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Oligopoly – Non Collusive Behaviour What is an oligopoly? 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 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 Examples of duopolistic markets: There are many examples of duopoly including the following: o Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble (detergents) o Bloomberg and Reuters (Financial information services), Sotheby’s and Christie’s (auctioneers of antiques/paintings) o Airbus and Boeing (aircraft manufacturers) o US diesel locomotive market is a duopoly of General Electric’s GE Transportation and Caterpillar’s EMD o 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. © Tutor2u Limited 2014 www.tutor2u.net 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. 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. 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. 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. 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. © Tutor2u Limited 2014 www.tutor2u.net 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: o Better quality of customer service including guaranteed delivery times for consumers and low-cost servicing agreements, good after-sales service o Longer opening hours for retailers, 24 hour online customer support. o Discounts on product upgrades when they become available in the market. o Contractual relationships with suppliers - for example the system of tied houses for pubs and contractual agreements with franchises (offering exclusive distribution agreements). For example, © Tutor2u Limited 2014 www.tutor2u.net 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 o BOGOF techniques – buy one, get one free tactics o 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 © Tutor2u Limited 2014 www.tutor2u.net 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: A higher growth rate (sales, revenues) than competitors and the market as a whole Higher-than average net profit margin (compared with others in the same industry) Better than average returns on investment – again, compared with competitors 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. The strongest brand reputation in the market – e.g. brand awareness A clearly defined unique selling point (“USP”) that enables the business to differentiate its product or service in the eyes of customers 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) Better product quality – e.g. reliability, product features, performance Better customer service – e.g. after-sales support, customer information, handling of problems & complaints 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 © Tutor2u Limited 2014 www.tutor2u.net 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 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 © Tutor2u Limited 2014 www.tutor2u.net 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. 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 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 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 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 © Tutor2u Limited 2014 www.tutor2u.net