Oligopoly

It is probably fair to say that this market structure is the most realistic of the four we have encountered. There are certainly more examples of this structure in the real world. As there are many different theories as to how firms behave in Oligopoly, we will not have a section looking at specific assumptions. Instead we shall look at the characteristics of oligopolistic industries.

The characteristics of oligopolistic industries

1. / . In oligopoly, there are relatively few firms in the industry. Although there could be quite a few firms, the concentration ratio tends to be fairly high. This means that, for example, the largest five firms in the industry accounts for 80% of the market share [note that concentration ratios can be calculated on the basis of employment as well as sales/output]. The implication of this is that firms in oligopoly are interdependent. The actions of one firm will directly affect the others. Each of the large firms in the industry has to try and predict the actions of the others. They may collude to avoid this unpredictability (see later notes).
2. / . This one is about barriers to entry. A bit like monopoly. It is assumed that barriers to entry are fairly substantial. It should be noted, though, that there are examples of oligopoly where there are very few barriers to entry. This will be covered in the next topic called ‘Contestable markets’.
3. / . Knowledge is by no means perfect, as in the perfectly competitive market, but firms sometimes collude so that they can act as one and eliminate some of the uncertainty that exists when one is trying to work out what one’s competitors are going to do.
4. / . Each firm will be producing a branded product. There will be definite differences in the products on offer. Many economists believe that the main form of competition in oligopoly is non-price competition, and advertising in particular, to highlight the differences in the products.
5. / . Although it is assumed that firms aim to maximise their profits in the kinked demand curve model of oligopoly (see later), it is quite possible that the managers of these firms may have other managerial objectives. An example that is associated with power is sales maximisation (if their salaries are based on sales), formally defined as the maximum level of output that can be produced without making a loss (i.e. where AR = AC).

Are there any examples in the real world?

In a word, yes! Quite a few, actually. The one that most textbooks like to discuss is the market for petrol, particularly in terms of retailing, but also its extraction. How many firms can you think of that sell petrol?

Another popular example is banking. This was a very good example when virtually everyone banked with Midland (now HSBC), NatWest, Barclays and Lloyds, but with the advent of building societies and Internet banking, this has become a more competitive industry and, perhaps, a less oligopolistic one.

Some economists argue that the food retailing market has moved away from the monopolistically competitive market structure towards oligopoly. The ‘big four’ (Tesco, Sainsbury’s, Asda and Morrisons) now control well over 70% of the market.

There are numerous different detergents to choose from at your local supermarket (powder and liquid). What you may not have been aware of is the fact that they are all supplied by either Unilever or Procter and Gamble. This is an example of a duopoly (only two firms in the industry) rather than oligopoly.

The Coca-Cola Corporation controls half of the world’s soft drink market. In some countries their market share is over 50%. Much of the rest of the market is occupied by the PepsiCo Corporation or the Cadbury Schweppes Corporation. This is a world wide oligopoly.

Finally, many of the recently privatised utilities are now oligopolistic. Although most of them were privatised as monopolies (gas and electricity in particular), the government has introduced competition to make these industries more oligopolistic. We will look at this in much more detail when we do ‘the regulation of privatised industries’.

Non-collusive oligopoly

Unlike with the extreme models of market structure, perfect competition and monopoly, it is very difficult to predict exactly what will happen to price and output in oligopoly. Each of the few firms in the industry are constantly trying to second guess their rivals’ reactions to their own pricing decisions. Given the uncertainty, the best economists can do is to try and understand the behaviour of particular firms in particular industries.

In this first section, we shall consider situations where the industry’s firms do not collude (i.e. they do not get together for the benefit of all firms). Even though we assume that these firms do not collude, they are likely to have strategies in response to observed pricing policies of the other firms. In practice, oligopolistic industries experience short bursts of price-changing activity (see price wars below), together with longer periods of relatively stable or rigid prices (see the kinked demand curve model below).

Price wars

A price war is where one firm cuts its price, the others follow and perhaps cut theirs by a little bit more, and so on. A war develops! Obviously, the motive is to protect, or increase, market share at the expense of immediate profits. Often this is the result of a broken collusive agreement (or cartel). In recent years, we have seen price wars in the following industries: newspapers, fast food (McDonald’s verses Burger King), mobile phones (especially between the four main networks), petrol retailers and package holidays.

The expansion of the number of superstores in the food retailing market caused price wars in the 1990s. The big names struggled to keep their sales high enough to earn a decent return on their investments. The competition from the low price stores such as Aldi, Netto and Kwik Save did not help either. The result was a series of price skirmishes which involved aggressive price cuts by Gateway (now Somerfield), Asda, Tesco and Sainsbury.

There was an extreme example of a price war in the cross-channel market in 1996. Many of the ferry companies were under threat from the newly opened channel tunnel – peak season cross-channel ferry fares fell by 60% between 1993 and 1996.

Of course, these price wars do not go on for ever. When markets go through a period of relative price stability, non-price competition comes to the fore.

The Kinked demand curve model

Remember that there are many different models that try to explain the behaviour of oligopolistic firms. This is the only diagrammatical one that you need to know for A level.

As we have already said, firms in oligopoly are interdependent. They monitor each other’s actions closely because any action by one firm will directly affect the others. This model tries to explain why we see so much price rigidity in oligopoly. Have you noticed that nearly every petrol station charges more or less the same price for a litre of unleaded? This model should explain why.

Assume that the price of a litre of unleaded petrol is £1.35. This is the price charged by all three firms in your area. If one of the three firms put their price up to £1.40 a litre, what would happen next? Most people would buy their petrol from one of the other two firms. The price-raising firm will experience a large proportionate drop in sales relative to the proportionate rise in price, and so a drop in revenue. It will have found that the demand for its petrol following the price rise was very elastic. This is because the other two firms knew that they would gain extra sales if they left their price at £1.35, so they did not follow the price rise.

What if one of the firms decided to cut its price to £1.30 a litre? Most consumers would try and buy their petrol from the cheaper firm. The other two firms know this is going to happen following the price cut, so they match the price cut (see price wars earlier). Assuming that overall demand is unlikely to rise substantially, all three firms will find that the rise in demand for their petrol is proportionately small compared with the proportionate fall in price, so their revenues fall. Demand is very inelastic following a price cut.

Hence, all three firms face a demand curve that is elastic (quite flat) above £1.35 and inelastic (fairly steep) below £1.35. There is little incentive to raise or lower price. There has to be a kink in the demand curve at price £1.35.

Note that the kink is the equilibrium, which in our example is the £1.35 litre of petrol.

Game theory

In oligopoly, the fact that the few firms are interdependent is very important. Before a firm carries out a certain strategy (like a price cut, for example) they have to consider what the other firm (or firms) will do and what the consequences of each reaction might be – very like playing a game of chess.

Most firms will go for the course of action that, given the likely responses of their competitors, will lead to the least bad outcome.Firms tend to be risk averse – they do not want to risk big losses and bankruptcy. Some firms may like to take a risk, but the probability is not on their side.

Game theory helps economists to analyse behaviour in oligopoly. The problem is, of course, that each firm in oligopoly is not entirely sure what the consequences of their action and their competitors’ reactions will be. In a sense, it is guesswork, but from experience they should have a pretty good idea of the results of any combination of actions and reactions.

It is well worth reading Unit in Anderton (pages ). It looks into some of the different ‘games’ that firms might face, how some ‘games’ lead to ‘stable’ equilibria but others lead to unstable ones, and how these ‘games’ become much easier when the firms collude. We now turn to the issue of collusion in more detail.

Collusive oligopoly

In the examples above, firms in oligopoly effectively have to guess what their competitors might do in response to a certain action. Firms do not like this uncertainty, so it makes sense for them to get together (or ‘collude’) to make things easier.

There are two main objectives of collusion: joint profit maximisation and the deterrence of new entrants. Obviously if a market with only a few firms competing becomes (effectively) a monopoly through co-ordinated actions of the firms, their ‘joint’ profits are likely to be higher. Deterrence of new entrants through limit pricing and the elimination of current competitors through predatory pricing are discussed below under ‘Other features of oligopoly’.

What follows is a look at the methods of collusion: formal collusion through cartels, and informal collusion through tacit agreement.

Formal collusion - cartels

Businesses hate uncertainty. Unfortunately, there is a lot of uncertainty in oligopoly. Firms need to know how other firms are going to act, and how they will react to their own strategies. This is very difficult, so firms in oligopoly often avoid this uncertainty by colluding. This means getting together and making an agreement about quantities produced and, therefore, prices. Some cartels (a formal agreement) are very open, the classic example being OPEC. They were very powerful in the 1970s, less so in the 1980s and 1990s, but managed to show that they still mattered in 1999/2000, doubling the price of a barrel of oil in one year.

Other examples include the International Air Transport Association (IATA – a cartel of international airlines, but a lot less influential nowadays with the advent of numerous low cost airlines) and the International Telegraph and Telephone Consultative Committee (ITTCC – members include most of the big international phone companies. They have been successful in keeping the price of international calls much higher than their cost, even though technology has reduced the real cost per minute of using a transatlantic cable from $2.53 per minute in 1956 to $0.015 in 2009).

The goal of a cartel is for the few firms in the industry to join together and, effectively, form a monopoly. The shared profit will be higher than if the firms were competing with each other. The big problem, of course, is the fact that it is tempting for a member of the cartel to cheat! This tended to happen in oil particularly. Agreements to restrict output (or extraction) of oil meant that the price rose, which was good for the oil producing countries. But some of the countries involved were otherwise relatively poor. It is tempting to increase output and sell as much of it as you can at the higher price before everyone else cottons on. Of course, once the culprit is spotted, everyone cheats and the agreement falls apart. The 1999/2000 agreement was unusual in that all the countries involved seem to be keeping to it! OPEC is also vulnerable to competition from non-members, like the UK.

Of course, most cartels, formal or secret, are illegal. It is an attempt by the firms in an oligopolistic situation to eliminate any competition, which is bad for the consumer. In the UK, collusion of any kind was outlawed in the 1956 Restrictive Trade Practices Act. So, there are no formal cartels in the UK anymore, although there used to be legal cartels in the cement industry and the book industry. In the first case to make sure that cement capacity was controlled in an orderly way, and in the second to make sure that small bookstores were not killed off. The new Enterprise Act 2002 has criminalised cartels, so that those caught breaking the law receive large fines and/or prison sentences!Even though cartels are now illegal, it is difficult to believe that the heads of major firms in oligopolistic markets do not ‘converse’ with each other on occasion (independent schools bursars?). Or is it just a coincidence that the prices are similar in the food retailing industry, the electrical goods retailing industry and the new car market? Hmmmm!

Tacit collusion – price leadership

Tacit means ‘understood, or implied, without being said’. Tacit collusion, therefore, often happens even though cartels are illegal. The most common form of tacit collusion is price leadership. There are three types:

1. / . Frequently the price leader is the dominant firm. In the 1960s, Brooke Bond controlled 43% of the market for tea, well ahead of their nearest rivals Typhoo (18%). Brooke Bond tended to raise their price first, and the others would then follow. It was so obvious that it attracted the attention of the authorities (the Prices and Incomes Board, as the OFT was called in those days).
2. / . In some cases the price leader is a small firm recognised by others as having a close knowledge of the prevailing market conditions. The firm acts as a ‘barometer’ to the others of changing market conditions, and its prices are followed closely. This has been seen with the ‘minor’ petrol wholesalers who have had an increasing influence on petrol prices.
3. / . This is a more complicated form of price leadership. In this case, there is an informal cartel where prices change almost simultaneously (sometimes known as ‘parallel pricing’). It often seems as though this is what happens in the market for petrol. But are the price changes simultaneous or do firms simply follow a price leader very quickly? In reality, both parallel pricing and price leadership will happen over a period of time.
Also, what if the firms are all reacting to something unrelated to collusion. In 1989/90, the OFT investigated parallel pricing and excess profits in the petrol wholesaling business. The large firms were cleared on the grounds that it was very difficult to prove that price collusion had occurred. It was found that prices did, indeed, change simultaneously, but that the prices changes came instantly after changes in the common world oil price.

Other features of oligopoly

Limit and predatory pricing

Limit pricing is where the firms in oligopoly try to set a price that limits the entry of new firms into the industry. They try to set a price that is low enough to put new entrants off, but hopefully still high enough to make some sort of profit. Obviously, the greater the barriers to entry, the higher the price can be and still deter entry. In industries with very high barriers, the ‘limit’ price may be as high, or higher, than the joint profit maximisation price, so the existing firms would not have to reduce their price at all. This tends to occur in industries that have significant economies of scale. In such industries it is easy for existing firms to set the price low enough to deter entry and still make some profit.

Limit pricing is temporary and not really designed to be a loss leader, unlike predatory pricing, where, as the title suggests, the goal is to kill off an existing competitor. The price is reduced to below cost price, a definite loss leader, so that the competitor cannot cope. Once the competitor has left the market, the price can be raised back up to the old level and there are more customers to go round! In recent years, it appears that the quality newspaper market is a good example. Certainly, ‘The Times’ newspaper cut its price to very low levels. The target was probably ‘The Independent’, but they seem to have survived. One does wonder, though, how low the profits must be in such cut-throat markets.