*Economics* Oligopolistic Uncertainty

“Oligopolies dominate the modern economic landscape, accounting for about half of all output produced in the economy. ” One example of such a market that can be described as an oligopolistic market is petrol in the UK. This is because petrol is mainly distributed by a few major companies, such as Shell. Because of this it will be hard for other businesses to enter this market as the barriers of entry are set very high for example the fixed costs are high, this is reinforces the strength of barriers.

Another example is due a lack of substitutes. Other oligopolistic markets include the soft drink market with Pepsi, Coca-Cola and Robinsons dominating the market. The sports footwear market is being controlled by Nike and Adidas with two firm concentration of around 60% [2]. And, finally, the major high street banks; the three largest in the UK are Hong Kong and Shanghai Banking Corporation (HSBC), Lloyds Banking group and Barclays. Oligopolies do not have a set of black and white rules they operate by.

There are many varying and distinctive factors which contribute towards their decision making; such as legal, political, price, cost and the market conditions. Unless a particular event occurs such as a price war, oligopolies function much like a monopoly. Though, oligopoly may be competitive and pursue an independent strategy and compete through price, but this may lead to a price war. Before I go on, it is important to understand what interdependence is.

This is where one firm is likely to provoke a reaction by a competitive firm by trying to anticipate how others will react but cannot guarantee they will be correct, there this creates uncertainty. To help better understand oligopolistic interdependence and the behaviour which coincides with this we can use kinked demand curve theory (first published in 1939 by Paul Sweezy [9]). The theory explains price rigidity in oligopolistic markets and we are able to use this to understand the procedures of oligopolistic markets. 10] [10] The loss of disproportionate number of customers is represented in the diagram by the vertical line here. The loss of disproportionate number of customers is represented in the diagram by the vertical line here. R R From the previous diagram it shows why there may well be price rigidity e can see that oligopolies will want to stay at a fixed price (P). This is because; the businesses are interde1pendent and as a result will be concerned with their competitors actions.

Therefore, these firms will understand that prices above “P” is very elastic (if they increase the price they will lose a disproportionate number of customers, shown as “R” on the diagram). Alternatively, if they lower their price, they will not gain a large number of customers as the other competitors and the demand curve below P is relativity inelastic due to other firms following also lowering their prices and they will engaging in a price war.

One further way to assess how oligopolies operate is by analysing their interaction with other businesses, acting and reacting to each other’s actions to try to become the dominant player, this can best be analysed and interpreted by game theory. Game theory (or, theory of games was developed by John von Neumann and Oskar Morgenstern (1944)) [4] is used to calculate and predict the possible outcomes, (or, pay offs) of certain decisions; this is further explained in the following diagram. 3] [3] From the diagram you can see that the pay offs for player A and B is “4” (the top triangle is the respective players, or a businesses pay off) if they beat their opponent, or their competition However, winning the game, is not guaranteed. Consequently, it is fair to assume that the risks do not outweigh other alternatives; such as cooperating (or, taking collusive action) which has an assured payoff of “3”.

Therefore, this demonstrates that it is almost certain that some form of collusive action, formally or informally, will be a common feature of many oligopolistic markets. In addition, it is important to actually understand what collusion (in economic terms) is. Collusive action, regards to oligopolies can be defined as an agreement by two or more businesses to control the market (much in a similar way a monopoly can) to achieve (typically) absolute profit maximisation and dominance in the market.

Collusive action may take several forms, this includes, price leadership and cartels. If the businesses decide to collude formally (or, an open agreement) then a cartel is formed. However, if the agreement is informal (or, a tacit agreement) the collusion takes the form of price leadership. A tacit agreement will often take place to reduce the reaction from competitors for instance it will be an agreement to avoid price cuttings and loss to each other’s market share.

This is often done by one of two main forms of price leadership; dominant firm price leadership and barometric price leadership. Dominant form price leadership is when the dominant company will set the price (PL – as show on the following diagram) for the entire market. This is achieved by calculating their own marginal cost (MC) and marginal revenue (MR) curves and incorporating the other firms MC and MR curves, to the extent the firm with the lowest curves will still not make a loss and not be at a competitive disadvantage.

This is displayed in the following diagram. [5] [5] Whereas, if barometric price leadership takes place then the company with the most substantial knowledge on the market, ability to respond to market conditions and also has the capability to best forecast the future of the market, then that firm will then set the prices, taking into consideration all businesses in the agreement MC and MR curves; this may not be the biggest and most powerful company.

One example of when an informal agreement has taken place and collusive action has undergone the form of price leadership, is a common, and perhaps regular occurrence with the major mortgage lenders where many suppliers follow the pricing strategies of the leading firms. In this particular scenario, dominant form pricing will most often occur (as the other firms will follow the same price strategies as the leading firms). In this industry, price leadership is typically more frequently established than cartels.

However, if the arrangement set by the oligopolies is a formal agreement, then a cartel is formed. Cartels are formed with the aim to “reduce market uncertainty and engage in some form of collusive behaviour” [7]; this is promoted and almost encouraged from the uncertainty within the market from a lack of security with oligopolistic interdependence. Cartels “may be imperfect or perfect by nature” [8]. Examples of perfect collusion take the form of either centralized cartels or market sharing cartels. Centralized cartels will be made up of a group of members, who will elaborate ith the other firms to set a price, control the volume of output and will determine the level of revenue each company shall receive. Market sharing cartels will be made up of a group of members from their respective firms. However, market sharing cartels will be concerned with how the relevant market will be divided and how much of the market will be distributed between each company. In addition, for a business to enter market-sharing cartels, this particular conduct is deemed illegal by the UK and European competition law.

Though, it is very hard for the EU and UK trading commissions to find sufficient enough evidence that the businesses are colluding to raise their prices. However, in recent times, “the EU has fined businesses involved in price fixing in the soap powder industry who agreed to raise prices even though they had all made their products smaller for the consumer” [6]. An example of centralized and market sharing cartels has been from the Organization of the Petroleum Exporting Countries (OPEC). The OPEC was born to take over the world leaders of the oil industry.

By using cartels, and driving the prices up and providing supplies worldwide, OPEC was able to obtain a substantial amount of market share and bring economic security to places like Kuwait (which is now the 11th richest county in the world per capita) and now the OPEC has around 40% market share of the world’s oil [11]. To conclude, within the oligopolistic markets there are a lot of unknowns and uncertainty which is as a result from the interdependence of the oligopolies, and their willingness to stay interdependent. Part of the almost, encouragement to collude can be seen in the kinked curve diagram, as it shows the price rigidity.

This implies why there will be collusion either for profit or non-profit because it is so elastic. So, this, and oligopoly behaviour of interdependence creates more uncertainty and starts a negatively re-enforcing cycle which drives the markets to be more and more unstable, and consequently creates uncertainty (which makes the markets more unstable and therefore more uncertain); this can be further understood by game theory. Thus, it is this uncertainty which creates the need and again promotes the use of collusive action by oligopolies. ————————————————- References