oligopoly

=**Oligopoly**=

What do the companies that comprise the following industries have in common: banking, telecommunications and petroleum? Many consider the companies within these industries to be oligopolies. As Michael Baye points out in his text, "Managerial Economics and Business Strategy", an oligopoly can occur whenever there exists a market dominated by a select few firms, each with large market share, relative to the total industry, //and// there exist barriers to entry.

Market share is simply defined as the percentage of a firms sales divided by total industry sales.

//Individual firm market share = Sales of Firm X / Sales of total industry//

Examples of barriers to entry include patents, high capital/start-up costs, meeting specific regulatory requirements, or acquisition of strategic natural resources (coal, oil, natural gas, etc).

Worth noting is that firms within oligopolies can produce either homogenous or differentiated products. Oligopolies can come about through mergers and acquisitions as well.

One tool that we can use to gauge industry concentration and detect the existence of potential oligopolies is the four-firm concentration ratio. The four-firm concentration ratio is the sum of the individual market shares of the largest four firms in an industry. The four-firm industry concentration ratio is as follows:

//C4 = W1 + W2 + W3 + W4//

Wx = sales of firm x / sales of total industry

If an industry is composed of a large number of firms, each of which is relatively small, the four-firm concentration ratio is close to zero. Conversely, if an industry is dominated by a handful of relatively large firms we should expect the four-firm concentration ratio to be close to 1. When we say large, what we are referring to is firms with a large market share.

Example: The North American Auto Industry during the early seventies. //__The percentages listed below are estimates only__//

GM: 70% Ford: 13% Chrysler: 9% AMC: 5%

The four-firm concentration of the North American Auto Indusstry is .7+ .13 + .09 + .05, which equals .97. This means that 97% of the market share of the North American Auto industry was controlled by these four companies.

As seen from above the North American Auto Industry during the early seventies had a four-firm concentration ratio of .97. Thus we can conclude that the North American Auto Industry during the early seventies was highly concentrated. However, were the firms that comprised the North American Auto Industry an oligopoly? Within the auto industry there does exist barriers to entry. As seen in the above table there does exist only a handful of firms. However, market share is disproportionate. Only one firm (GM) has substantial market share. Thus an oligopoly does not exist.

What if Ford were to have acquired Chrysler and AMC? (Don't laugh! It is rumored that Ford looked into this strategy as a way to compete more effectively against GM) Now there exist only two firms: GM with 70% market share and Ford with 27% market share. Does an oligopoly now exist? An argument could be made that yes, an oligopoly now exists. Again, there exist barriers to entry and now there exist two relatively large firms.

Let’s go one step further in our examination of Ford’s purchase of Chrysler and AMC. Would the Department of Justice have allowed this merger to occur? The DOJ utilizes a tool called the Herfindahl-Hirschman Index (HHI) to measure firm concentration in a given industry. HHI is the sum of the market shares (squared) of firms within a given industry, multiplied by 10,000.

//HHI = 10,000(SUM Wx(squared))// //Wx = Individual Firm Market Share//

The DOJ may choose to block mergers when industries have HHI scores greater than 1,800 and the resulting merger will increase the HHI by more than 100.

What is the pre-merger HHI for the North American Auto Industry?

//HHI= 10,000(.49+.0169+.0081+.0025) = 5175//

What is the post-merger HHI for the North American Auto Industry?

//HHI=// 10,000(.49+.0729) = 5629

As seen from above the pre-merger HHI exceeds 1,800 and the post-merger HHI exceeds the pre-merger HHI by more than 100. Thus, the DOJ would probably carefully scrutinize the merger of Ford, Chrysler and AMC. The DOJ on occasion does permit mergers in industries with HHI scores in excess of 1,800. If there exists evidence of strong foreign competition, new technologies, increased industry efficiency, or one of the firms involved in the merger is experiencing financial problems the DOJ may allow the merger to occur, despite the pre and post-merger HHI scores. As most of us are aware, Chrysler acquired AMC in the late seventies due to AMC experiencing financial troubles. Using the above market share data, the post-Chrysler-AMC merger HHI is 5265; ninety points higher than the pre-merger industry HHI.

What is most unique about oligopolies is that one firm’s pricing and quantity decisions not only affect their profits, but the profits of their rivals as well. Thus, we tend to see a lot of strategy relative to oligopolies and profits. A manager of a firm within an industry classified as an oligopoly who wishes to maximize profits must always consider how other firms will react to pricing or quantity changes. Price increases are not always met by rival firms, meaning a potential loss of profits for the firm choosing to increase prices. Further, if a manager is hoping to maximize profits through output he or she needs to consider whether or not their firm is considered to be a first-mover or not. William King of Drexel University has hypothesized that oligopoly prices and profits lie somewhere between those of competitive firms and monopolist firms.

In oligopoly settings, given that a manager must always place himself in his opponents shoes, and vice-versa, it would seem that Collusion has a strong probability of occuring. In fact, in the last fifteen years collusion has been identified within food industries providing services to schools and the military, as well as within the livestock feed industry. When collusion occurs, firms within the oligopoly either fix prices or fix quantities in an effort to maximize total industry profits. So long as each firm sticks to the collusive agreement total industry profits will be higher than they would be absent a collusive agreement. However, there is incentive for firms to cheat on collusive agreements. If a firm can convince its rival to produce at given level, and then renege on the deal the "cheating" firm can make even greater profits than those attainable by restricting output or setting prices. However, regardless of how enticing it may appear, collusion in most forms is illegal and is monitored by various regulatory agencies.

Review Questions: 1. Which industry could be considered an oligopoly: A) Aerospace B) Agriculture C) Steel Manufacturing D) A & C

2. What are the characteristics of an oligopoly: A) A few relatively large firms with low market entry barriers. B) Several small firms with high market entry barriers. C) A few relatively large firms with high market entry barriers. D) A few relatively large firms that can easily enter and exit the marketplace.

3. What is this industry’s four firm concentration ratio: Firm 1’s market share = 7% Firm 2’s market share = 14% Firm 3’s market share = 18% Firm 4’s market share = 25% Firm 5’s market share = 2%

A) .66 B) .64 C) .59 D) None of the above

4. Using the above firm market share data. What is this industry’s HHI score? A) 6045 B) 1194 C) 1198 D) 1492

5. A profit maximizing strategy within an oligopoly environment is: A) MR = ATC B) P = MC C) MR = AVC D) P = ATC E) None of the above.

Answers: 1: A 2: C 3: B 4: B 5: E

References:

http://en.wikipedia.org/wiki/Collusion http://en.wikipedia.org/wiki/Oligopoly http://william-king.www.drexel.edu/top/prin/txt/Imch/Im11a.html http://www.fidelityinfoservices.com/NR/RDONLYRES/F17091E4-81C3-4062-97DE-C8A7463B873E/0/OLIG2004PDF.PDF http://www.agecon.purdue.edu/staff/connor/papers/Price_Dispersion_IIOC_03-27-05.pdf