American economy is known for and is dominated by conglomerates such as, automakers, airlines, department stores, pharmaceutical companies, supermarkets, financial institutions, and home improvement giants. Despite the variety of products they offer and the services they provide, they have lead to the demise of friendly neighborhood stores. By the way the professional sports like NFL, NBA, and NASCAR are also oligopolies that we love despite their exorbitant ticket prices and what they charge for a can of soda if you can get in.
Oligopoly's characteristics are:
1. Small number of firms The number of firms is rather very small (2 to 50) each having captured a large share of the market.
2. Differentiated or standardized product The product may be differentiated, such as electronic goods, or standardized, such as steel and aluminum.
3. Secrecy is supreme Due to their small number firms can tightly guard their business secrets from each other or may collude.
4. Barriers to entry and exit Financial, legal, and already captured markets by trusted brand names are barriers that new firms cannot easily cross to enter the market. It is also not easy for a big corporation to pack and leave the market.
Why in certain markets, such as cigarettes, airlines, tea, steel, etc. the market competition is limited among few large corporations? Here are some possible answers:
1. Economies of scale: When output doubles while inputs are less than doubled, a firm enjoys economies of scale, i.e., output is increasing faster than the inputs and its long run average cost begins to fall. This is more likely to happen when the size of the firm can be expanded and scale of production increased manifold. Smaller companies cannot enjoy such benefits and their long-run average cost tends to rise when they try to enlarge their plants and/or output. Many of them do not survive in the long run.
Barriers to entry: Banks, insurance companies, oil companies, coal mines, and soft-drink manufacturers are so big that it requires a fortune to enter such markets. Moreover, they also are protected from competition through trade marks, patents, and even government regulations. They also have political clout that can create hurdles for new firms to enter the market.
3. Technology and bigness: Technological changes in manufacturing and transportation had two major effects on the structure of enterprise. First, while the cost of producing many goods fell, low-cost production could only be attained by firms that could increase their scale of production.
4. High fixed costs: Since you will have to continue making the payments on the factory and equipment (fixed costs) even if you are temporarily not producing anything, you will generally continue to produce as long as the price is high enough to cover your labor and raw materials (variable) costs. This will continue until enough of the weaker ones are driven into bankruptcy to bring the prices back up. Only few big ones survive.
5. Mergers: As the idiom goes if you can't beat them, join them. Merger manias are a common phenomenon and its scope is now global. Financial institution-particularly banks--, oil companies, and contractors of all kinds are merging through friendly or hostile bids. The three broad categories of mergers are:
Horizontal merger involves firms selling a similar product such as, merger of banks, insurance companies, and manufacturers of soft drinks or tires.
Vertical merger is a merger between suppliers and buyers of a part of the finished product-also called a top to bottom merger. A firm may buy a cotton growing farm and use the cotton to manufacture cloth in its own textile mill. Then create or buy a fashion designing firm and tailor and market the clothings in its own stores. Oil companies also own oil fields, oil refineries, oil tankers, and patrol stations.
Conglomerate merger is a merger between firms producing or selling unrelated products, though they may supplements each other. Airlines, for example, may own car rentals, hotels, banks, and retail stores at an airport or even the airport itself. Also PepsiCo owns Pepsi cola, pizza hut, Kentucky fried chicken, and taco bell for example.
6. Strategic Alliances and Partial Ownership are another form of walls to block entry of new firms. Recently Motorola joined the strategic alliance formed earlier by IBM, Siemens and Toshiba to jointly develop the next generation of memory chips. Toshiba and IBM have a separate agreement for computer-screen technology and will jointly operate a flat-screen factory in Virginia, USA. Kodak entered into a strategic alliance with Canon, Minolta, Nikon and even arch-rival Fuji to develop a new film format.
Pricing policies in oligopoly markets
How oligopolies determine the prices of the products they sell has no clear cut unaswer. However, her are some theories:
Price Leadership-tacit collusion: 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 (higher labor costs, lower raw materials costs, etc.) and the others will fall into line. Of course this arrangement is entirely informal and unwritten - since any actual agreement to follow such a practice would violate the law.
Predatory Pricing: A large or diverse firm that can stand temporary losses can cut its prices below the cost of production until it runs competitors out of business or establishes its price leadership. Then it can raise prices again. This is illegal. But it is very hard to prove.
Price Fixing: Formal agreements to fix prices are also used, although they are unquestionably illegal. Collusion is probably as old as markets. Adam smith, founder of modern economics, wrote in his classic book an inquiry into the nature and causes of wealth of nations, published in 1776 on page 128, the following:
"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."
such a conspiracy undoubtedly results in monopoly power of oligopolists.
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 just images rather than truly different products.
Price Discrimination: Oligopoly can increase profits if it can separate its markets. Airlines are the classic example. Sell business fliers seats at high prices, since their demand is highly inelastic. Sell seats to tourists, who will only fly if the price is right, at a lower price. The trick is to design restrictions which will keep business fliers from getting tickets at the tourist price.
Obstacles to collusion
Collusions among the oligopolies have limitations, such as:
1. Differences in the demand for their product and cost of production.
2. Larger the number of firms more difficult it is to collude or monitor compliance.
3. Potential for new entrants is always there, thus, they try to moderate price hikes.
4. A recession affects all oligopolies but not equally. Some may not survive low prices.
5. The public outrage of their exploitative prices invites government regulation and laws to curb their market power. .
6. Cheating is common among oligopolies cartels even among members of world's most famous oligopoly OPEC - Organization of Petroleum Exporting Counties.
Consumer advocates, labor unions (who themselves are oligopolies), and government has tried their best to rein in the oligopolies but not with much success. Another article discusses that.
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