What is an Oligopoly - Essay Example

What is an oligopoly Explain the difference between natural and strategic entry barriers in oligopoly Oligopoly Introduction Barriers to entry play alarge role in the success or failure of any oligopoly.These barriers can have important repercussions for merger reviews and antitrust policy of which will allow the firms operating as an oligopoly to maintain a stable and large amount of revenue.1This essay involves the discussion of the game theory and other related strategic and natural barriers. The oligopoly theory is well known for the employment of, "Credible threats to punish cheating from cooperative outcomes (and) the extent to which imperfect information may restrict the scope of firms to employ such punishments. One way in which firms may seek to make threats credible is through strategic investments, for example in production capacity 2" Oligopoly, (which is Greek for many sellers) demonstrates a very characteristic feature of mutual interdependence 3of each in the model onto other firm's action. Each firm in an oligopoly recognises that the pricing or output decisions made by one firm will affect the profits of all firms in the industry.4 Because of this mutual interdependence, the firms in an oligopoly market need to act strategically, and it is this existence of strategic behaviour or barriers which distinguish the oligopoly model from perfect competition and monopoly.5 The fundamental features are that sellers are price-makers and the demand curve of every firm is slightly slopping down.As the figure below aptly demonstrates, (Diagram is courtesy of wikipedia) the demand curve in an oligopoly will be a "Kinked" demand curve which may be similar to the traditional demand curves in the Perfect competition, as they are downward-sloping but it will have a kink or a bend. 6 The diagram above shows how the oligopoly displays a significant market share and how the kinked demand curve allows the monopolies to make supernormal profits. Before I discuss the barriers utilised by a monopoly it would be useful to show how the factor of interdependence manifests itself as game theory which can be well illustrated as the prisoners dilemma as apparent from the diagram below. The above diagram (taken from the internet) shows the classic example of the Game theory being played out between two firms in an oligopoly. These two firms are aware of their price levels and cautious in an increase or decrease in the prices which can break out into a price war/or cause cut throat pricing which will ultimately cause losses to all the firms in the oligopoly .Economic theory dictates that these firms will inevitable return to the original position in case of such a price war. Barriers in Oligopolies The Game theory as apparent from the diagram above shows some interesting incites into strategic barriers and their dilemmas and this theory became popular in the decade of the 1970's where there was a substantial shift to firm behaviour with regards to firm behaviour. Barriers in a monopoly can be natural or strategic. They are aimed at keeping competing firms away 7.Market entry is very difficult in oligopolies. Oligopolies operate on a large scale and therefore have high sunk costs( which are industrial expenses that cannot be recovered once a firm has started business). This means that if large amounts of capital are used to enter an industry which depreciates in value rather quickly there will be a barrier to entry for new aspiring firms. Secondly if the firm has problems in establishing the reputation of its product through high scale advertising and discount schemes it will be too expensive for other firms to enter the market and actually attain the same level of excellence without incurring large amounts of initial losses.An example of this is the telecoms industry where the various cell phone carriers have established oligopolies in their price and service mechanisms. Oligopolies generally operate at an international level and can be either 1.Impure oligopolies (differentiated product model) 2.Pure oligopolies (homogeneous product) Firms in Pure oligoplies produce identical products like gold and steel etc.Impure monopolies produce the same product with different brand names like the perfume industry relying heavily on its individual brand names.Because of economic differences these companies find it very beneficial to collude with each other mainly due to the fear of losing their market share. Government restrictions,trade policy and the local law present a major barrier to entry in an oligopoly.This is mainly because these oligopolies are either dominating the market with enough power and resources to block market entry by lobbying for stringent industrial standards and capital requirements. At this point it is worth mentioning that the government will make it make it very difficult to allow entry and exit both into these markets. This is because some oligopolies are strategically important for the economy of a country.The government will therefore make the use of legal barriers to prevent market entry for firms they feel would be too irresponsible for the economy.The This is why the government will set high industrial and safety standards and capital requirements and for services like Water,Oil,telephony and Gas companies. . Other strategic barriers include non price rivalry and strategies to gain greater market shares through investing large amounts of profit on advertising and product differentiation. This is important to maintain large portions of the market and promote brand loyalty.There is always a threat of other new entrants in the market gaining this share . Market entry can happen in a number of ways 8 and the new entrants offering a much wider range of products with newer technology.Large companies expanding in a new field can easily afford the financial set backs usually faced by a firm which is new in an oligopoly structure.New market entrants will enter hoping to gain from the high profits made by the already existing firms in the Oligopoly. Natural barriers to entry which are also known as structural barriers to entry arise from differences in the cost of production.This is because the firms in an oligopoly who are in the business for a long time are able to exploit the internal economies of scale and low average costs.These advantages will ofcourse not be available for the new entrants .Other barriers to entry include geographical and cultural differences which may cause huge problems for potential multinationals in gaining a market share. Strategic entry barriers are deliberate actions by these oligopolies to gain and maintain their market shares by discouraging potential new entrants from entering into competition.These firms will be resorting to tactics like market dominance. Large multinationals keep a control over large markets by the use of Acquisitions and mergers with new competition perceived as a threat to their profit maximization. These firms will often resort to predatory pricing and offer large discounts to maintain their customer base. A modern example is the sports shoes industry which has slowly expanded into a global monopoly under the auspices of large multinationals like Nike and Bata. From a closer study of the Nike business model it is possible to see that this company enjoys large economies of scale which gives them cost advantages.In addition its highly sophisticated industrial set up will cost another firm a large amount of money to match upto.Through the tactics of mergers at a vertical integration level they are able to open discount factory outlet stores in under developed areas where the wages are not very high.In addition to this with these low costs they are able to operate with in large retail centres to compete with rival shoe makers .9 As one of the many firms in an oligopoly it utilizes the advantages of economies of scale that come through product endorsements and advertisements .Nike's strategy of product differentiation is also very interesting as it utilizes the use of "visible air chamber in the sole" which is very unique to its brand entirely.Although the shoe industry for shoes has very high barriers to entry in terms of capital requirements ,there is always an increased risk or new entry by existing dress or fancy shoe manufacturers to enter the market with a lesser hassle because they would be using almost the same machinery and capital.Another barrier to entry for a new firm entering the market dominated by players like Nokia,Service and Bata is the dealership and distribution channels especially if these firms have no history of dealing with these outlets from before. Also what can be seen from the business structures of other players like Reebok and Service these large shoe manufacturers have to manage their price and output owing to their mutual dependence However the price fixing does not prevent these firms from utilizing aggressive advertising in their favour and monitoring each others marketing moves. This allows for effective brand and name recognition.Thus the sports industry banks heavily on advertising and sponsorship revenues from these firms. An example of a natural barrier to trade arises from with in the airplane and travel industry.Airplanes are expensive to buy and maintain.Therefore any firm planning to enter the oligopoly set up in this case to come up to certain industrial and safety standards due to the large customer base and airfare ,travel and tourism being a strategic industry in the economy .The Airplane and tourism industry generates high amounts of revenue and employment for the country .Therefore any firm planning on starting an airplane travel service will have a host of legal nuances in front of them in order to achieve a contract to sell airplane services. In conclusion the modern oligopolist faces the very tough task of setting up and maintaining these barriers for the sake of their revenues and stability, but the law keeps a strict control on possible cartels and ensures that there are responsible entrants with in the oligopolies in order to maintain economic stability. References 1. 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The implementation of social choice rules: some general results on incentive compatibility. Review of Economic Studies 12. Dixit, A. (1980) The role of investment as entry deterrent. Economic Journal 90, 95-106. Read More