An oligopoly occurs when a few
number of firms dominate a certain market (Investopedia, n.d.). An oligopoly is
similar to a monopoly, only that in an oligopoly, there are at least two firms
controlling the market. Examples of industries that take on an oligopoly market
structure are the automobile industry, the oil industry and the soft drink
industry.
One
of the main characteristics of an oligopoly is that a few large firms dominate
the market, as mentioned above. For example, in the soft drink industry, there
are two firms controlling the market – Coca-Cola Company and PepsiCo [refer to Figure
1].
Figure
1
In the United States of America, these two soft drink companies take up 73%
of the soft drink market [refer to Figure 2] (Bhasin, 2013).
Figure
2: Coca-Cola and PepsiCo take up 42% and 31% of the soft drinks market share
respectively
As few firms control the market,
they have great market power. With market power, firms in the oligopoly market
are price makers. As firms’ main goal is to maximize profit, Coca-Cola and
PepsiCo have the ability to set higher price for their beverages in order to
make profit.
In
an oligopoly, there is high research and development (R&D). With the profit
that the firms make, they have access to a large amount of capital and with that
capital, the companies can afford to invest in R&d. Coca-Cola and PepsiCo
spend millions of dollars every year for R&D purposes. For example, in
2008, with the annual revenue of 31.94 billion, Coca-Cola invested more than
$60 million dollars to advance climate-friendly hydrofluorocarbon (HFC)-free
cooling technologies. Since then, the company has increased their energy
efficiency of their cold-drink equipment by 40%. Coca-Cola is now using
HFC-free insulation foam for their new equipment in order to reduce 75% of
greenhouse gas emissions. With already more than 500,000 units of HFC-free
cooling equipment in use, the company plans to stop using HFCs in all of their equipment
by the year 2015 (The Climate Group, n.d.).
An
oligopoly also has high barriers to entry. As only a few large companies
dominate the market, they have economies of scale. The few large firms produce
for the whole market. Therefore, with high quantity produced, the firms get to
minimize cost as the fixed cost is distributed among the output. Besides that,
large firms have access to technology to minimize cost as well. As the existing
firms in the market have economies of scale, new firms will find it hard to
compete as their cost will be relatively higher than that of the existing
firms. Furthermore, an oligopoly has legal barriers to entry such as patents
and copyrights. For instance, Coca-Cola has various patents on vending machines
(Google, n.d.). This means that when another company wants to use a vending
machine to dispense its products, that company would have to pay royalties to
Coca-Cola. This legal barrier makes it hard for new soft drink companies to
enter the market as they would have to incur extra costs. Moreover, as the
existing firms are already established and have brand loyalty, a new company
would have to spend a substantial amount of money for advertising in order to
break into the market.
The
most distinct and unique characteristic of an oligopoly is interdependence. As
an oligopoly is made of a few large firms, these firms’ decisions impact the
whole market. This indicates that in making a decision, an oligopolistic firm
will have to consider the possible effects on other competing firms and those
firms’ reaction. For example, when Coca-Cola decides to have a price reduction
on their beverage, it would have to consider the effects of that decision on
PepsiCo, whether or not PepsiCo would respond with a price reduction as well
and that in reducing its product’s price, they may start a price war in the
market or if Coca-Cola is considering to increase its price, they would want to
find out if PepsiCo will also increase its prices to increase profit or instead
PepsiCo would maintain its current price in order to captivate more customers
as Coca-Cola’s prices increases.
Another
feature of an oligopoly is that it has a kinked demand curve. Oligopolistic
firms face a kinked demand curve as the demand curve is slightly kinked at the
current price of a good, signifying that the demand above the current price is
more elastic than that below the current price. Using Coca-Cola as an example,
as seen in Graph 1, if they raise the price of their products, it is assumed
that PepsiCo and other rivals will not increase its products as the demand for
Coca-Cola is more elastic above the current price. This is because consumers
can opt for Pepsi since it is a substitute with a cheaper price. If Coca-Cola
reduces its price, the assumption is that PepsiCo and other competing companies
will also decrease its price to not lose out in the price competition. As firms
will not decide to reduce price without making a price-output decision with
other competing firms, there is price rigidity in an oligopoly (Preserve
Articles, n.d.).
Graph
1: Kinked Demand Curve
Graph 2: Kinked Demand Curve
with Average Revenue, Marginal Revenue and Marginal Cost Curves
Based on Graph
2, when the quantity is less than Q1, the marginal revenue (MR) curve will
correspond to the shallow part of the average revenue curve (AR) whereas when
the quantity is more than Q1, the MR curve will correspond to the steeper part
of the AR curve. Assuming that the marginal cost (MC) curve lies between point
a and b, the profit maximizing price and output will be P1 and Q1 as profit
maximization occurs when MC = MR. This explains price rigidity as the price
will remain stable despite a change in its cost.
Oligopolists can be pulled into two
different directions – competitions or collusions. Firms in the oligopoly
market can collude with each other due to the interdependence or they can
compete with each other to gain a larger percentage of the market share
(Sloman, 1997). Thus, there is two types of oligopoly – collusive and
non-collusive oligopoly. For example, if Coca-Cola decided to produce less soft
drinks and made an agreement with PepsiCo, they can reduce the quantity supplied
thus increasing price and profit due to the demand from consumers. This is an
example of a collusive oligopoly whereby firms compromise to reduce competition
among themselves. As for non-collusive oligopoly, there is an existence of
oligopoly games due to the presence of competition. This theory is to investigate
strategic behavior which is the recognition of mutual interdependence and the action
with consideration of the reaction of others (Parkin, 2010). An oligopoly game
has four features – players, strategies, payoffs and outcomes. The Prisoners’
Dilemma is an example of an oligopoly game that illustrates the four features.
The global market for soft drinks is dominated by two brands – Coca-Cola and
PepsiCo. As seen in Figure 4, Coca-Cola holds 43% of market shares and PepsiCo
holds 31% of market shares.
Figure
4: Market Share for Soft Drinks Market
In
1964, PepsiCo increased the intensity of the competition in the soft drinks
market by creating “Diet Pepsi”, a no-calorie carbonated drink. A few years
later, Coca-Cola came up with “Diet Coke”, a sugar-free carbonated drink with
the similar concept as “Diet Pepsi”. This competition can be seen as a
Prisoners’ Dilemma game. It has a dominant-strategy Nash equilibrium, meaning
that Coca-Cola decides on the best reaction given the action of PepsiCo and
vice versa.
Figure
5: Coca-Cola and PepsiCo’s Prisoners’ Dilemma Payoff Matrix
Based on Figure
5, if Coca-Cola develops and markets a new soft drink, PepsiCo makes a greater
profit by also developing and marketing a new soft drink (+$30 million versus –$60
million) and if Coca-Cola does not develop and market a new beverage, PepsiCo
again makes a greater profit by developing and marketing a new beverage (+$90
million versus +$50 million). So PepsiCo’s best strategy is to develop and
market a new soft drink. On the other hand, in Coca-Cola’s point of view, if
PepsiCo develops and markets a new drink, Coca-Cola makes a greater profit by
also developing and marketing a new drink (+$75 million versus –$40 million)
and if PepsiCo does not develop and market a new beverage, Coca-Cola again
makes a greater profit by developing and marketing a new beverage (+$275
million versus +$175 million). Therefore, Coca-Cola’s best strategy is also to
develop and market a new soft drink. As both companies’ best strategy is to
develop and market a new soft drink, that is the equilibrium of the game. The
firms are in a prisoner’ dilemma because each firm is better off continuing to
sell their old beverage than to develop and market a new soft drink as they
will have to incur a larger cost. If neither company introduces a new drink in
the market, Coca-Cola would gain $100 million ($175 million versus $75 million)
and PepsiCo would gain $20 million ($50 million versus $30 million). However,
it is evident to each firm that if it does not introduce a new drink to the
market, the other firm will do so and the firm that does not have a new
beverage will have to bear a large loss.
In
conclusion, in the firms’ interests, they would want to maximize profit and
therefore would prefer to collude to retain market power. However, in order to
benefit the consumers, oligopolies should engage in competition so that
consumers will enjoy more variety and quality. In my opinion, an oligopoly should
come up with new products from time to time. In doing so, consumers will be
interested and willing to buy those products. Firms should take consumers
satisfaction seriously because ultimately, consumers equal to revenue.
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