Key Economic Theories Of Price Fixing Economics Essay

2A. Features of an oligopoly and key economic theories of price fixing :

Introduction :

This part of the coursework aims to identify the key features of oligopolistic competition in market and the economic theories related to price fixing. In monopoly one company controls the major market share while in oligopoly; market is controlled by more than one firm or a group of small firms. This analysis describes the features of oligopoly and kinked demand curve in oligopolistic situation.

It also explains the pricing theories in context with game theory and Nash Equilibrium.

Oligopoly :

In oligopoly, large percentage of market is captured by leading firms, producing same product or services. Such firms agree to cooperate and act as single monopoly thus making a cartel to generate maximum profits.

Key features of oligopoly are:

Same product or service by the group of dominated firms.

Branded product by each firm.

Entry barriers.

Interdependence among the firms.

Non-price competition.

Small firms may exist in oligopoly but the market is usually controlled by large players having more than half of the industry output.

Each firm produces branded product, therefore creating high competition resulting in high marketing and advertising costs.

Entry barriers such as government regulations, patents, setup cost and undivided resource ownership, restricts a new entrant to enter the oligopolistic market.

Interdependence means that each firm must take into account the likely reactions of other firms in the market when making pricing and investment decisions (Begg & Ward). Such an uncertainty in market can be resolved by the use of game theory which is applied by a firm taking account of the decisions made by the rival firm.

Non-price competition among the oligopolistic firms, aim at increasing their market share significantly e.g. media advertising, promotional offers and discounts, use of technology, customer friendly services such as self scanning machines and customer loyalty benefits etc.

Kinked demand curve theory

According to Paul Sweezy’s assumptions, if an oligopolistic raises its price, the rivals are unlikely to follow the same suit because keeping the prices constant will increase their market share. Revenue of the firm that raised its price will fall by fairly large amount, making the demand curve relatively elastic.

However if the firm reduces the prices, it is highly likely that the competitors will also reduce the prices.

Source: Tutor2u Limited,2010

This non-collusive theory explains the stability once the price is set but fails to explain how the stable price is achieved. In oligopolistic situation; each company has an option either to start a price war with the rival or to cooperate. Game theory deals with the prediction of probable outcomes of the games of strategy in which rivals have incomplete information about other’s intensions e.g. Prisoner’s dilemma is a situation in which two suspects are interrogated in separate rooms, depicts an example of game theory. Each suspect has simple options either confesses and bears the consequences or denies and hopes the other has also done the same.

To explain which strategy the firms will adopt can be explained by Nash equilibrium, in which each firm considers its rivals response before taking their own strategy.(Begg & Ward,p.131) Equilibrium occurs when each player takes the best possible action for themselves given the action of the other player. Nash equilibrium is a situation in which none of the firms could improve pay-off, given the rivals strategies e.g. firm A would not be able to improve profits , given firm B’s strategy and vice versa.

Each firm may indulge in high or low price strategies. If both firms collude to adopt high price strategy, both would yield above normal profits and if both adopt low price strategies, both would yield normal profits. Suppose in long run, each firm fails to trust the rival and indulge in low price strategy to increase its profits and the rival adheres to the high price than the rival may face heavy loss. Such a fear that the rival may adopt a damaging strategy exists within the firms and it is therefore in the interest of both the firms to adopt a low price strategy. Such a situation is called Maximin strategy where the player adopting the strategy yields maximum profits, assuming that the rival may inflict maximum damage.

At times a group of oligopolists engage in an overt agreement to fix the prices and the level of production. Such an overt collusion, in order to act as a monopolist, is called collusive oligopoly and aims to earn maximum profits by restricting the production and increasing the prices. Price changes of one firm are sometimes matched by the other firm and the firm initiating the price change is called price leader; such collusion is called as tacit collusion.

Rectangle abcd depicts the cartels’ profits.

Cartels are likely to break in long run as the members are intended to cheat sometime or the other by increasing production. By producing more output than decided, the member can increase its share from cartel’s profit. If each member cheats than cartel ends up in earning monopoly profits and thereby leaving no reason for the firm to remain in the cartel.

Conclusion

Interdependence is the key feature of oligopolistic market. The outcome of any strategy by a firm is uncertain and the price competition may lead to price-war. Entry barriers help the dominant firms to maintain their control over the market. Formation of cartels may yield short term gains but are hazardous in long run. It is also observed that non-price competition may benefit oligopolists to increase market share and sustain in long term.

2B.Extent to which telecom sector in India is an oligopoly and price determination strategy

Introduction

Indian Telecommunication industry is the second largest and fastest telecom industry in the world with around 706.37 Million telephone (landline and mobile) subscribers and 670.60 Million mobile phone connections as of Aug2010.Dominance of few major players has made this sector perfect case of Oligopoly in India. Due to the presence of limited number of players, each player is aware of the rival’s actions and therefore the decisions of one firm is affected by the action of the other firm.

Service Provider wise Market Share as on 31-7-2010

Source: Telecom Regulatory Authority of India

Concentration Ratio

Players

Market Share(%)

Bharti (Airtel)

21.34

Reliance

17.37

Vodafone

17.08

Tata

11.47

Concentration Ratio

67.26

Table above shows that four firm concentration ratio is above 40%

Barriers to entry in Telecom

The high entry barriers in telecom sector as mentioned below turns the market oligopolistic in nature.

High capital investment required by the new entrant for initial setup

competition with well established operators Airtel, Vodafone, Reliance and Tata

license fee on revenue sharing basis plus one time entry fee

continuously emerging technology e.g. VOIP,3G

lowest tariffs in the world

acquiring spectrum

high initial operating losses. Lower rates makes it longer for the new entrant to achieve

equilibrium as most new subscribers churn from one network to another.

Low Tariffs: Facet of Competition

Indian telecommunications is the lowest cost market in the world. The cut throat competition among operators has left no scope of having single price leader in market as all the operators compete for lower prices and high customer base. Increased number of players has resulted in increased price wars among the competitors, with consumer being the beneficiary. Such factors declines the profit margins which are expected to consolidate the industry.

Offset of price wars

In mid nineties, at the start of cellular services in India, operators used to charge heavily for the incoming calls on their network. After the launch of BSNL’s free incoming call facility, other operators followed the same suit. Still the major chunk of customer remained with BSNL due to its low call rates and better network coverage.

With the launch of Reliance Communications as a new telecom giant, teledensity in India raised enormously to 8.2% in 2004 from that of 2.32% in 1999 and to 54.10% in April 2010 (as per TRAI).Introduction of low cost cellular services, along with handset, made Reliance the price leader in telecom industry attracting a huge chunk of customer base. Other leading service providers like Airtel, Vodafone and Hutch had to match their prices with that of Reliance.

To monitor and regulate the irregularities in tariffs charged by telecom operators, Telecom Regulatory Authority of India was formed by the government of India. The Telecommunication Tariff Order 1999 started declining tariffs and influenced the rapid growth of cellular phone users. TRAI is also responsible to monitor and prevent the formation of cartels by cellular operators in the cover of associations such as COAI and AUSPI.

Source: Telecom Regulatory Authority of India

Source: Telecom Regulatory Authority of India

Graphs show the percentage decline in national and international call rates. This occurred due to intense competition that generated after TRAI regulations.

Steps taken by TRAI that affected tariffs:

Interconnect Usage Charge – payable by one operator to another for using their network

Reduction in Access Deficit Charge also contributed in bringing down the call rates

Calling Party Pays regime fixed low termination charges further reduced prices

Unified Access Service License gave operators the privilege to determine tariffs

Impact of price-war

Price war among operators hits the revenue growth significantly. For the new entrants, the break-even point at which expenses equals’ revenue also increases.

The decline in prices due to competition increases the consumer base to unsustainable levels. Previous data suggests that only 50% of the subscribers are new and the rest are either churning the network or keeping an additional connection.

Graph shows increase in demand with decrease in price

Table below shows market revenue growth in terms of MRPU.

major players.jpg

Marginal Revenues Per Minutes (MRPU)

Graph below depicts the growth in usage actuated by reduction in tariffs. Apart from low call rates, reduced cost of handsets and free handset facility by service providers also contributed to the increase in customer base.

Source: Telecom Regulatory Authority of India

Non-Price Competition

Recent launch of per second billing option by Tata, pushed its rivals to indulge in non-price competition.

Most of the operators have now started offering similar per second billing to its customers and this has resulted in creating more pressure on margins. Value added services and customer friendly facilities like online payment, internet access and better network coverage constituted in non-price competition.

Conclusion

The above research and analysis of data implies that Indian telecom industry exist in oligopolistic situation where few major players are having large share of the market. Strategic change of one operator impacts the strategy of other players, resulting in interdependence among operators. High entry barriers restrict new entrants to enter the industry and regulatory authority like TRAI monitors the formation of cartel in the industry. Analysis also shows that competition in oligopolists is not only due to price-wars but other factors such as better services and low cost of handsets also influence a large customer base.