Assumptions of Market Theory and The Role of Competition - Assignment Example

Question Market theory is based off of some assumptions. One of these is the idea that a market is competitive (Francis). Consider what logicallyhappens without competition in a market system. Markets are based on self-interest or greed. Producers want to cut wages. They want to offer cheaper products and they want to charge more for them. Since cheaper products are worse products, that means they want to charge more for less. And they want to externalize as much of their production onto third parties. That means they want to pollute more, dont want to spend on worker disability, etc. They want to exploit public goods (Francis). Without competition, producers can gouge consumers. With competition, consumers will choose the best option. They will choose the company that pollutes the least, or charges the least, or pays their workers the best. Workers will similarly choose the company with the best wages and benefits. When you have competition, you generally have cheaper products, better wages, better quality, and less externality and abuse of public goods. This means that, by definition, an oligopolistic market structure is a market failure Why is competition good? Adam Smith, in his seminal Wealth of Nations, argued that markets reach a so-called “harmony of interests” only when they are fully competitive (Francis). A “harmony of interest” is a situation where an individuals self-interest and the pursuit thereof also benefits society. It is also called pareto optimal. But competition has a strict definition and so is never perfectly achieved. The market must be composed of a great many buyers and sellers, almost as many as there are dollars flowing through the market, with only infinitesimal islands interrupting the free market sea. These buyers and sellers must produce and consume, respectively, only a tiny portion of the goods available. This way, no one buyer or seller can control supply and demand. Further, all the goods flowing through the market must be functionally the same. And there has to be no or extremely low barriers to exit and entry on the part of both consumers and producers. An oligopolistic market is one where a collection of large firms own a lot of the market of the market (Lecture Slides 7-9). Different markets and different economic theories mandate different amounts of coordination between the firms and different amounts of market share shared between the firms, but the general idea is the same. A bunch of companies work together, but not quite the same as a cartel. They can agree to lower prices, or to not compete in terms of a product offering so as to segment the market. However, they are still competing, actually and nominally, so their coordination is more ad hoc. There are lots of oligopolies: Cars, cell phones, etc. Since an oligopoly tends to make items less identical, raise the barrier to entry since if you come into the market you compete not with one firm with 20% of the market share but a bunch of coordinating firms with 90% of the market share, allows the oligopoly to control and influence supply and demand, and means that effectively there is one big firm, it is a market failure. Under oligopolistic conditions, the oligopoly will coordinate to keep prices steady. Consumers dont have an option: They have to buy from one of the oligopolists. They can also make mini-monopolies by divvying up the market into smaller chunks. But an oligopolistic market structure is better than a monopoly, for a few reasons. Its easier for government to break up. They can just regulate against collusion or break up one or two of the companies. Its less stable. At any time, one company could decide to increase their profit or their revenue by lowering prices. Their competitors would then follow suit and the coordination would be broken. And consumers still have some options, since its likely that their goods will be slightly different, instead of a monopoly where there is literally one good offered, take it or leave it. Oligopolies also avoid the problem of monopolistic competition (Francis). Thats where single firms offer a product that is similar to, but somewhat distinct from, another firm. Taco Bell and McDonalds both offer fast food at cheap prices with drive-thrus. But they are technically not in the same market, since some people wont eat hamburgers and some people wont eat tacos. They serve two kinds of cuisine. In most towns, that means that there “is a main road that has a bunch of fast-food restaurants, too many used car lots and a zillion motels”. They provide options but none of the businesses are operating at capacity so space, time and money is being inefficiently allocated. Oligopoly can avoid that because the participants in the agreement can agree on where to build businesses to avoid competing with each other and having a glut. Another thing that oligopolies do is make it so that other markets are less competitive too. Remember that both consumers and producers need to be as small as possible for a competitive market. But companies and firms are consumers too. They buy things, like raw materials, labor, and capital. So when you have oligopoly, the consumers in the market also get bigger, and that makes the market and related markets less competitive. Oligopolies can be worse than markets in terms of barriers to entry and exit. If Im starting a new company against a monopoly, I can just focus my advertising against it and talk about how I have a better deal. But if Im against an oligopoly, I have to focus on fighting several companies who are all fighting me. Image courtesy of Business Book Mall. Image used under fair use educational doctrine. To be clear, oligopolies in America (though not historically) are not usually about direct cooperation (Webster). Rather, they involve tacit coordination. The market, for whatever reason, has large firms or generates large firms. Maybe the capital investment to start up the business is large, so new investors dont bet on names that arent established. So that means that oligopolists are still competing with each other and trying to get larger market share. But theyre not too likely to compete too viciously. They cant really knock anyone else out of the market, so they focus on slow gains and dont change the status quo too fast. An oligopolistic market is a very different one from a competitive or a monopolistic market. Thus, it poses different managerial challenges. Question #2 Management in an oligopolistic market therefore poses unique challenges. When a firm is already in the oligopoly, they have to make sure that their management coordinates with the other members of the oligopoly. It is in the business best interest to maintain the oligopoly, even though it does harm the market as a whole. That means that all prices need to stay within bounds and no discounts too extreme are offered. If that isnt done, then you get a chain reaction where member of the oligopoly then lowers their prices in an underbidding war. When a firm is trying to enter an oligopolistic market, it has to bear in mind that, while it is worth approaching the oligopoly to participate, the oligopoly has little incentive to tolerate newcomers since the more members, the more diluted and unstable the oligopoly. Management then has to prepare for an uphill struggle against numerous coordinated attackers. When a firm is interacting with an oligopolistic market, they have to realize that theyre not going to get discounts. A monopoly might cut a bidder a deal, but an oligopoly cant do that, or else it might unravel. So the firm approaching the oligopolistic market needs to be very careful. A good strategy would be to talk to all of the firms and arrive at a favorable bid. Another strategy, a more risky one, is to try to pry a member of the oligopoly away with a good deal. This can cost in the short term but is beneficial in the medium term. One thing oligopolistic markets do is make market makers and middlemen much more important. Ju, Linn and Zhu in a study on oligopolies and market makers/middle-makers concluded that middlemen, oligopolistic firms, and market makers can all coexist peacefully. These market makers are able to post bid prices for both sale and purchase. Middlemen then are able to match these bids, using them as the higher or upper bounds. It is even predictable which direction firms will go. The more efficient as an intermediary a firm is, the more likely it is to be a market maker; conversely, the less efficient an intermediary, the more likely it is to be a middlemen. Costs are highly determinative: Fixed cost of capacity installation is positively correlated with middlemen and negatively correlated with market makers. Over time, all these factors cause bid and ask prices to be more diffuse and lay within a broader range (Ju, Linn and Zhu). Management in an oligopolistic market has to bear this in mind. A smaller company can succeed if it becomes a middle-man or market market. That means many things. It can negotiate when members of the oligopoly have a grievance. It can negotiate and coordinate market information. It can coordinate bids with the dominant oligopoly. An oligopoly makes employee management somewhat easier. Since one is coordinating with other firms in the industry, it is harder for employees to leave. This means that management has the upper hand in negotiations and can terminate more easily. Managers must know not only the number of firms, but their degree of coordination. “The distinguishing feature of oligopolistic... market [structure]... is not simply a matter of the number of firms... [I]t is the degree to which the output, pricing and other decisions of one firm effect the others” (Webster). This means that managers and managerial economists monitoring an oligopolistic market have to pay careful attention to the other members of the oligopoly and follow suit. In cell phones, for example, unlimited nation-wide calling and texting is increasingly becoming standard, presumably with coordination among the cell phone giants. In a perfectly or highly competitive market structure, monitoring the behavior of other firms is unnecessary (Webster). Theyre too small. Every firm can therefore focus just on providing the right price for their customer base. But in an oligopolistic market, you have to pay attention to your opponents strategies too. If they cut prices, or offer more benefits to their consumers, or have a sweeps-stakes, or have a better ad campaign, they get market share. In an oligopoly, its possible to target your opponents. Look at AT&T and Verizons ads. They go back and forth all the time, with insults and arguments. This has many implications for managers. They have to keep abreast of their rival companies business strategies. Advertising needs to be very carefully done. Further, advertising cant just be about why your product is good, it has to also be about why their product is bad or worse. They need to watch and read press releases, watch TV, and so on. Coordination cant be done directly since its illegal (Webster). The best way of doing it, then, is a tacit game. The oligopolists never unilaterally lower prices. When they do, they only do so to match. It is a “non-cooperative game in which the actions of one firm to increase market share will, unless countered, result in a reduction of the market share of other firms in the industry”. In an oligopoly, firms take turns setting the price. Managers must make sure they understand this. Oligopoly, however, is ultimately beneficial for companies. It means they stick around and can make a good promise to investors. They have a permanent image and brand so they dont need to constantly be promoting. They only have to worry about a few competitors and not about upstarts. Proper management can make those opportunities realities. Resources Francis, Robert. “Market Failures”. http://elmo.shore.ctc.edu/economics/market.htm Ju, Jiandong, Linn, Scott C., and Zhu, Zhen. “Middlemen and Oligopolistic Market Makers”. Journal of Economics and Market Strategy. January 25, 2010. Webster, Thomas. Managerial economics: theory and practice. Read More