Download Oligopoly – Non Collusive Behaviour

Oligopoly – Non Collusive Behaviour
What is an oligopoly?
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An oligopoly is an imperfectly competitive industry where there is a high level of market
concentration. Examples of markets that can be described as oligopolies include the markets for
petrol in the UK, soft drinks producers and the main high street banks. In the global market for sports
footwear – 60% is held by Nike and Adidas
Oligopoly is best defined by the actual conduct (or behaviour) of firms within a market
The concentration ratio measures the extent to which a market or industry is dominated by a few
leading firms. A rule of thumb is that an oligopoly exists when the top five firms in the market
account for more than 60% of total market sales.
What are the main characteristics of an oligopoly?
An oligopoly usually exhibits the following features:
1. Product branding: Each firm in the market is selling a branded product which is built and protected
by heavy spending on advertising and marketing
2. Entry barriers: Entry barriers maintain supernormal profits for the dominant / established firms. It is
possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of
them is large enough to have any significant effect on prices and output
3. Inter-dependent decision-making: Inter-dependence means that firms must take into account the
likely reactions of their rivals to any change in price, output or forms of non-price competition
4. Non-price competition: Non-price competition is a consistent and crucial feature of the competitive
strategies of oligopolistic firms especially when they are growing or defending market share
There is no single theory of price and output under oligopoly. If a price war breaks out, oligopolists may
produce and price much as a highly competitive industry would; at other times they act like a pure monopoly.
Duopoly
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Duopoly is a form of oligopoly. In its purest form two firms control all of the market, but in reality
the term duopoly is used to describe any market where two firms dominate
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Examples of duopolistic markets: There are many examples of duopoly including the following:
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Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble (detergents)
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Bloomberg and Reuters (Financial information services), Sotheby’s and Christie’s
(auctioneers of antiques/paintings)
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Airbus and Boeing (aircraft manufacturers)
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US diesel locomotive market is a duopoly of General Electric’s GE Transportation and
Caterpillar’s EMD
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Glencore and Trafigura form a duopoly that controls as much as 60 per cent of some
markets, such as zinc
In these imperfectly competitive markets entry barriers are high although there are usually smaller players
in the market surviving successfully. The high entry barriers in duopolies are usually based on one or more
of the following: brand loyalty, product differentiation and huge research economies of scale.
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Analysis: The Kinked Demand Curve Model of Oligopoly
Costs
Revenues
Raising price above P1
Demand is relatively elastic because
other firms do not match a price rise
Assume we start out at P1 and Q1:
Firm loses market share and some
total revenue
Will a firm benefit from raising price
above P1?
Will it benefit from cutting price below
P1?
P1
Reducing price below P1
Demand is relatively inelastic
Little gain in market share – other firms
have followed suit in cutting prices
Total revenue may still fall
AR
Q1
MR
Output (Q)
The kinked demand curve model assumes
that a business might face a dual demand
curve for its product based on the likely
reactions of other firms to a change in its
price or another variable.
The common assumption is that firms in an
oligopoly are looking to protect and maintain
their market share and that rival firms are
unlikely to match another’s price increase
but may match a price fall. I.e. rival firms
within an oligopoly react asymmetrically to a
change in the price of another firm.
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If a business raises price and others leave their prices constant, then we can expect quite a large
substitution effect making demand relatively price elastic. The business would then lose market
share and expect to see a fall in its total revenue.
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If a business reduces its price but other firms follow suit, the relative price change is smaller and
demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in revenue with
little or no effect on market share.
The kinked demand curve model makes a prediction that a business might reach a stable profitmaximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.
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The kinked demand curve model predicts there will be periods of relative price stability under an
oligopoly with businesses focusing on non-price competition as a means of reinforcing their market
position and increasing their supernormal profits.
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Short-lived price wars between rival firms can still happen under the kinked demand curve model.
During a price war, firms in the market are seeking to snatch a short term advantage and win over
some extra market share.
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Recent examples of price wars include the major UK supermarkets, price discounting of computers in China
and a price war between cross channel speed ferry services. Price competition is frequently seen in the
telecommunications industry.
Changes in costs using the kinked demand curve analysis
One prediction of the kinked demand curve model is that changes in variable costs might not lead to a rise or
fall in the profit maximising price and output. This is shown in the next diagram where it is assumed that a
rise in costs such as energy and raw material prices leads to an upward shift in the marginal cost curve from
MC1 to MC2. Despite this shift, the equilibrium price and output remains at Q1. It would take another hike in
costs to MC3 for the price to alter.
Price (P)
MC3
MC2
P2
MC1
P1
Increase in marginal cost from
MC2 to MC3 does lead to a
change in output and price
Increase in marginal cost
from MC1 to MC2 does not
lead to a change in the profit
maximising price and output
AR
Q2
Output (Q)
Q1
MR
There is limited real-world evidence for the kinked demand curve model. The theory can be criticised for
not explaining why firms start out at the equilibrium price and quantity. That said it is one possible model of
how firms in an oligopoly might behave if they have to consider the responses of their rivals.
Importance of Non-Price Competition under Oligopoly
Oligopolistic theory predicts that firms in this market structure will
tend to prefer non-price competition rather than price
competition due to the self-defeating outcome of a price-war.
Non-price competition involves advertising and marketing
strategies to increase demand and develop brand loyalty among
consumers.
Businesses will use other policies to increase market share:
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Better quality of customer service including
guaranteed delivery times for consumers and low-cost
servicing agreements, good after-sales service
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Longer opening hours for retailers, 24 hour online customer support.
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Discounts on product upgrades when they become available in the market.
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Contractual relationships with suppliers - for example the system of tied houses for pubs and
contractual agreements with franchises (offering exclusive distribution agreements). For example,
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Apple has signed exclusive distribution
agreements with T-Mobile of Germany, Orange in
France and O2 in the UK for the iPhone. The
agreements give Apple 10 percent of sales from
phone calls and data transfers made over the devices
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BOGOF techniques – buy one, get one free tactics
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Loyalty cards, free delivery, online ordering, free gifts,
guarantees
Advertising spending runs in millions of pounds for many
firms. Some simply apply a profit maximising rule to their
marketing strategies. A promotional campaign is profitable if
the marginal revenue from any extra sales exceeds the cost
of the advertising campaign and marginal costs of producing
an increase in output. However, it is not always easy to
measure accurately the incremental sales arising from a
specific advertising campaign. Other businesses see
advertising simply as a way of increasing sales revenue. If
persuasive advertising leads to an outward shift in demand,
consumers are willing to pay more for each unit consumed.
This increases the potential consumer surplus that a business
might extract.
High spending on marketing is important for new business
start-ups and for firms trying to break into an existing market
where there is consumer or brand loyalty to the existing
products in
Brands and Non Price Competition
Brands provide clarity and guidance for
choices made by companies, consumers,
investors and other stakeholders. They
embody a core promise of values and
benefits consistently delivered and provide
the signposts needed to make decisions
Global Top Brands for 2013
Apple
Google
IBM
McDonald’s
Brand loyalty
A brand name is a name used to distinguish one product
from its competitors. It can apply to a single product, an entire
product range, or even a company (e.g. Virgin, Ferrari, Bang
and Olufsen)
Brand loyalty is hugely important in all kinds of industries and
markets. The costs of acquiring a new customer vastly
outweigh the expense of selling more to existing buyers and
most of the mobile phone suppliers in this oligopolistic
industry focus an enormous effort in building brand identity
and brand loyalty to reduce the rate of customer churn
(people who switch brands).
When brand loyalty is strong, the cross-price elasticity of
demand for price changes between two substitutes weakens
and fewer consumers will switch their demand when there is a
change in relative prices in the market. Robust brand loyalty
makes it easier to charge premium prices and enjoy
supernormal profits in the long run because loyalty is a barrier
to entry. When we become strongly attached to a brand, our
purchasing decisions are more likely to stay in default mode
and we may no longer even consider rival products.
Coca Cola
AT&T
Microsoft
Marlboro
Visa
China Mobile
General Electric
Verizon
Wells Fargo
Amazon
UPS
Vodafone
Walmart
SAP
MasterCard
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Non Price Competition
Competitiveness – a key to success in an oligopoly
Traditionally, the main measures of competitiveness are in financial or marketing terms. For example, a
competitive business might be expected to achieve one or more of the following:
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A higher growth rate (sales, revenues) than competitors and the market as a whole
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Higher-than average net profit margin (compared with others in the same industry)
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Better than average returns on investment – again, compared with competitors
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A high (perhaps leading) market share – measured in either value or volume terms. The leading
firms in a market usually enjoy a significant proportion of the available revenues or customer
demand, unless the market is highly fragmented.
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The strongest brand reputation in the market – e.g. brand awareness
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A clearly defined unique selling point (“USP”) that enables the business to differentiate its product or
service in the eyes of customers
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Significant access to, or control of, distribution channels in the market (e.g. products or brands that
are widely stocked or demanded by intermediaries who provide distribution to the final consumers)
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Better product quality – e.g. reliability, product features, performance
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Better customer service – e.g. after-sales support, customer information, handling of problems &
complaints
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Better than average efficiency – e.g. being able to produce at a lower unit cost than most other
competitors, either though better productivity or economies of scale
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Case Study: Oligopoly and Duopoly in UK Bus Markets
The UK Competition Commission has published an important
report into the market structure of local and regional bus
services in the UK, twenty-five years after the industry was
deregulated and largely privatised
Largely as a result of a long-term process of consolidation
through merger and acquisition, the UK bus industry is found
to be highly concentrated with five businesses dominating the
sector even though more than 1,200 businesses provide
services.
The five largest operators (Arriva, FirstGroup, Go-Ahead,
National Express and Stagecoach) carry 70 per cent of those
passengers. The CC also found that head-to-head competition
between operators is un-common and that-on average-the largest operator in an urban area runs 69 per cent
of local bus services - effectively a monopoly position.
Because of the absence of genuine in competition in many towns and cities, the Competition Commission
argued that market power had lead to passengers facing less frequent services and, in some cases, higher
fares than where there is some form of rivalry.
The Commission wants to increase the contestability of the market and proposes better ticketing, better
customer information, and fair access for all operators to bus stations and closer scrutiny of future bus
company mergers. Most areas are served by just one or two operators with a significant share of supply
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Low price elasticity of demand - the report found that changes in the fare or service on existing
services offered by local bus operators had little effect on passengers’ overall use of the bus. It found
that the price elasticity of bus demand, from all individuals in the sample, with respect to bus fares is
–0.36 (i.e. inelastic). No significant differences were found for the time of day suggesting little actual
difference in Ped between peak and off-peak times
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Business stealing effects: The Commission finds this is a key feature of the market; most
customers board the first bus heading towards their destination rather than compare prices between
rival operators. If an operator increases its frequency, the increase in demand for its services will
largely be as a result of customers switching from other operators, rather than as a result of an
increase in the total market demand for bus services.
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Multi-modal competition: The CC report finds that price elasticity of demand for bus service is
always low and nearly always less than -0.5 which provides an opportunity for operators to increase
fares and raise profit margins. But the bus operators claim that multi-modal competition provides a
constraint on their pricing power even when they have a local monopoly. Higher fares might prompt
people to use a car or take local rail and tram services if they are available. Fare rises might also be
limited by the risk of creating adverse publicity in local areas
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Rates of return (profit): Bus operators have earned profits that were persistently above the cost of
capital on a national basis suggesting some supernormal profits for these businesses. The overall
average rate of return on capital employed (ROCE) for the five-year period investigated was 13.5%.
Profitability at the end of the 5 year investigation period were higher than at the start
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Barriers to entry: Sunk costs of bringing a route to profitability are high as are the risks from an
intensity of post-entry competition as incumbent operators react and respond to new bus operators
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Competition Commission
concerned about lack of
competition in the UK cement
industry
The Competition Commission (CC)
has finishes a market investigation into
the supply of aggregates, cement and
ready mix concrete (RMX) in Great
Britain and has concluded that
coordination between the three major
cement producers (Lafarge Tarmac,
Cemex and Hanson) in the cement
market is likely to be resulting in
higher prices for all cement users.
The CC’s finding does not relate to explicit
collusion between these producers. Rather, as
the cement market is highly concentrated with only four GB producers (Hope Construction Materials (HCM)
being a new entrant), who have an unusually high level of understanding of each other’s businesses—this
has created conditions which allow three of them to coordinate their behaviour, thereby softening competition
and resulting in higher prices for consumers.
The CC is now looking at a wide range of possible remedies to increase competition in the cement market,
including requiring the major producers to divest (sell) cement plants (and RMX operations as part of the
remedy to coordination in cement).It may also look into the creation of a cement buying group to rebalance
the power in the market between sellers and purchasers.
Despite low demand for cement over recent years, prices and profitability for UK producers have still
increased.
Adapted from news reports, June 2013
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