Why Do Oligopolists Engage in Little Price Competition but Extensive Product Development and Advertising - Essay Example

Order 161145 Chosen Topic: Why do oligopolists engage in little price competition but extensive product development and advertising? Introduction: This paper seeks to analyze and discuss the reasons why oligopolists engage in little price competition but extensive product development and advertising. The paper presupposes already a thesis hence understanding the reason is the more compelling objective of this paper. The paper therefore talks of knowing what is an oligopoly, understanding why oligopolists exists, characteristics of an oligopoly and the relationship of each to one and another. By knowing those things, we would be in a better position to know the reasons that they do what they do and this paper will attempt also to provide some evidences to assertions made. Graphs will be made to illustrate and support analysis made. 2. Analysis and Discussion 2.1 What is an oligopoly and how do firms in an oligopoly come about? An oligopoly is a market structure in which there is domination little number of sellers called oligopolists (Samuelson and Nordhaus, 1992). When one hears Big 4 or Big 5 as in the auditing firms in the US, these firms are part of an oligopoly. Given limited number of participants in this type of market, it is believed that the action of each oligopoly is known by others in industry making the oligopolistic markets to be known or branded to be having some interactivity. As an additional effect, the decisions of one player can influence or subject to be affected or influenced by the decisions of other firms. Knowing their few numbers, they, the players took advantage in their planning by always taking into account the likely responses of the other market participants if in case one of them makes a move. This is the reason why the charge of collusion is more prevalent for this type of markets structure and the firms in the industries are also the ones being possibly involved in anti-trust regulations. Knowing the characteristics of an oligopoly would help us more to analysis and discussion. They are as follows: competition amongst the few, high barriers to entry, competition on non-price, price stability, kinked demand curve, product differentiation, possibility of collusion, abnormal profits and interdependence between firms (Biz/ed, 2007). Wikipedia (2007) explained that for the purpose of quantitatively describing an oligopoly, the four-firm concentration ratio is often utilized. The ratio then determines to total the market share of the four largest firms in an industry as a percentage of the total. This makes it possible to define an oligopoly as a market in which the four-firm concentration ratio is more than forty percent. It cited an example the four-firm concentration ratio of the supermarkets industry in the United Kingdom, where Sainsbury, Morrison and ASDA belong, is over seventy percent the British brewing industry which has a staggering eighty five percent ratio. On the other hand, examples oligopolies cited in the USA “the accounting & audit services, tobacco, beer, aircraft, military equipment, motor vehicle, film and music recording industries.” (Paraphrasing made). Figure I below illustrates the typical demand graph of an oligopoly where the demand curve curved is kinked to the left which of course signifies a meaning when in comes to pricing by the players. Figure 1. Demand curve for an oligopoly., Source: Wikipedia (2007) Wikipedia (2007) explained that above the kink, demand is relatively elastic because all other firm’s prices remain unchanged but below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut leading, eventually, to a price war. It then argued that the best option, for the oligopolist, is to produce at point E which is the equilibrium point and, incidentally, the kink point (Paraphrasing made). If one observes the implication of the demand curve, one could infer two possibilities. The players could choose to compete or not to compete in prices. Thus price war is a possibility but since because the few players know that they are few, they normally behave not to compete with price primarily. As stated earlier relating to the kink of demand curve, there is greater price elasticity and this would be detrimental to the them (the oligopolist) if they compete big on price, such that a big change in price (a decrease to specific) would make a big reaction from member of the oligopoly that could trigger the price war because the market would really react as they buyers would patronize the company who has decrease the price. Hence the better option is to maintain price even if there is low demand that may be brought by economic depression or any phenomenon. If other members will do the same thing, which is normally expected, none of the players can be forced to stop unless the government can prove collusion. It is therefore more logical to expect that in oligopoly prices are usually stable. This is also very logical in the sense that below the kink there will be inelasticity of the price where it would be use less to bring down the price because buyer will find it irrelevant. Above the kink therefore where price elasticity is high because the line is approaching a horizontal direction, it is safer to engage in little price competition by further differentiating their products through extensive product development and advertising. It must be noted that demand curves have for different market have an effect of the strategies of players in the industry. If the demand is price elastic, a change in price will be matched by greater quantity demanded. This will happen if the demand curve approximates that of a horizontal line (See Figure 2. Appendix A) . On the other hand, if the demand is inelastic, a change in price it matched by a lesser change in quantity demanded (See Figure 4, Appendix C). In between the two curves is the unit elastic where a change in price is matched with a change quantity demanded. (See Figure 3, Appendix B) When we apply these economic concepts to oligopoly, it would mean that a high price elasticity of demand would cause revenues of producers or firms in the industry would fall because customers will react strongly with the change in price. For the oligopolists to engage in price war when the above the kink in the demand curves in Figure I is a waste of chances for greater profitability. Wikipedia (2007) confirmed that in an oligopoly, firms operate under imperfect competition, where “the demand curve is kinked to reflect inelasticity below market price and elasticity above market price.” The player’s competition then is on non price basis, where “the product or service firms offer is differentiated and barriers to entry are strong.” It also posited that there is a “fierce price competitiveness created by this sticky-upward demand curve.” It could be deduced then clearly that the use of non-price competition for greater revenue and market share is more preferable to oligopolists. It would sound that where there is heavy advertising, the firm would most probably an oligopolist trying to bring competition in product quality. Players can compete in prices if they want but it is the less preferable option. Their tendencies because of knowledge of their little number is to collude to raise prices and control production and the presence a formal agreement makes it cartel which is illegal. The other purpose of colluding may to put a go signal, especially by the price setter or price leader, to other players for the stabilize an otherwise unstable markets. This will necessarily reduce the risks inherent in oligopolistic markets thus paves the way fro for other investment in differentiated products by further product development. Legal restrictions exist to prevent collusion in most countries. Agreement could be implied and but formal agreement for collusion is possible. To prove illegality there is a need to prove real communication between companies. There could be on the other hand in some industries, an acknowledged market leader which unofficially sets prices to which other producers respond, known as price leadership which is legal (Wikipedia, 2007) (Paraphrasing made). Product differentiation as strategy may be understood to create unnecessary levels of differentiation in order to suffocate price competition and reap revenues or more profit as a result of high prices. This is not foreign in business management for companies which will try to create competitive advantage (Porter, 1980) so that they can sell their product at a premium (Kotler, 1994). 2.2 Why do oligopolists exist? Oligopoly’s existence could be understood in the way the firms in a capitalist economy operate. As a rule, all companies desire to earn profits to maintain the investment of stockholders who must earn above opportunity costs. They want their earning to be long term and therefore they dream to have economies of scale where they could produce more at a lower unit cost. This is one motivation of companies to merge for synergies and greater profitability until a point where an oligopoly in an industry exists. This could be seen in automobile industry, for example. Not many large firms can produce at minimum average cost and not many can become large firms. The economies of scale make it hard or almost impossible for new firms to enter the industry. A small company which could not produce at minimum cost could not compete with big firm would soon find itself acquired or be driven out of the business. Starting big is not simple and many oligopolies are more believable to have been the result of merger and acquisitions over the years as it are hard to raise big money and become profitable (Brigham and Houston, 2002) for the first years of operation. So the effects are interrelated reinforcing each other for oligopolies. With economies of scale and differentiated products comes ownership of patents by the oligopolists. Put massive advertising still and virtually would-be newcomers find little or no chance to start a presence in the mind of the consuming public. Driven for more profits, they find time merging that have the clear advantage of putting competition almost nil. If this is not power what is this? Just like the principle of money begetting more money, oligopolies have tendencies to create more economies of scale and thereby increase the barriers to new entrants and government will find they may be colluding and it is here where anti trust come in to stop them from becoming monopolies. It could be inferred that the urge to merge to create more economies of scale presupposes a tendency collude and their knowledge that they are few in the industry makes them more powerful. 2.3 How do the other characteristics of oligopoly relate to each other? Some of relationships may have been explained earlier already but at this section we a complete integration of the characteristics and see their consistency. Starting therefore with the fact that the competition in a monopoly is only amongst, interaction is logically presumed among them. As believed a number of oligopoly must have been results mergers and acquisitions from the past. In merger a company will acquire its competitor to be a bigger company. After a series of merger in the past only a few firms have survived and they have found their way how to maintain and sustain their sized. They actually want to become a monopoly at the other extreme but anti-trust laws would prevent them from attaining the same, As to high barriers to entry, this may be possible by economies of scale that is created by being able to produce in great quantity at a lower average cost per unit. This will give the advantage of above normal profit as compared with those under a perfect competition Competition on non-price is more prevalent was already discussed involves the competition on the quality of the product. They used branding to make their products looks different from competitors and they sustain this with heavy product development and advertising The price stability was a result of the avoidance to compete on price. A typical member of the oligopoly will normally think on how to differentiate the product while maintaining the price The, kinked demand curve, product differentiation, possibility of collusion and interdependence between firms are already discussed in other parts of the paper. 2.4 Why do they compete little in price but engage in extensive product development and advertising? Advertising is known to provide information about new products and product improvements to the consumer. It may result in an increase in competition by promoting new products and product improvements hence it is but logical increased output for a firm will arise. More quantity pushes s average total cost curve when seen in a graph and this will lead closer to what economist called productive efficiency. On the other hand advertising can produce manipulation and persuasion rather than information as increased brand dependability and patronage through advertising will increase the producer’s power to influence the market. As stated earlier advertising creates barriers to entry into the industry by making it appear that products are highly differentiated and there could high switching cost for those who have developed brand loyalty (Porter, 1980) 2.5 Give some proofs. The case of American Tobacco Company was an oligopoly which almost reached a monopoly. The company’s strategy of massive advertising despite all costs, including the acquisition of smaller companies before it became an oligopoly, and the eventual dissolution proved the little competition or even absence of competition in price. With massive advertising done by the company, only one is clear it must engaged in product development but not to tell the world about the price of its products lower than its competitors. Norris (1990) reported the case of The American Tobacco Company which dominated the modern history of the tobacco industry; from its formation in 1890 until its court-ordered dissolution in 1911. The Company then controlled the cigarette, smoking tobacco, plug tobacco, and snuff market in the United States (Porter, 1969). In 1889, James Duke of the tobacco company “allocated $80,000, 20 per cent of his gross sales, to advertising.” (Norris, 1990). A period in time when the tobacco industry faced a decline in the rate of growth of the demand, but Glen Porter noted, "Cooperation became an ever more appealing and logical solution, and, once more, James Duke led the way." (Porter, 1969) Norris (1990) reported that American Tobacco Company from 1890 had absorbed “over two hundred rival firms to gain control of the cigarette and smoking tobacco industries” which brought the formation of the Continental Tobacco Co. and the American Snuff Co. thereby giving almost every part of tobacco business at that time. Came 1904 when the Department of Justice forced Duke to scrap the Consolidated Tobacco Company (a holding company) and to merge all of the firms into the American Tobacco Company but the Supreme Court ordered its dissolution in 1911, creating several firms, including the new American Tobacco Company, R. J. Reynolds, Liggett & Meyers, and P. Lorillard and Company. The oligopoly of these large firms replaced the near-monopoly of the old American Tobacco Company (Porter, 1969) (Paraphrasing made). One could readily see the following events in an life of an oligopolist in the case of American Tobacco Company which could prove the behaviour of the firm. It adopted advertising as a preferred strategy allocating even to the extent of 20% of gross sales, merged with smaller companies to eliminated competition and to gain economies of scale, attempted to become a near monopoly but was subjected to anti-trust laws. Neither could evidence presented find any strategy to lower the company price to increase revenue. To spend heavy on advertising at the magnitude of 20% of gross sales could not have meant to compete on price. It could only mean bringing the fight into bringing more product differentiation through product development. Heavy advertising is simply inconsistent with competing in price. Conclusion Oligopoly exists first and foremost because of the desire for more profits. In economics, the firms belonging into oligopoly market structure are between two spectrums, they are the monopoly and the perfect competition. Players in perfect competition have the following characteristics: many buyers and sellers, freedom of entry and exit, homogenous products, perfect information, sellers-price takers and long run normal profit (Biz/ed, 2007). On the other hand monopoly has the following characteristics: firm = industry, natural monopolies, 25%+ market Share, control over price or output, price discrimination, high barriers to entry, consumer choice and abnormal profits (Biz/ed, 2007). Because of profit motive, it could be said that an oligopolist will have the greater tendency to become monopoly and it will have urge to merge. However government will try preventing collusion to protect consumers through anti-trust laws. The behaviour therefore of oligopolists show engaging little in price competition because of the great possibility that fellow competitors will follow and it will be for the detriment of the group and that would lead them to perfect competition. To avoid becoming part of perfect competition they will try to differentiate their products from competitor and they will accomplish the same by extensive product development and advertising. Not all consumers behave because of the price. In business language, firms create competitive advantage (Porter, 1998) over that of competitors so that they can sell their products at a premium. Appendices Appendix A – Elastic Demand Appendix B - Unit Elastic Demand Appendix C - Inelastic Demand References: Biz/ed (2007) Market Structure, Mind-map {www document} URL http://www.bized.co.uk/educators/16-19/economics/firms/presentation/structure_map.htm-, Accessed April 6, 2007 Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South Western, London, UK Kotler, (1994) Marketing Management, Analysis, Planning, Implementation and Control, Prentice Hall International, London, UK Norris, J. (1990) Advertising and the Transformation of American Society, 1865-1920, Greenwood Press. Place of Publication: New York. Pp. 129-130 Porter (1980) Competitive Strategy, Teaching and Analyzing Industries, Free Press, London UK Porter, 1998, Competitive Advantage, Competitive Advantage: Creating and Sustaining Superior Performance (Hardcover), Free Press, London, UK Porter, P. (1969) "Origins of the American Tobacco Company", Business History Review, vol. 43, 59-76. Samuelson and Nordhaus (1992), Economics, McGraw-Hill, Inc. Wikipedia, (2007) Oligopoly {www document} URL http://en.wikipedia.org/wiki/Oligopoly, Accessed April 6, 2007 Appendix A Figure 2. Elastic Demand Illustration Appendix B. .Figure 3.Unit-elastic demand Appendix C. Figure 4. Inelastic demand Read More