Oligopoly and Entry Barriers

Oligopoly and Entry Barriers

Oligopolies are found in many sectors of the economy such as the auto industry, gasoline industry, consumer goods and steel production in industrialized countries. Unique levels of competition powered by the increasing globalization have resulted in the emergence of oligopoly in many market sectors. (Wikipedia 2006)

Oligopolistic competition gives rise to a broad range of different outcomes. In some situation, firms get together to raise prices and restrict the production in the same way as a monopoly. In other situation, competition between sellers in oligopoly can be stern with relatively low prices and high production that could lead to an efficient outcome approaching perfect competition. But what is oligopoly? (Wikipedia 2006)

An oligopoly is a form of economy. The four-firm concentration ratio that expresses the measure of the market share of the four largest firms in an industry is often utilized as a quantitative description of oligopoly. Thus, an oligopoly is defined as a market in which the four-firm concentration is above 40 percent. Example of which is the supermarket industry in United Kingdom with a four-firm concentration ratio of over 70 percent and the brewery industry in United Kingdom with 85 percent concentration ratio. Moreover, the industries that produce cigarettes, beer, aircraft, and motor vehicles as well as the music recording industry are the oligopolies in United States. (Wikipedia 2006)

Oligopoly is also the common market form. It is a more prevalent form of market situation in which there is a small number of buyers or sellers, each of whom handles a large share of the total supply and therefore has certain attributed of monopoly and monopoly power. (Bauer 1963)

Furthermore, it is dominated by small numbers of sellers, the oligopolist. Each oligopolist is aware of the actions of others since there are only few participants in this type of market. The strategic planning of oligopolist always involves taking into account the likely responses of the market participants. (Wikipedia 2006)

Hence, the decision of one firm influence and are influenced by the decisions of the other firms. This causes oligopolistic markets and industries to have the highest risk of conspiracy. Oligopoly firm operates under imperfect competition. The demand curve is kinked to reflect inelasticity below market level and elasticity above market price. (Wikipedia 2006)

Oligopoly literally means few sellers. However, it is not ultimately the number of sellers in a market that is the critical factor but the relationship between the sellers. The most sensible approach is, therefore, to concentrate upon the interdependent nature of decisions made by firms within a particular market, irrespective of precisely how many firms there may be. (Else 1990)

What is meant by interdependence is that a behavioral change on the part of one firm has a significant effect upon the other firms’ positions, and therefore forces the other firms in the industry to reconsider their own behavior. In other words, in contrast to what happens under perfect competition and monopoly, each firm is forced to consider whether or not to react to a behavioral change by any other firm, and to consider in turn whether a positive reaction will induce a counter-reaction. (Else 1990)

An oligopolistic market is characterized by uncertainty because no one firm can be sure what its competitors will do if it changes its behavior. If it acts in isolation, then it is forced to work its way logically through all the possible eventualities, and to try to pin down the likeliest reaction to any behavioral change. For obvious reasons, firms are not altogether enthusiastic about the effort required by this approach, and seek constantly to improve their knowledge base in other ways. It does not take much thought on their part to realize that collusion offers the most direct route towards this objective. (Else 1990)

The realization by each oligopolistic firm that its fortunes depend very closely upon the actions of the others in the same market is an important and distinctive characteristic of oligopoly. Their behavior is influenced by the realization of mutual interdependence. Mutual interdependence results in the coordination of the policies and acting together of oligopolistic firms since they find that it is convenient and profitable. (Bauer 1963)

Thus, each firm appreciates that in initiating price changes it must expect the other firms to react to these changes, and that in assessing the net effects of a price change it must take account of the probable reaction of others. Oligopolistic firms also consider not only the general market situation and its own financial and stock position but also the probable conduct of its principal competitors in deciding on price changes. (Bauer 1963)

Market-sharing arrangements particularly in the supply of standardized products and services between a number of producers or firms frequently accompanied oligopolistic situation since price-fixing agreements may be effective and stable even without formal market-sharing arrangements. (Bauer 1963)

Co-operation by no means is the inevitable outcome of oligopoly. Individual firms may decide to try their strength and to enlarge their share in the market by active competition. However, the unity within the co-operating group tends to be weakened when new entry is possible or when some firms do not participate in group activity since differences over the pursued appropriate price and marketing policy in the light of the actual or potential outside competition arise. (Bauer 1963)

ECONOMICS AND DESIRABILITY OF OLIGOPOLY

There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances. For example, if an oligopolistic firm cuts its price, it is met with price reductions by competing firms. On the other hand, if it raises the price of its product, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period of time. (Competition Commission n.d.)

It is hard to make concrete statements regarding price charged and quantity produced under oligopoly. However, from the point of view of the society, one can say that an oligopolistic market structure provides a fair degree of competition in the market place if the oligopolists in the market do not collude. Collusion occurs if firms in the industry agree to set price and/or quantity. (Competition Commission n.d.)

Oligopolistic Practices

Oligopolies have a number of strategies and tactics to either limit competition or expand their markets. They enjoy periods of stability in which price competition is limited or absent even while these firms struggle over market share through various forms of non-price competition. There are also periods of instability particularly when a new firm is invading an established market since the leading firms might use price as a competitive weapon. However, oligopolistic firms have developed a number of practices to limit entry into the industry, avoid price competition and manipulate demand. (The Arthritic Hand of Oligopoly n.d.)

Limiting Entry

When a new firms attempt to gain entry, oligopolies can become unstable. Thus, the high cost of acquiring plant and equipment acts as barrier to entry. Entering an industry dominated by a small number of known trade names is also costly. Also small firms already in the industry present a special problem. The large firm often simply purchases the up-and-coming small firm. Sometimes, the large firm or firms rely on its established relationships with customers or suppliers to limit the activities of smaller firms. (The Arthritic Hand of Oligopoly n.d.)

Avoiding Price Competition

Changing a price is always a dangerous practice for an oligopoly. . If the firm lowers the price, its competitors are also likely to lower theirs, and then all will suffer from lower profits. On the other hand, raising prices may lead to a loss of market share unless competitors also raise their prices. In many industries, one firm (usually the largest) is accepted by the others as the price leader. The price leader will be the first to adjust prices to new conditions and others will fall into line. (The Arthritic Hand of Oligopoly n.d.)

Predatory pricing where in a large or diverse firm that can stand temporary losses cut its prices below the cost of production until it runs competitors out of business or establishes its price leadership and then raise its prices again and the price fixing where formal agreements to fix prices are used is also practice by oligopolistic firms to avoid price competition. (The Arthritic Hand of Oligopoly n.d.)

Manipulating Demand

The large firm is often in a position to create a demand for its own product through advertising. While this sometimes leads to actual product improvement, it can also lead to the production of images rather than truly different products. (The Arthritic Hand of Oligopoly n.d.)

BARRIERS TO ENTRY

Entry barriers refer to the disadvantages of potential entrants, vis-à-vis already established firms that imposed on the former higher costs or require them to accept lower per-unit prices for goods of the same quality. These barriers are measured in terms of how much the established firms can raise the price above a competitive level without inducing new firms to enter. (The Arthritic Hand of Oligopoly n.d.)

Oligopoly market structures can be sustained over time only if there are barriers to entry. Firms in oligopolistic industries can sustain market power only if they can prevent other firms from entering the industry. (The Arthritic Hand of Oligopoly n.d.)

Natural Barriers

Natural barriers include economies of scale, economies of scope, absolute cost advantages and capital costs. (The Arthritic Hand of Oligopoly n.d.)

Strategic Barriers

Strategic barriers include actions taken by firms such as product differentiation and increasing the cost of entry. (The Arthritic Hand of Oligopoly n.d.)

Differentiation of Entry Barriers in Oligopoly

Economies of scale, economies of scope, absolute cost advantage, capital costs and product differentiation are the most common barriers to entry in an oligopoly. Economies of scale are reductions in the average cost of producing a product as the firm expands the size of its plant in the long run. On the other hand, economies of scope are savings that are acquired through simultaneous production of many different products with the same plant and equipment. (A Guide for Industry Study and the Analysis of Firms and Competitive Strategy n.d)

In absolute cost advantage, the long-run average cost of an entrant is higher than that of incumbents while in capital costs the Minimum Efficient Scale (MES), the larger the financing needed to enter the industry at the MES. If entrants must pay a higher interest rate on financing than incumbents, then there is a barrier to entry. Product differentiation matters when the consumer perceived the product in different ways in terms of the benefits. Advertising itself can also be a barrier to entry. (A Guide for Industry Study and the Analysis of Firms and Competitive Strategy n.d )

BARRIERS TO ENTRY AS A KEY ELEMENT OLIGOPOLY

Oligopolistic firms necessarily have the power to influence market prices, which, however, does not imply that the price can be set at a level which will secure a return to the firms, or remuneration to their management or employees, above the level which could be secured in trades or employment of similar risk and complexity elsewhere. The establishment and continued maintenance of such a price postulates not only oligopoly situation, but also appreciable and lasting obstacles to the entry of new firms. (Bauer 1963)

The duration and extent of the power to influence prices, and the likelihood that it will be exercised to secure additional profits and advantages, depend primarily on the nature of the obstacles which impede the provision of additional independent sources of supplies and additional suitable substitutes. The nature of the obstacles also conditions the prospects of remedial government action designed to widen the range of independent alternatives open to buyers and sellers. (Bauer 1963)

The obstacles to new entry or to the development of suitable substitutes can be classified in a number of ways, of which two seem of particular relevance, especially from the point of view of public policy. In the first place, the criterion may be the length of time over which the advantages of the power to control the market are likely to persist in the absence of specific government measures designed to remedy the situation. In the second place, the distinction may be made to turn upon whether the obstacle represents largely or wholly some natural scarcity, or whether it is the result primarily of a specific action or attitude of government or of firms in the market. An important subdivision in practice is whether the contrived obstacle is the result of private arrangements or of actions by authority. (Bauer 1963)

Unfortunately, it is not generally possible to apply these various criteria unambiguously to the blurred complexities of particular situations. The categories shade into each other and overlap. Frequently the obstacles may be compounded of short-lived or long-lived natural scarcities and of government measures and private arrangements. (Bauer 1963)

However, from the point of view of public policy the potentialities of government action are greatest where new entry and the development of substitutes are obstructed partly or largely by contrived barriers, whether resulting from legislation or administrative action or from the private arrangements of the participants in the market. Further, those barriers which derive from government action paradoxically tend to be the most formidable and durable, though they are technically the easiest to rectify if it were thought desirable. (Bauer 1963)

The obstacles to entry presented by natural scarcities vary greatly as regards the time required by ordinary market forces to remove them. At one extreme short-lived delay in transport may enable a few favored firms to control a profitable market. The situation will be redressed quickly, a process which will normally be accelerated by the attraction of high profits. At the other extreme the scarcity may reside in an exceptional combination of special experience, knowledge, enterprise, skill and large sums of capital. Here a long period may elapse before the successful combination can be reproduced. Corrective action is clearly unnecessary in situations at the first-mentioned extreme; the early widening of alternatives and limitation on the exercise of monopoly power are provided for in the situation itself. (Bauer 1963)

On the other hand, the natural difficulties of reproducing the special combination make corrective action in the sense of widening the area of choice particularly difficult. Such circumstances require that special care is taken to ensure that the results of natural scarcities, which underlie the obstacle, are not aggravated by the contrivance of additional barriers; for example, while a measure of price and profit control may be desirable, it may at the same time delay or discourage efforts to surmount the obstacles. (Bauer 1963)

Summary

An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high. Firms within an oligopoly produce branded products. There are also barriers to entry.

Another important characteristic of an oligopoly is interdependence between firms. This means that each firm must take into account the likely reactions of other firms in the market when making pricing and investment decisions. This creates uncertainty in such markets - which economists seek to model through the use of game theory.

The ongoing interdependence between businesses can lead to implicit and explicit collusion between the major firms in the market. Collusion occurs when businesses agree to act as if they were in a monopoly position.