The Market Oligopolies - Essay Example

? In many of our industries today, a few firms are considered dominant. These firms are what we call the oligopolies. An oligopoly is a market characterized by the existence of a few large firms, producing a homogeneous or differentiated product, that dominate the market (McConnell and Brue 1993, p. 220). Their dominance is evident through their control over prices of the goods or services they provide and the barriers that they set to make it difficult for new firms to join their industry. This “fewness” results to firms be mutually interdependent because each has to consider the possible reactions of its competitors to its price, marketing and product innovations or development. Other significant feature of this market model is the presence of a great deal of non-price competition as control over price is limited by their mutual interdependence. This is one of the significant behaviors of oligopolies when it comes to their pricing strategy. To have a better understanding of this oligopolistic pricing behavior, we will adopt a game theory model and use the matrix illustrated below. FIGURE 1. GAME THEORY AND PRICING STRATEGY Applying game theories in pricing strategies work like what is shown in Figure 1. Supposed we have the two oligopolists, Firm 1 and Firm 2 and each can choose either a high or low price. Their payoff matrix shows that if both firms will choose a high price, each will make $6 million but if both decided to sell at a low price, each will make $4 million. However, if one of them chooses a high price and the other one chooses a low price, the low- priced firm will make $8 million but the high-priced firm will only make $2 million. So, they will end up charging the low price because it is the dominant strategy. Oligopolists who are independent compete with respect to price and this will result to lower prices and lower profits. Consumers will end up benefitting from this. On the other hand, the oligopolists are at disadvantage because they will experience lower profits than if they both had charged high price. To avoid the outcome lower profit, they would rather choose to collude than to establish price competitively or independently. But the positive effect of collusion on variety and quality more than compensates consumers for the negative effect of collusive prices, so that consumer surplus is larger with collusion (Pakes 2000, p.1). Collusion is a situation in which firms act together and in agreement to set price of the product and the output each firm will produce or determine the geographic area in which each firm will sell (McConnell and Brue 1993 p.224). It may be in an overt or covert form. The most comprehensive form of an overt collusion is the cartel which typically involves a written agreement with respect to both price and production. Cartels can control output by making sure that the market is shared among members and the agreed price is maintained in the market (Lande and Marvel 2008, par. 2). The Organization of Petroleum Exporting Countries (OPEC) is one of the most successful oil cartel in the world. There are countries like United States where cartels are illegal and there is a strict enforcement of anti-trust laws (Danieljensenlaw.com par.2). So, in cases like this, oligopolists tend to collude implicitly This can be done through tacit collusion. “Tacit collusion” need not involve any “collusion” in the legal sense, and in particular need involve no communication between the parties. It is referred to as tacit collusion only because the outcome (in terms of prices set or quantities produced, for example) may well resemble that of explicit collusion or even of an official cartel. A better term from a legal perspective might be “tacit coordination” (Marc, Julliene and Rey 2003, p.4). This may be seen in form of a price leadership. In the theory of price leadership, the basic assumption is that the dominant firm- usually the largest or the most efficient firm in the industry- sets the price and allows the other firms to sell all they can at that price and then the dominant firm will sell the rest (Miller 2004,p. 638). It is the dominant firm who always initiates or makes the first move in this model being the leader. Cartels and other collusive agreements are not easy to establish or maintain because obstacles are present in the economy. These barriers include demand and cost differences, number of firms, cheating, recession, potential entry and legal obstacles like anti-trust laws (McConnell and Brue 1993, p.229-230). But despite the presence of these obstacles, oligopolies still have the collusive tendencies and are tempted to collude because such actions may permit them to reduce uncertainty, increase profits and even prohibit new firms to enter the industry. Risk and uncertainty are important concepts to be considered in analyzing the business’ returns in the future. Risk refer to the chance that some unfavorable event will occur (Brigham, Houston and Clark 2004,p. 5-3). And because most businessmen are risk averse, if they are given the chance, they will choose options that bear lower risk. In this case, an oligopolist chooses to collude as collusion may reduce the risks and uncertainties that their firm may encounter while in the industry. In collusion, each oligopolist has a reaction function or an expected behavior from each oligpolist is already set. This means that for every action or changes that may occur within the market like a change in price, output or quality, each firm included in the collusion has a prescribed manner of reacting or behaving. Because of the agreement or the formal arrangement among oligopolists, then there is no way that a firm will be left out or lost in the game within the industry. Firms’ operations are motivated and guided by their interests to earn profits. And for oligopolist whose primary goal is profit maximization, collusion is seen as a solution. This is because price and output combinations predetermined in a collusion makes it conducive for profits to be maximized. Prices set by noncollusive oligopoly are flexible resulting to kinked demand curves but sticky prices of collusive one gives the curve a different direction. This is because of the fact that demand and profits from the consumers are indeterminate if oligopolists are to set their prices independently or competitively. Their demand and marginal revenue curves will depend on whether their rivals will match or ignore any price changes. FIGURE 2. THE KINKED DEMAND CURVE In Figure 2, the firm’s assumption that rivals will not match the changes in price results to demand curve d?d? and marginal revenue curve MR?. But if the firm will assume that rivals will match the price changes, it will have the demand curve d?d? and marginal revenue MR?. However if the firm assumes that rivals will not react to an increase in price but will react to a decrease in price, meaning at prices above P?, it will have demand curve d?d? and at prices below P?, it will have demand curve d?d?. Now, there will be a kink in the overall demand curve ( d?d?) at price P? and the marginal revenue will have a vertical break. The inflexibility of price under the kinked demand curve is the reason for the discontinuous portion of the marginal revenue curve. The analysis of the kinked demand curve also explains why price changes might be infrequent in an oligopolistic industry without collusion (Miller 2004 ,p. 635). The increase in price will make the firm lose many of its customers because of the rivals who do not raise their prices. From the figure, it means the firm moves up from point A along demand curve d?. If the price will be lowered by the firm, and its rivals will do the same action, its sales will not increase that much. New players joining the industry tend to attract the attention of the oligopolists as they will cause disturbance in the system and may break the established status quo within the market. This scenario is one of the reasons why oligopolists are tempted to collude. Through collusion, they form barriers by using entry deterrence strategies such as increasing entry costs, limit-pricing model and raising customers’ switching costs to discourage entry (Miller 2004, p. 639-640). Price war is a technique used by the existing firms in the industry to threat new entries. This is done by repeatedly cutting the prices to get additional market share. This will then serve as a signal for potential competitors that they will engage in a price war. However, existing firms need to invest in excess capacity to sustain the long price war. Another strategy being used by other countries to protect its domestic producers is by imposing stringent environmental or health and safety standards on products provide by foreign firms. Limit-pricing model is also used to discourage new firms from entering the industry. In this model, the existing firms set lower level of market prices even making it impossible for entering firms to earn a normal profit. Existing firms also can make it costly for consumers to switch from its product or service to a competitors’ to deter possible entry and competition. This could be done by further developments of the existing product or service to come up with an innovation in a sense that it will not match any competitors’ product or service. This is usually evident in the computer- related industries. They altered the operating systems and software products of their equipment so that it will be impossible for it to work in a competitors’ product and customers who want to change from one computer system will bear the high switching cost. Bibliography Brigham, Eugene F., Joel F. Houston and Dana A. Clark. Fundamentals of financial management. Ohio: Thomson South-Western, 2004. Danieljensenlaw.com. Collusion. n.d. 30 March 2011 . Hall and Leiberman. Economics: Principles and Application. 2004. Investopedia.com. Oligopolies. 2011. 30 March 2011 . Lande, Robert H and Howard P Marvel. The Three Types of Collusion: Fixing prices, Rivals and Rules. 19 May 2008. 30 March 2011 . Marc, Ivaldi, et al. "The Economics of Tacit Collusion." 2003. McConnell, Campbel and Stanley Brue. MICROECONOMICS: Principles, Problems and Policies. New York: McGraw-hill, Inc., 1993. Miller, Roger LeRoy. Economics Today: The Micro View. Boston: Pearson Education Inc., 2004. Pakes, Ariel. A Dynamic Oligopoly with Collusion and Price Wars. 22 June 2000. 30 March 2011 . Read More