profit to Each: The profit received by each firm is then the difference between revenue generated at the $1 price and the total cost each firm incurs when producing its quota of soft drinks. This profit is indicated by the yellow areas.
Market Efficiency under Collusion:
The output produced and the price so fixed by firms operating under collusion agreement will be different than that of a perfectly competitive firm. As a result, colluding oligopolist firms are inefficient from the point of view of market efficiency. The efficiency of colluding firms is exactly same as that of a monopoly. Under collusion, price so fixed by the firms is higher than marginal cost of production while quantity is less which creates deadweight loss in the society. Now as we know that the colluding firms control the market like a monopolist, their demand curve will be negatively sloped and price will be greater than marginal revenue and since the objective of firms to collude was to earn maximum profits, the succeed by charging price higher than marginal cost and producing output at equilibrium of MR=MC.
- Amosweb (2010) COLLUSION, EFFICIENCY, Available at:http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=collusion (Accessed: 13th January, 2014).
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