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Tuesday, April 6, 2010

Oligopoly: its Price and Output Behaviours



An oligopoly is a market condition in which the production of identical or similar products is concentrated in a few large firms. Examples of oligopolies in the United States include the steel, aluminum, automobile, gypsum, petroleum, tire, and beer industries. The introduction of new products and processes can create new oligopolies, as in the computer or synthetic fiber industries. Oligopolies also exist in service industries, such as the airlines industry.

An oligopoly may be categorized as either a homogeneous oligopoly or a differentiated oligopoly. In a homogeneous oligopoly the major firms produce identical products, such as steel bars or aluminum ingots. Prices tend to be uniform in homogeneous oligopolies. In a differentiated oligopoly, similar but not identical products are produced. Examples include the automobile industry, the cigarette industry, and the soft drink industry. In differentiated oligopolies companies attempt to differentiate their products from those of their competitors. To the extent that they are able to establish differentiated products, companies may be able to maintain price differences.

Being part of an oligopoly affects a company's competitive behavior. In a competitive market situation that is not an oligopoly, firms compete by acting for themselves to maximize profits without regard to the reactions of their competitors. In an oligopoly, a firm must consider the effects of its actions on others in the industry. While smaller firms may operate at the fringes of an oligopoly without affecting the other firms in the industry, the actions of a major firm in the oligopoly typically cause reactions in the other firms in the industry. For example, if one company in the oligopoly attempts to undersell the others, then the other firms will respond by also lowering prices. As a result, price cuts in oligopolies tend to result in lower profits for all of the firms involved.

Prices in oligopolistic industries tend to be unstable to the extent that companies will shade, or lower, their prices slightly to gain a competitive advantage. It must be remembered that collusion between firms to fix prices is illegal under U.S. antitrust laws, so oligopolies must reach industry agreements on pricing indirectly. Companies can signal their pricing intentions indirectly in a variety of ways, such as through press releases, speeches by industry leaders, or comments given in interviews. In some cases there is a recognized price leader in the oligopoly, and other firms in the oligopoly set their prices according to that of the industry's price leader.

Industrial concentration is a matter of degree. This means that there is no absolute definition of an oligopoly in terms of the number of firms accounting for a certain percentage of an industry's output. In the United States the Census of Manufacturers reports on each industry's four-firm concentration ratio. This figure indicates what percentage of an industry's output is accounted for by its four largest companies. It is not uncommon for the four largest firms to account for 30 percent or more of an industry's output, and in some cases they account for more than 70 percent of production.

In the United Kingdom, for example, the top four food retailers accounted for 45 to 67 percent of the nation's $150 billion grocery market in 1998. In Russia, economic development under Boris Yeltsin has been described as a "new oligarchy," in which government officials and business leaders join together to gain control of industries such as banking, television, the business press, and other companies.

Oligopolies tend to develop in industries that require large capital investments. Studies have shown that industries with high four-firm concentration ratios tend to have higher margins than other industries. In order to maintain an oligopoly, potential investors must be discouraged from establishing competing companies. Oligopolies are able to perpetuate themselves and discourage new investments in several ways. In some cases the oligopoly is the result of access to key resources, which may be either natural resources or some patented process or special knowledge. New firms cannot enter the industry without access to those resources.

The established, experienced firms in an oligopoly also enjoy significant cost advantages that make it difficult for new firms to enter the industry. These cost advantages may be the result of the large scale of production required as well as of experience in keeping manufacturing or operating costs down. Another factor that tends to perpetuate oligopolies is the difficulty of introducing new products into an oligopoly characterized by a high degree of product differentiation. Prohibitively large expenditures would be required of a new firm to overcome consumer reluctance to try a new product over an established one. Finally, oligopolies perpetuate themselves through predatory practices such as obtaining lower prices from suppliers, establishing exclusive dealerships, and predatory pricing aimed at driving smaller competitors out of business.

REVIEW OF RECOGNISED MUTUAL INTERDEPENDENCE

Four possibilities: Because of the recognised mutual interdependence and uncertainty in price and output, there are four possibilities of behaviour ranging from outright price competition, price rigidity and non-price competition, price leadership and collusion.

OUTRIGHT PRICE COMPETITION

Because different cost advantages, firms tend to compete one another by cutting prices hoping to increase market share, TR and profit. Succeed if other firms will not react to reduce their prices. The demand curve for your product is elastic; Fail if other firms do react, thus leading to zero economic profit for all firms, loss for some firms and a higher market concentration. This possibility often prevails in the oligopolistic market with a few equally sized firms.

PRICE LEADERSHIP

A large firm takes the lead in setting a price which is followed by other firms. Necessary Conditions: The leading firm must be able to predict how other firms to react to (follow) its price and quantity decisions. If the reaction is as expected, there will be no pressure on the leading firm to change price other than due to new changes in costs. Two Problems: How is the first price is established ? How is the established price changed ? This possibility often prevails in the oligopolistic market with very high concentration ratio.

PRICE RIGIDITY AND KINKED DEMAND CURVE

Without cost advantages, firms are reluctant to change their prices because, if one firm reduces its price, all other firms will follow and no increase in Q sold is possible; if one firm increases price, no other firms will follow and there is a decrease in quantity sold. No benefit but loss; Kinked Demand Curve: One firm decreases price, all other firms follow, no increase in quantity sold. One firm increases price, no other firms will follow a decrease in quantity sold. There is no benefit but loss in changing prices. There is rigidity in price.
Firms go for non-price competition such as product differentiation, product proliferation, and advertising, etc. Price rigidity in oligopoly is expressed by a kinked demand curve.



COLLUSION AS A CARTEL

Collusion is opposite to price competition. Oligopolistic firms always have incentives to collude by agreements to act as if they were a monopoly in order to capture the maximum monopoly profit. But the collusion is always temporary and the competition is inevitable because of the conflict of interest.

GAME THEORY

The decision behaviours of oligopolistic firms are not stable and predictable because of mutually recognised interdependence. The conflict of interest and the strategies in the context of conflicting goals are demonstrated in the game theory and expressed by a payoff-matrix. It indicates a profit gain or loss from each possible move for each possible rival reaction.

PAY-OFF MATRIX FOR A DUOPOLY IN PRICE WAR (millions in profit)

FIRM Y’s strategy FIRM X’s max loss
cut price
do not cut price

FIRM X’s strategy cut price (1) X’s profit - $3
Y’s profit - $3 (2) X’s profit +$2
Y’s profit -$5 -$3
do not cut price (3) X’s profit -$5
Y’s profit +$2 (4) X’s profit, no change
Y’s profit, no change -$5
FIRM Y’s max loss -$3 -$5

1. Firm X is worse off because it cuts price when Firm Y follows. the worse case for all
2. Firm X is better off because it cuts price when Firm Y does not follow. the case in favour of Firm X
3. Firm X is worse off because it takes no action when Firm Y cuts price. the case in favour of Firm Y
4. Both firms are better off because no price is cut. the best case for all

• Logically, the best case (No. 4) for all firms is that no one cuts price (they collude tightly). But in reality, due to the conflict of interest, the worse case (No. 1) always prevails because:
• each of them wants to seek +2 m for which the necessary condition is that one person cuts price while the other person does not cut; and ironically
• no one can get +2 m because everyone chooses to cut price due to the fact that the maximum loss -3 m (if they cut price) is smaller than -5m (if they refuse to cut price).
• Competition is inevitable and collusion is temporary.

COMPARISON OF OLIGOPOLY WITH OTHER MARKET STRUCTURES

Views on Oligopoly: The strict comparison of oligopoly with other markets is largely a fiction. Advantages: 1. Oligopoly is more realistic; 2. It is an ideal combination of the opportunity for profit giving incentive to innovation and the existence of competition encouraging efficiency. Problems: concentration ratios are higher in some industries than can be justified by economies of scale; industrial concentration and large firm size are not consistently related to inventive and innovative activity; There is also a positive relationship between industrial concentration ratio and the amount of advertising..

Challenge on Assumption of Profit Maximisation: The theory of firm is based on the assumption that the only business goal for a firm is to maximise its profit. In reality, firms may maximise either short run profit or long run profit, or something other than profits altogether, such as growth of sales revenue, market share, salary and life style package for executives, the luxury of inefficiency, etc. However, the profit maximisation is fundamentally important for firms' survival.

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