Tuesday, 25 February 2014

Oligopoly - what's there to fear?

Oligopolies - are they so troublesome?

Running through an overview of oligopoly with one of my students last night, several issues came up.

Oligopolies are defined as markets in which only a few dominate. The structure contrasts with (a) monopoly in which only one firm exists and (b) competitive markets in which many firms compete with one another. Oligopoly sits in the middle. Not surprisingly, there are two ways of looking at oligopoly - either as monopolies or as competitive structures.

1) Oligopolies as monopolies

These few are said then to collude either formally or informally on setting prices and thereby act as monopolies. They may, for instance, ensure that profits are shared equally, or that new customers or markets are shared proportionally.

They may engage in predatory pricing in which they reduce prices below cost to scare away the competition.

Ultimately, they aim to screw the customer by exploiting markets and using the power gained from possessing a large market share.

The few companies that exist in the market aim to create a cartel - an explicit contract between the firms to regulate profits, quality, market share, etc. Thereby they can form a monopoly of sorts.

Accordingly, the government is required, so it assumed, to enter the market to monitor such collusive activity and penalise companies when they act uncompetitively.

This is from the greatest monopoly in the nation of course. Government. If you think that markets fail (which by definition they don't - markets are always right), you must also look into government failure.

Governments tend to like oligopolies (and monopolies). They like dealing with a few contenders in the market place rather than thousands of small companies. That's why western governments have been trying to remove competition from farming - they know that nationalisation and the formation of  a single government enterprise would prove a disaster (cf. USSR collectivisation of farming), so governments prefer to use the 'market' and then manipulate it by imposing subsidies and restrictions to cause smaller farms to drop out of production leaving a few big players to cajole and politicise.

In a sense, government policy towards the big oligopolies is reminiscent of Tudor policy regarding the creation of state licensed enterprises that were given a monopoly on trade in certain areas of the world ... in return for a big licence fee (tax).

2) Oligopolies constrained

On the other hand, oligopolies are also constrained - according to the wonderfully entitled kinky, I mean, kinked demand curve - on what they can actually do.

The theory here is that if an oligopolist decides to raise prices, then its competitors will not follow suit as they will experience rising turnover from disgruntled customers rushing over to buy the now relatively cheaper produce.

If the oligopolist then thinks, ah, I should have lowered my prices. So then he lowers them and finds that the competition this time does follow suit thereby undermining his ability to gain higher revenues.

In economics parlance, the demand curve above the status quo price is elastic and inelastic below.

In a sense, the oligopolist is damned if he increases prices and damned if he lowers them. Accordingly, this creates a stable price from which we are not likely to see much movement.

The level of profits depends on the average costs of production. The model suggests that firms will shuffle around until a stability emerges and for which long run average costs can't be pushed further without a technological change in production. LRAC curve is assumed to have more of a tea-cup shape rather than a quadratic curve:


The oligopoly model splits into two - either oligopolies are assumed to act as monopolies and so empower themselves at the cost of the customer or they are assumed to constrain themselves by virtue of the structure of the market. 

However, what is often missing in the textbooks is an analysis of the dynamics of markets and the formation of the barriers to entry that supposedly hold back competition. 

Firstly, barriers to entry only make sense when there are legal impediments to competing with the big companies. If they have managed, through lobbying, to secure a range of licences and other prerequisites required off the government to permit production, then the barriers to entry are legal. Such barriers are true impediments that restrict free competition and hence the smaller companies cannot gain a foothold in the market place without investing heavily in securing the legal right to compete. 

All such barriers are inimical to trade and freedom of course. They secure the oligopoly's ability to maintain a quasi-monopolistic structure over time and thereby encourage the earning of higher than otherwise profits. If such companies hold their market place by virtue of a government quota (only five companies may run mobile phone licences, for instance)

The only manner in which other firms may compete is through attracting enough capital from the large firms and banks. The budget airlines successfully did this (not without a fight from the state subsidised airlines though!) - they were able to surmount the barriers through their own market power gained either through raising capital or from the profits from other sectors. 

Secondly, other barriers to entry are market produced but are no active restraint on competition. The only true restraint is legal. The theory is that high research and development costs, or economies of scale gained by large corporations, or the high marketing budgets of the big companies, or brand loyalty all act to put off would-be competitors. Well, they might put off salaried academics in university departments but they do not put off business people. Where there is a profit to be sniffed out, entrepreneurs will find a way to compete and offer a better service or a niche service not offered by the large companies. 

The market place is dynamic - it is always changing. 

Each so-called barrier is in effect a psychological barrier putting off some people - but not all.

High marketing costs? Not heard of Twitter/facebook or word of mouth?
High research costs? Not met any sole producers of organic health supplies?
Economies of scale? Small companies can run on lower costs than large companies; they can club together to gain access to bulk ordering.

Business people are in business. They are not in government. That is a world of difference: the entrepreneur's goal is to serve as many people as possible, for then they attract more of what they want in life. Impediments are often merely psychological barriers and can easily be overcome. 

What stops many people from succeeding in the market place is not the presence of barriers to trade (unless they are legal) but the fear of doing things wrong and losing money. Such fears can be overcome - that's what entrepreneurs specialise in.

An alternative view: the Austrian theory of oligopoly. (From Salin)

In a nutshell, as long as there are no legal barriers to entry, informal or even formal agreements are not wrong in themselves.  

When they are legislated, the trip over into the realm of anti-competitive measures. 

The number of firms in an industry does not have meaning. The notion that markets should be perfectly competitive is a Platonic notion that has no real meaning in the market place - firms distinguish themselves through differentiation rather than through having a few or many competitors.

Where they do converge onto similar standards or homogeneous products, there are usually technical reasons for doing so (e.g., digital bandwidths or the size and shape of CDs) and while such moves generally encourage lower cost producers to enter the industry there is no a priori reason to condemn the existence of a few companies producing a similar product/service or a few producing differently branded products or services. 

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