Wednesday, October 29, 2008

All That You Should Know About An Oligopolist

(1) Few large firms. The oligopoly market structure is characterised by the dominance of few big firms. Few here mean less than 10. It can also be as low as 2 firms. In this case we call it as duopoly. Good example will be firms for personal care product such as Proctor & Gamble and Unilever. Here they dominate almost entirely the market for these products

(2) Highly interdependent. Some may think that just because the industry is dominated by few large firms, therefore competition is less intense. This is untrue. Any action by an oligopolist, will have a large impact on its rivals. For instance, say there are 4 firms. If firm A reduce prices, its rivals will likely follow suit. If not, they will lose all their customers to firm A. Likewise if B comes up with a new product, very likely others will come up with a similar or improved version of products

(3) Prefer non-price competition. Since price war will actually lead to lower profits in the long run for oligopolists, therefore they prefer to engage in non-price competition such as effective advertising & branding. Furthermore, this form of strategy is difficult to be modelled by its rivals. For price cutting, there is a limit as further cut will entail firms to losses.

(4) High concentration ratio. Concentration ratio is defined as the percentage of total sales contributed by the top 3 to 5 firms. In oligopoly market structure, concentration ratio tends to be very high as each firm actually command a large portion of market share. Normally, we classify a market as oligopoly if the concentration ratio of 4 largest firms is above 60%. However, different industry may have different nature of concentration ratio. For instance, telecommunication industry in Malaysia which is heavily dominated by Maxis, Digi & Celcom, could have concentration ratio as high as 90%

(5) High barriers to entry. Barriers to entry are defined as obligations created by the government or existing firms to make the entrance of new firms into the industry difficult. Factors like patents, control over key inputs, control over distribution network, high upfront expenditure, high & continuous advertising expenditure etc can insulate existing firms from competition. Due to that, we can therefore say that the market is less contestable. Also its sunk costs are very high. Sunk costs are costs that are not retrievable upon exiting the industry. Good example will be specialised equipments or machineries used in production. It's extremely difficult to resell these for other usage unlike some e.g. van, lorries etc

(6) Economies of scale (EOS). Defined as fall in long run average cost curve (LRAC)associated with an increase in output Oligopoly firms do enjoy great EOS such as purchasing EOS, managerial EOS, technical EOS etc as they produce in large scale although not to the extent of natural monopolies. This can give them further competitive edge as they are able to pass on the lower costs to customers. Newer firms are unlikely to be able to do so.

(7) Pricing strategy. Large dominant oligopoly firms may also practice predatory pricing & that is the practice of lowering down the price of their goods to the extent of loss making in order to drive out their competitors. Once successfully in doing so, their will gradually increase the price once again. Also they may practice limit pricing, a strategy of lowering down the price of their goods to the level where new firms find it unprofitable to join the industry. The primary reason for them to be able to do so, is due to their strong cash reserves since they already earned substantial supernormal profits

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