Why do monopolies/oligopolies limit the market supply when they could just raise prices?

Definition of an Oligopoly

An oligopoly is a market arrangement that is highly concentrated under a few firms control. It is possible however, that many small firms can also operate within an oligopoly market. For example, major airlines like American, United and Delta operate their routes with only a few close competitors, but there are also many small airlines catering for the short haul market like Alaska and Hawaii Airlines.

Ratios of Market Concentration

Oligopolies can be identified by concentration ratios, which is the proportion of total market share controlled by a given number of firms. High concentration ratio in an industry gives economists the argument to identify the industry as an oligopoly.

As an example of a hypothetical concentration ratio might look like: A concentration results from a 95 participation units in a 140 unit market or 95/140 x 100 = 67.8%

In Banking the Herfindahl – Hirschman Index (H-H Index) is an alternative method for measuring concentration ratios and for following changes in concentration after mergers. “The H-H index is found by adding together the squared values of the % market shares of all the firms in the market. For example, if three firms exist in the market the formula is X² + Y² + Z²; where X, Y and Z are the percentages of the three firm’s market shares. If the index is below 1000, the market is not considered concentrated, while an index above 2000 indicates a highly concentrated market or industry – the higher the figure the greater the concentration.” Square(15%+20%+25%)=1250

Mergers between oligopolies increases concentration to a point that it becomes monopolistic concentration and are most likely to be regulated or be subject to merger disapproval by regulators.

The Key ingredients of firm’s operating in a market with oligopoly concentration include:

Interdependence

Interdependence of a firm operating in a market with just a few competitors must take the potential reaction of its closest rivals into account when making its own decisions. An understanding of game theory and the Prisoner’s Dilemma helps appreciate the concept of interdependence.

Strategy

Strategy is extremely important for an interdependent firm as it cannot act independently and they must anticipate the most likely response of a rival for any given change in pricing or other tactics.

• Oligopolies need to make critical strategic decisions, at times such as:
• Compete with rivals, or collude with them.
• Raise or lower prices, or keep price constant with competition.

There exists a first and second turn strategies to be played. Sometimes it pays to go first because a firm can generate head-start profits. A second move advantage is to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them.

Market Entry Barriers

Oligopolies and monopolies more often than not, maintain their dominance in a market because it is too costly or difficult for potential rivals to enter a particular market. These obstacles are called barriers to entry and the incumbent can create them deliberately, or they can use existing blockage.

For instance:

• Economies of Scale
• · Ownership or control of a crucial scarce resource
• · High Start-Up Costs
• · High Research and Development Costs

Fake Barriers Can Be:

• Predatory pricing
• Predatory pricing
• Limit pricing
• Superior knowledge
• Predatory acquisition
• Advertising
• A strong brand
• Loyalty schemes
• Exclusive contracts, patents and license obtain through corruption
• Vertical integration

Another main feature of oligopoly behavior is that firms may attempt to collude, rather than compete where colluding participants act like a single monopoly and can enjoy the benefits of higher profits over the long term.

Types of collusion:

· Overt

· Covert

· Tacit

· Competitive oligopolies

· Predatory pricing to force rivals out of the market

They may also operate a limit-pricing strategy to deter entrants, which is also called entry forestalling price or collude together to discourage new entrants using cost plus pricing.

Non-price strategies:

Non-price competition is the favored strategy for oligopolies but it can lead to destructive price wars such as offering extended guarantees, spending on advertising, sponsorship and product placement, sales promotion, and loyalty schemes among others.

Game Theory Applied to Pricing:

· Raise price

· Lower price

· Keep price constant

The Prisoner’s Dilemma

Co-operation among oligopolies is likely to be highly rewarding. Co-operation reduces the uncertainty associated with a mutual interdependence of rivals in an oligopolistic market. Cartels are illegal in most parts of the world but members can conceal their unlawful behavior.

Aside from all the negatives oligopolies can may provide benefits such as:

· By adopting a highly competitive strategy, they can generate highly competitive market structures that can result in lower prices.

· They can be dynamically efficient in terms of innovation like introducing new product or process development.

· Price stability may bring advantages to consumers at the macro-economy level because it allows people to plan ahead and stabilize their expenditure, which in turn can help stabilize the trade cycle.