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.

How does managerial economics have a relationship with general economics, mathematics and statistics?

Managerial economics has a close interaction with Economics, Mathematics and Statistics but also Management theory and Accounting concepts. Managerial economic integrates concepts and methods from these disciplines and brings them together to solve managerial problems.

Economics applied to decision making is a special branch of economics, joining pure economic theory and managerial practices. Economics has been divided in two main branches: Micro-economics and macro-economics.

Micro-economics studies the behavior of the individual units and small groups of units. In particular firms, households, prices, wages, incomes, individual industries and commodities. Thus micro-economics gives a cellular view of the economy.

The background of managerial economics originates from micro-economic theory. Theory of price, elasticity of demand, marginal cost marginal revenue, the short and long runs and theories of market structure. It makes use of well-known models in price theory such as monopoly price, the elasticity of demand and the many pricing models for market competition.

Macro-economics on the other hand, deals with the behavior of the large aggregates in the economy. The large aggregates are total saving, total consumption, total income, total employment, general price level, wage level, cost structure, etc. As such, macro-economics is aggregate economics and examines the interrelations among the various elements, and causes of fluctuations in them.

Macro-economies are also extended managerial economics. The setting, in which a business operates, variables in national income, deviations in fiscal and monetary measures and variations in the level of business activity that have relevance to business decisions. The understanding of the complete process of the economic system is very useful to a managerial economist in the formulation of policy such as business forecasting. The most widely used model in modern forecasting is the gross national product model and its component parts.

A relatively new subject in economics is the theory of decision making and has gained significant importance for managerial economics. In the process of management such as planning, organizing, leading and controlling, decision making is always essential. Managers face a number of problems connected to production, inventory, cost, marketing, pricing, investment and human resources training.

Economist are interested in the efficient use of scarce resources and as a result their interest in business decision problems as applied to economics in the process of managing a business thus, managerial economics is economics applied to decision making.

Mathematicians, statisticians, engineers and others have joined together and developed models and analytical tools which have grown into a specialized subject known as operations research. The basic purpose of the research and development is to designed scientific model for the micro and macro systems which can then be utilized for policy making.

The development of techniques and concepts such as Linear Programming, Dynamic Programming, Input-output Analysis, Inventory Theory, Information Theory, Probability Theory, Queuing Theory, Game Theory, Decision Theory and Symbolic Logic and more recently neural training networks have each had a defining contribution towards the understanding of socio-economic systems.

Statistics provides the basis for the empirical testing of theory. It provides the individual firm with measures of appropriate functional relationship involved in decision making because a business runs on estimates and probabilities. Technique like multiple regression is used; measures of central tendency normal distribution, correlation, regression, least square, estimators are widely used in conjunction with computer software programs.

Managerial economics is also related to accounting as it records financial operation of a business. A business is started with the main aim of earning a profit. Capital is invested and engaged in purchasing properties such as building, furniture and daily running cost of the firm.

Goods produced are bought and sold for cash as well as credit, expenses are met and incomes derived. This goes on the daily routine work of the business transactions that must be transparently accounted for and evaluated for performance, specially, when the firm goes public and sells stock in the market.

Mathematics and numerical analysis have helped in the development of economic theories and now mathematical-economics has become a very important branch of economics. The most important branches of mathematics generally used by a managerial economist are geometry, algebra, calculus and computer software developed with powerful algorithms that solve complex problems and dynamic analysis.