What Are The Key Features Of Oligopoly Economics Essay

Introduction:

Oligopoly is imperfect competition and is a situation between the monopoly and perfect competition. Oligopoly is characterised by the dominance of a handful of players in one particular sector where they have products or offerings are very similar in nature and can be either homogeneous or differentiated. Under perfect competition, monopoly, and monopolistic competition, firms have a well defined demand curve for their output and need to reach a situation where MR=MC. In both the scenarios firms will not bother about the competitors’ response because they are either very small or monopolies. Under oligopoly, a seller is big enough to affect the market; each of the firm has substantial market power so as to avoid them as being price takers. They would however not be in a position to consider the market demand curve as their own due to the presence of similar forces rivalling them in the market. Oligopolists behave strategically because of the presence of equally powerful players in competition. Entry barriers ensure a high concentration ratio in the industry (Mankiw 2004, Begg and Ward 2010, Lipsey and Chrystal 2004).

The key features of Oligopoly are:

High Concentration Ratio- In an oligopoly the market is dominated by a few major players, typically 4-5. They are individually big enough to make an impact on the market.

Interdependence with competing firms- Interdependence implies that firms must take into account probable reactions of the rivals to any price cuts, increase in output or non-price competition.

Entry Barriers- Entry barriers due to natural (exogenous) or strategic (endogenous) reasons facilitate above normal profits over the long run. Natural entry barriers can be attributed to factors like Government policy, It can be due to various factors like, Minimum efficiency of scale, Government policy, Patents, Distribution control, Mergers and acquisitions etc.

Price Fixing- Competing firms either by tacit or overt collusion agree on price, production and other strategic decisions so as to maximize profits.

Game Theory- Due to the interdependence of the competing firms, one player’s actions may have repercussions on the entire industry. It is therefore imperative on their part to evaluate the strategic options, anticipate the stake holders’ reaction so as to make the perfect combination for the highest possible pay-off. Game theory is the analytical approach through which strategic decisions can be made ( Rittenberg and Tregarthen).

Price Fixing In Oligopoly:

Price fixing can be explained as an attempt by the firms to control supply and set price levels to the extent prevalent in a monopoly. It is achieved by collusion amongst the competing firms with a motive to exert the maximum possible profitability.

Apart from a mutually agreeable price, firms must also be able control market supply. Figure 1.2 explains the price fixation by a cartel and effect on the individual firm. The cartel fixes the price at output Qm and price Pm is decided where the marginal revenue MR equals marginal cost MC and thus the cartel is at the profit maximizing point. The output is decided amongst the members on a mutual basis. Here the individual firm’s output may not necessarily be at the profit maximizing point. Hence if an individual firm wants to maximize profits, it can reduce the price and increase output. It may however run the risk of inducing a price war amongst the constituents resulting in over supply and consequent loss to the cartel as a whole.

C:UsersSAMARENDRADesktopPrice fixation-cartel and firm.jpg

Fig.-1.2 ( Adapted from tutor2u.net)

Fig.:1.2. Cartel price fixation and effect on individual firm.

In instances where a cartel is not formed and the firms compete with each other, price rises will not be matched by rivals, but a price cut will be matched. Such a situation is explained by the “kinked demand curve’. In figure 1.2 we can see that demand is price elastic above the equilibrium price but below the equilibrium price, demand is inelastic as rival firms match price cuts.

C:UsersSAMARENDRADesktop10024821.jpgFig.1.2-Kinked demand curve.

In industries having product differentiation the oligopoly behaves differently, where the competing firms indulge in non-price competition and emphasize on other factors such as advertisement, customer service etc. for gaining market share.

Price leadership:

Firms in an oligopoly may not necessarily posses similar market power. Some companies might be relatively bigger than rivals with superior technology or brand leverage. In such cases, prices fixed by the dominant firm are normally accepted by the other firms.

Egg producers from Western Orissa (India) functioning as an oligopoly:

In economics, we would generally come across many references on agricultural commodities as being perfect markets. That the producers normally are too nominal in size compared to the market so as to make an impact. This possibly should also be the case with egg producers in most markets. However, it could be a different scenario al together, characterised by a few large farms controlling a majority share of the market and operating in an oligopolistic manner.

India is world’s 4th largest egg producer with an average per capita consumption of 42 eggs. The Indian livestock sector contributes 4 % to the GDP. The egg industry in particular is estimated at around USD 2.5 billion and despite the avian influenza outbreaks it has grown at a healthy rate of 15 %( 1991-2009). According to the Ministry of Agriculture, Government of India egg production is estimated at around 55 billion eggs. Of the total eggs produced in the organised sector, nearly 70% comes from the three main production centres of Andhra Pradesh, Tamil Nadu and Punjab. The rest of the states apart from the local produce depend on the production centres and are known as consumption centres. The writer of this coursework is the owner of Orissa’s largest egg farm. We would in this case discuss the scenario in the state of Orissa and particularly western Orissa (WO). Orissa’s daily requirement of table egg is approximately 3 million eggs as against a production of 1.9 million. The production is divided between the two main belts of southern and WO. Average daily production in WO is 1.2 million as against an average demand of 1 million per day. The below chart refers to the production/ supply quantities;

(Fig-2.1, Source- Ovo Farm P Ltd. 2010)

The top five companies here produce 74% of the total requirement with the top three contributing 59%. If we consider the concentration ratio (Riley 2006) and the extent to which the market is dominated by the top five leading firm we could possibly be looking at an oligopoly. In a perfect market they should be price takers considering the scale of the industry and should ideally be getting prices quoted at the production centres and some premium towards the transportation costs. They are however able to command a premium on their produce because of an oligopolistic nature of the market by a tacit understanding amongst them. The price fixing is made possible by geographic demarcation according to the capacities of the constituent farms. Here for the egg producers, the marginal and average cost remains constant. During periods of lower demand the farms need to lower the prices so as to push the demand rightwards in a demand curve but are faced with the dilemma of competitor response (“Prisoners’ Dilemma”). However considering the rivals likely response to a price cut they prefer to dispose off the excess stock in other markets rather than cutting the price to retain demand, which is known as the “Nash Equilibrium”. They are able to achieve this by a possible collusion or cartelisation. Some farms still find it difficult to sell their excess stock during dull periods and resort to price cutting which has a cascading affect and results in a price war. It can be observed in fig.2.2 in the month of November where the difference in price from the nearest production centre is nominal. This consequently leads them to a kinked demand curve because above the equilibrium price, demand is elastic and competitors do not follow the increase in price. However demand becomes inelastic below the equilibrium price when competitors tend to match the price reductions. Apparently such situations are occasional and can be referred as a single period game.

(Fig.-2.2, Source- Ovo Farm P Ltd. 2010)

Entry Barriers:

Natural Factors-

One of the biggest factors going in favour of the farms here is the risks associated with the business after the “Bird Flu” aftermath. It has become increasingly difficult for new entrants to generate funds as lending institutions has put poultry financing in a high risk bracket.

The presence of maoist insurgents has discouraged new investment coming from other states in spite of the lucrative market.

Government policies like entry tax on eggs coming from other states add up to the cost of import.

Strategic factors-

The fact that the existing players in the market have depreciated infrastructure works to their advantage as the current MES for the industry is around 75000 eggs per day capacity with a turn around time of at least 1 year.

Most of the farms have developed their own distribution outlets spanning across the market which gives them the market leverage vis-a-vis a new player and individual traders.

Pricing Constraints:

Al tough the farmers are able to get a higher price, they are however constrained by the market demand. It is based on the market rates in general and any further increase in prices from the nearest production centre (which is based on a pan Indian perspective) can result in a reduction in quantity demanded. Considering the fact that Egg is considered to be a substitute to other non-vegetarian sources of food in India, they will run the risk of losing customers to the alternatives. Therefore the WO farmers are only able to price the produce to the maximum extent which the market is able to accept.