Terms Beginning With 'o'

Oligopoly

  • January 07, 2020
  • Team Kalkine

What is an oligopoly?

Industries evolve over time and pass through several competition patterns. Competition in an industry is the effect of behaviour of firms. Fiscal policies also have an influence on the competition with industries. Policy intervention is implemented through a competition commission/regulator. 

Oligopoly is a term used to define an industry, a specific market, or a company. It is a market dominated by a few players and can have many small players. This type of competition in a market is known as oligopolistic competition. A few enterprises dominate the market, often selling similar goods and services. 

Since only a few firms dominate an oligopoly market, competition is muted from smaller payers. Firms in oligopoly gain significant market power, thus preventing other small players from flourishing or entering the market. 

Firms often replicate the behaviour of each other, and also recognise that action will likely provoke a similar response from other firms. In this way, firms also understand interdependence among each other in the oligopoly market. 

What are the characteristics of an oligopoly?  

Entry Barriers

It is an important source of oligopoly. Barriers to entry make it difficult for firms to enter the market. It essentially refers to hindrances and restrictions an aspiring firm faces when entering new markets. Some markets have high barriers to entry, like an oligopoly, while some have very low barriers. 

Firms can have barriers in the form of licences, patents, intellectual property, or established economies of scale. Oligopoly could also exist in professions, which require licensing and specific educational qualifications. 

Since there are a few firms in oligopolistic competition with significant market share, oligopolies must realise economies of scale, which is an important barrier to entry. With economies of scale, firms realise cost benefits over competing and small players. 

Further, barriers could be in the form of the capability of firms with respect to developing intellectual property, patents, access to complex technology and capital. Government policies could be a source of barriers, especially when licenses for operating in a market are granted to a limited number of players.

In many economies, entry barriers have given birth to oligopolies in many markets and industries. In the past 50 years, the increasing level of globalisation has also intensified competition across the industries. 

Price leadership

Firms in an oligopoly market are also dependent on each other, and this interdependency is also defined as an oligopoly. The competition remains so intense that changes in price level and output are replicated by firms in the market. 

Collusion is a term used in competition and occurs when two competing firms join hands. This could result in restrictive trade practices, voluntary cut in volumes and price hikes. It remains illegal across most of the economies, and competition commissions keep a check on such practices. 

Price leadership may lead to tacit collusion in an oligopoly market, but it could be difficult to identify. The leader firms choose the prices, and other firms follow by raising or lowering prices to match. When other firms respond to price changes, it does not necessarily mean tacit collusion. 

Competition laws direct to firms to not explicitly communicate prices, therefore making it illegal. In an oligopoly, firms may agree tacitly and respond to the price or output changes by the price leader. 

Product differentiation 

Product differentiation is a procedure of developing goods or services that are distinguished from others available in the market. It is a source of higher demand for the product from the target market and includes differentiating products from substitutes as well as their own products. 

Although the differentiation may be small from a producer’s perspective, the buyers in the target market could have different perceptions for available products. This distinguishing feature may allow the producer firm to charge a premium price. 

Differences in goods and services can exist through differences in quality, functional features or designs, sales promotion activity, or availability. The motive of achieving product differentiation is to develop a position, which customers perceive as unique. 

As a result, the goods or services offered with differentiation have the ability to lower competition. A growing level of differentiation leads to fewer comparison and competition. 

In an oligopoly, firms make standardised products or differentiated products with similar attributes such as toothpaste, steel pipes, copper, gold. A firm in an oligopoly market is not necessarily needed to achieve product differentiation. 

However, when a firm successfully implements product differentiation strategy, it allows to gain further market power and dominate some parts of the industry.   

Increasing returns to scale 

In an oligopoly market, firms should have a significant market power, which would deter other firms from entering the market. Increasing returns to scale is a stage of business in which the rate of increase in output is higher than the rate of increase in input. 

Put another way, when a firm is operating at increasing returns to scale, doubling the input levels would result in more than doubling output levels. This simply implies that larger firms have lower average costs compared to smaller firms. 

In this way, larger firms can benefit from efficiency gains at a higher level of production. Oligopolies and monopolies typically exist in industries where increasing returns to scale are achieved at higher output levels. 

When a new firm seeks to enter the oligopoly market, the market penetration would be smaller, and it would have high average costs of production. It is because most of the market share is dominated by a few firms operating large outputs, thus more cost-efficient production. 

What are the disadvantages of oligopoly?

  1. Since there are few firms dominating a market, the choice with consumers is relatively less. 
  2. By tacitly responding to each other’s move, a firm may act as a cartel, and reduce outputs to raise prices. 
  3. Competition lacks in an oligopoly market, and firms could make consumer decision making a complex process. 
  4. When consumers are manipulated at a large scale, there could be a loss of economic welfare. 
  5. Since there are high levels of barriers to entry, aspiring firms may not enter markets, thus lower competition and lower consumer benefits. 

What is imperfect competition? Imperfect competition is a competitive market setup that includes multiple sellers engaged in selling heterogenous goods. Imperfectly competitive markets are a more accurate depiction of the markets in the real world than a perfectly competitive setup. The sellers in an imperfect market have the liberty to influence prices and are thus price makers. The sellers in this market are often protected by barriers to entry. What are the types of imperfect markets? Imperfect competition can be observed in various forms, including: Monopoly: Monopoly is a single producer market, wherein the producer has entire power as it is a price maker. The producer has control over the output, price, and the quality of the product in the market. There are no substitutes in the market, leaving the consumers with only one choice. Besides, there are many barriers to entry of new firms. Thus, the firm continues to hold its monopoly position. Public utilities are generally a monopoly set up as they have a single provider with no substitutes. Since these are government regulated, the prices are not too high to crowd out certain sections of individuals. Oligopoly: The number of players in this set up is more than one, however it is less than the number of sellers in a monopolistic competition. Here there are few barriers to entry and exit. A few producers have control over the market while other firms are small and are price takers. Thus, there exists a high level of interdependency between firms. This can also lead to firms coordinating in some instances to obtain higher profits. This is most frequently seen in the form of cartels. Monopolistic competition: Just like perfect competition, monopolistic competition also comprises of many buyers and sellers. However, both lie on the opposite end of the competitive market spectrum. Products are heterogenous and producers have greater control over the prices of their products as compared to perfect competition. Monopsony: In monopsony there are many sellers but a single buyer. Thus, buyer has greater bargaining power as compared to other market setups. Thus, buyers may ask for lower prices than what sellers want to sell for. Oligopsony: In oligopsony, many sellers serve a few buyers. Thus, buyers have slightly more bargaining power than in other market setups excluding monopsony. What are the characteristics of imperfect competition? The following characteristics define a market with imperfect competition: Number of buyers and sellers: The number of buyers and sellers vary largely, depending on the type of imperfect markets. Under monopolistic competition, firms are usually small in size and each firm is insignificant with respect to any changes in the entire market. Thus, no single firm can affect the sales of another firm. Each firm functions independently of the other. However, in a monopoly there is only one firm and, in an oligopoly, firms are highly interdependent. Heterogeneous Products: Products provided by different sellers may be similar. However, they are differentiated. This means that there are different variations offered in the same type of product across the market. This allows customers to have a variety of goods to choose from, even when the goods perform similar tasks. These variations in the products may come because of the differences in the quality of the product across sellers. For instance, ice creams are offered by different companies selling dairy. Thus, consumers may prefer one brand over the other for their quality or for their range of flavours. However, the product itself serves the same purpose irrespective of which company it belongs to. Free Entry and Exit of Firms: The free entry and exist exists in monopolistic competition under the imperfect market set up. Free entry and exit of firms allow them to produce close substitutes and consequently leads to a greater supply of goods in the market. However, this is not the same for all types of imperfect markets. For instance, in monopoly there are barriers to entry and exit. Imperfect Knowledge About the Market: Both sellers and buyers do not possess perfect knowledge about the market. Under monopolistic competition firms use advertisement to make consumers aware about their products. Thus, advertisements play an important role. However, same is not true for monopoly. Price Makers: Firm in imperfect markets are price makers. Each firm can decide the price for their products. Thus, producers may charge a price that is higher than the marginal price. This is especially true for a monopoly. Kalkine Group Image How did the theory of imperfect vs perfect competition come to light? The theory of perfect competition was given by French mathematician Augustin Cournot in 1838. The theory helped theorise the economic relationships that existed in the market. The theory, however, was too ideal a representation to fit into the real-world scenario. This model of perfect competition was a hypothetical one and was an oversimplification of real-world scenarios. It did not include other aspects like barriers to entry, imperfect knowledge in markets and heterogeneity of products. Despite these shortcomings, the model of perfect competition was widely accepted and is still popular in theory. Theoretical economics still includes the topic of perfect competition as an integral part. Markets like oligopoly, monopolistic competition, monopsony, monopoly, etc are all extensions and variations to the model of perfect competition. Importantly, the theory of imperfect competition was most prominently popularised by Joan Robinson in 1983 in her book “The Economics of Imperfect Competition”. In this book, Robinson gave the model where each firm enjoyed some monopoly power. This was later extended into the idea of monopolistic competition.

What is a Monopoly? A monopoly occurs when a firm is controlling a substantial market share in any given market. The threshold to deem a business a monopoly rests with the laws of any jurisdiction. Simply, it refers to a market situation where a firm has a dominating position in an industry. Monopolists are crafted through various modes, including scarce resource, intellectual property, exclusive rights, Government granted monopoly, merger of two large players. The owner can also sell exclusive rights to other parties like songwriters have rights over their songs. Historically, the Governments across jurisdictions-built monopolies across goods and services destined for the public good and social cause such as postal mail, railways, but not limited to industries like power, mining, banking. The ramifications of free markets have uprooted monopolies in the private world, and firms have gone on to capture large market share driven by numerous factors, including product utility, innovation, intellectual property systems and more liberal laws. Perhaps investors love monopolies. Firms that construct a superior level of barriers to entry carry the arsenal to thrive in markets as the potential of new competition is bleak. It is the competition that sets monopolies apart from other businesses. Since competition is limited, a monopolist can sustain supernormal profits in the long run. Competition in any monopoly is suppressed along with its potential benefits, therefore growing monopolies become a problem in an economy. Consequently, it raises prospects of more stringent competition and antitrust laws. How enterprises become Monopolists? Barriers to entry: It literally means the restrictions, inability or incompetence of new players to enter an established market where the existing player commands higher barriers to entry. Firms develop processes, products or services that are very hard to replicate, keeping new market players out of the competition. Companies that naturally acquire such status are said to have a moat around them. Term made famous in the investing world by Warren Buffett. Read more on Moats: Economic Moats versus Stock Valuation Intellectual property (IP): Secrets to supremacy are critical for thriving in an industry. Proprietary technologies and exclusive rights of those technologies rest with a firm that has developed such intellectual property. But it is perennial for proprietary technology and IP to be far more superior than the next available substitutes in the market to gain a monopoly. A meaningful gap between the next best alternatives will likely provide an advantage. IP rights allow a firm to construct barriers to entry in its market. Interesting read: COVID-19 Vaccine: Battle of Intellectual Property Economies of scale: It is perhaps the intention of almost all companies to achieve economies of scale. A large scale production enables firms to sell products in large volumes and lower margin. Under economies of scale, firms have centralised purchasing, which improves the scale of business and average cost per unit. Branding: Developing a brand will enable a firm to have a differentiated product which may provide different levels of utility to customers. It is a brand which creates perceptual value for its customers to attain a better position in the market. A firm has a monopoly over its brand, therefore developing a powerful brand is a way to achieve a monopoly. Firms are inclined to develop brand loyalty and brand awareness. Networking: When all your surrounding is using the same product or service, you might be inclined to use it as well. Twitter, Facebook, Instagram, LinkedIn are some examples of services that thrive on network effects. What are the types of competition? Perfect competition: It is a market in which there are large number of buyers and sellers. As a hypothetical market, the competition is assumed at its greatest possible level. Buyers and sellers have all the possible knowledge of products or services. Pricing is derived from the prevailing demand and supply in the market. There are no barriers to entry, and firms sell similar products. Monopolistic competition: Under this type, the market has many players similar to perfect competition. Customers perceive that products sold by sellers are differentiated even though products serve a similar purpose. A perception of differentiated products is developed by various factors, including brand name, style, quality, networking effects. People may prefer Coke over Pepsi, despite both products being almost same. Behavioural economics has been a popular study these days to understand the human mind and make products more targeted to its audience. Pricing is quite active in monopolistic markets because a meaningful divergence in prices of two similar products can force customers to choose lower-priced products. As a result, sellers would try to match the price. The location also impacts consumer preferences many times like a barbershop will attract customers who live nearby. A gas station is another example where a nearby customer will have a preference. Advertising can also impact consumer preference. Oligopoly: In an oligopoly, the market is concentrated with few sellers of a product. Sellers also control a substantial part of the market because of a few numbers of competitors. Oligopolistic market requires larger investment for entry, and the cost of starting a business is usually high, keeping new entrants detracted. Since oligopoly requires large scale investments, the industry under this competition generally includes industries like airlines, telecom, space travel, automobiles, defence equipment, shipbuilders. Since products or services are similar, the pricing remains active in an oligopoly. A promotional offer by a firm will force others to replicate or at least a lower price of the product or service. Creative Destruction Joseph Schumpeter introduced the concept of creative destruction. He was of the belief that business cycles under capitalism could derail large scale players in a market by way of smaller new entries in a market. It is important to evolve with changing technologies since smaller new entrants with disruptive technology and innovation could build competitive advantages over existing large firms in a market.

What is monopolistic competition? Monopolistic competition is an imperfect competitive market. A monopoly has a single producer, an oligopoly has a few dominating firms, but there are a large number of firms in monopolistic competition.  Perfect competition and monopoly sit at the opposite ends of the competition spectrum. A market with perfect competition assumes perfect information among many buyers and sellers, trading homogenous products.  Imperfect competition includes monopolistic competition, oligopoly, duopoly, monopoly. Industries that usually fall under monopolistic competition include clothing, footwear, restaurants etc. But why these markets have monopolistic competition? Monopolistic competition will have a large number of buyers and sellers dealing with differentiated products with low barriers to entry and exit. With product differentiation capabilities, consumers also perceive goods as unique to each other.  Moreover, products and services in monopolistic competition are not perfect substitutes, and consumers can differentiate on account of brand, location, quality.  Firms in monopolistic competition undertake decisions independently, and there exists some degree of market power among producers. They maximise profits when marginal costs equal marginal revenue.  When firms compete under monopolistic competition, it leads to an increase in selling expenses, which are aimed to influence the demand curve of the firm. Unused capacities would also hurt firms because the cost will be higher than the profit maximising output.  Some industries with monopolistic competition  Restaurants are often large in numbers, but they largely sell different food, cuisine etc. In addition, there is usually no barriers to entry.  Consumer electronic market has great intensity of differentiated products in terms of features. There are many sellers and buyers in the market, and globalisation has also increased the number of sellers.  Consumer staples like toothpaste, soaps, detergents also fall under monopolistic competition since there are several large players and many small players. These products are differentiated on the basis of ingredients, use etc.  There are many bakery shops in a city or town selling slightly different products in terms of say taste, price, appearance to consumers. If the brand is famous in the town, the firm could dictate the prices as well.  Generally, there is an abundance of hairdressers. But the service offered by each would not be similar. If a customer had an unpleasant experience with any barbershop, he will likely not go to the same place again. On the contrary, when the customer is satisfied, he may be reluctant to visit other barbershops.   Market power  The demand curve for an individual firm is downward sloping in monopolistic competition. It means a decrease in prices will lead to an increase in quantity demand. Because firms have market power stemming through product differentiation, the price can be influenced without losing customers.  Firms that achieve a price leadership are positioned as a price setter and dictate the prices of products. Since competition is intense, firms emphasise on product differentiation to achieve market power.  They seek to reflect that products are an imperfect substitute for each other, and this is gained by differentiating factors, including brand awareness, quality. As a result, firms are able to increase the price without losing the consumer base.  Moreover, every firm in monopolistic competition aspires to dominate the market and expand the size of the market. Therefore, firms incur selling expenses to influence the quantity demanded at different price levels. Product differentiation Product differentiation is a strategy of the seller to differentiate their products from other products in the market. In monopolistic competition, there is a significant level of non-price competition among many firms.  It becomes imperative to build favourable product differentiation for firms operating in a monopolistic market. Product differentiation is essentially the key in monopolistic competition.  Firms undertake research to improve differentiation and demonstrate unique aspects of the product through marketing and advertising. Differentiation does not mean creating differences between the products.  Varying consumer’s perception regarding the product is differentiation. Some factors that drive differentiation include distribution, marketing, and availability. Product differentiation could be in terms of quality, which will likely result in a higher price.  Producers can differentiate products on the basis of design and features offered by the product. Sales promotion and advertising also differentiate products among consumers. Buyers can ignore price and features depending on the brand.  Overall, the objective of product differentiation is to create a unique image of product among existing and prospective consumers. Firms always aspire that product differentiation should deliver non-price competitive benefits. Marketing in Monopolistic competition A secret sauce of many successful companies has been branding and advertising. A marketing strategy is very crucial for a firm to achieve its long-term goals as well as short-term.  Since firms in monopolistic competition race to differentiate products, advertising, and branding is often a go-to strategy for firms. Firms try to engage with clients through various point of contacts such as television, hoardings.  Advertising is a practice for companies used to communicate with customers. Its objective is to inform, educate and familiarise existing consumers or prospective consumers with the products and brand. Moreover, advertising is used to develop brand image and awareness.  The motive of branding is to ignite a response or reaction among consumers when they come across a brand or its products. Brand reputation is constructed through consumers’ previous experience and continuous advertising.  Brand reputation, as a non-price differentiating factor, is perhaps the best strategy to compete in monopolistic competition. Firms also work consistently to manage brand reputation and ensure products deliver the highest quality.  Via advertisements, the consumers are informed about the product and features, and an informed buyer knows what to buy, therefore minimising the cost of choosing product since consumer already knows the features and about the brand.  When entering new markets, advertisements are extensively used by firms to communicate their value proposition to consumers and establish a brand image. It would eventually make consumers comfortable when they try the product.  More importantly, failed and misleading advertisement can backfire at a brand reputation. Before the advertisement is launched, there lies an uncertainty on the expected reactions from consumers. Therefore, reputational damage to the brand and firm would also impact the firm in the market. 

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