Oligopolistic Markets

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Management Economics Assignment – 2

Q1. Is an oligopolistic market structure an example of market failure? Explain you answer. To understand if an oligopolistic market structure is an example of market failure, we first need to understand oligopolistic markets. An oligopolistic market is one in which the market is dominated by a small number of large firms. Oligopoly exists in several markets such as the cola industry, petroleum, breakfast cereals etc. In these markets, the activities of these firms are interdependent. They know that everything they do will affect the market and their competitors. For example, if Pepsi starts a major advertising campaign, we can be sure that Coca Cola will follow suit. Coca Cola know that if they do not advertise, they will probably lose market share to Pepsi. The number of firms in oligopolistic markets can vary from two to as many as fifteen and still be considered an oligopolistic market structure. If there are only two firms, then it is a duopoly. These large firms in an oligopolistic market control the market. Each firm has a substantial degree of market control. So the action of one firm can influence the actions of the others. This interdependence of firms leads to collusion between the firms. Collusion is an agreement between firms to limit the competition amongst them and to raise the barriers of entry to keep potential competitors out. Without forming these agreements, the firms in an oligopolistic market face a high degree of uncertainty about their rival’s reactions. Consider this situation: - If Pepsi reduces the price of a can of Pepsi, then Coke will follow suit and reduce their price as well which in turn might cause Pepsi to reduce prices again leading to a price war with prices leading progressively downwards. This is very bad for business and can lead to firms being led out of business, maybe even the firm that first decided to lower its prices. So co-ordination between firms can reduce the risk of a firm starting off a series of bad reactions which might leave every firm in a bad state. Firms can also collude to act as a monopolist. If two firms merge to form a single firm, then this single firm will have a much greater degree of market control. Collusive oligopoly can be defined as “the agreement among firms in the market about quantities to produce and/or price to change.” (N. Gregory Mankiw and Mark P Taylor 2006 pg.323) In most oligopolistic markets, the firms tend to keep the price relatively rigid. They prefer to fight for market share by other means such as advertising, product differentiation and barriers to entry. It makes more sense for firms to increase their market share without having to reduce their prices. Oligopolistic markets can exist in industries which produce identical products as well as in industries that produce different products. Examples of identical product oligopolies are industries such as aluminium, steel etc. This is usually the case in industries involving raw materials. Examples of differentiated product oligopolies are industries involving computers, music players, automobiles etc. A cartel is a formal agreement among competing firms to fix prices, production etc. The formation of cartels in outlawed in several countries such as the US, UK etc. Barriers to entry are the difficulties a firm faces when it attempts to get into a market. The possibility of entry in a market may affect the behaviour of established firms in that market, in oligopolistic markets, who wish to keep potential competitors out. A new firm may not enter a particular market even though they feel the industry could be profitable because they feel that the established firms will cut their prices to force the new firm out. Established firms will probably be able to survive for a short run on losses from past profits. There are several ways established firms can prevent new entrants from entering a market. Some of them are:- Legal barriers –...
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