Chapter 11

OLIGOPOLY

Reported By: Bulda, Rubie Jane C.

BSIE IV – E
 Objectives:

1. Understand oligopoly
2. Cite example of firms/industries under oligopoly
3. Distinguish imperfect collusion from centralized
cartel
4. Discuss some problems facing cartels
5. Evaluate the welfare effects of oligopoly
 Oligopoly

 Is a market structure characterized by a small number of

firms and a great deal of interdependence among them.

 Each oligopolist formulates his policies in relation to what his

rivals might make.

 Since, there are only small number of firms, any changes in

the firm’s marketing or price strategy would influence the
sales and profits of competitors.
 A good example is the oil industry. Only three major
players and several small oil companies account for
the gasoline and oil needs of the Philippines.

o Each of the oil company must consider the reaction

of others when it formulates its price and output
policy.
o There was a tendency towards a uniform price
charged by the different firms. Competition was
evident in other areas, specifically nonprice areas.
o To increase sales and create brand loyalty, oil companies
advertise their products heavily. Sales promotion discounts,
free services were resorted to.

 Another example is the cement industry. Were in our early

stages of industrialization and cement was needed by
industries.
o Attracted by prospects of big profits, investors flocked to this
area until a glut in supply developed.
o The oversupply was further aggravated by low demand due
to the general economic downtrend of business activities
during the latter part of the period.
Classification of Oligopoly Markets

 Pure Oligopoly
- if the products produced by the various firms are identical.
- this model is found in some of the capital goods industries,
such as the cement and the oil industries.

 Differential Oligopoly
- exists in industries where products are not homogeneous.
- this model found in most manufactured consumer goods.
Collusion versus Independent Action

 Collusion
- a secret agreement between two or more persons
or institutions to achieve certain objectives among
the industry’s firms.

- involves direct negotiation and agreements among

competitors.
There are three (3) major incentives leading oligopolistic firms
toward collusion:

a) They can increase their profits if they can decrease the amount
of competition among themselves

b) Can decrease oligopolistic uncertainty. If the firms act in

concern, they reduce the likelihood of any one firm’s taking
actions detrimental to the interest of the others.

c) It will facilitate blocking newcomers from the industry. However,

once a collusive arrangement is in existence, any single firm
has a profit incentive to break away from the group and act
independently, thus, destroying the collusive arrangement.
Perfect Collusion

• A cartel, a formal organization of the producers within a

given industry, is an example of perfect collusion
among the sellers in an industry.

 Organization of Petroleum Exporting Countries (OPEC)

- a good example of cartel

• its effectiveness can be gleaned from the fact that it

was able to increase price of oil substantially.
• Cartels, in order to be successful and effective, must
possess the ff. characteristics:

 All producers or sellers in the industry are included

in the agreement.

 The agreement is definite and enforceable on all

parties to it.
 It covers both the price to be charged and the quantity
of output to be produced by each agreeing seller, the
output allocation being calculated as to minimize the
aggregate cost of producing the total output of the
industry.

 It also includes a formula for distributing the profits of

the combined operations among the agreeing parties;
and

 All parties adhere rigorously to the terms of agreement.

Imperfect Collusion
- is made up mostly of tacit informal arrangements
under which the firms of an industry seek to establish
prices and outputs.

• This variation can come about basically in the ff.

ways:
 Incompletely observed collusion. There is a collusion
agreement among existing sellers, either formal or
tacit, aired at fixing prices or outputs, but is not
rigorously observed by some or all of the sellers
 Collusion with indefinite terms of agreement among
sellers affecting prices or outputs, but its terms are
either ambiguous or ambiguously understood by
some or all sellers

 Collusion with incomplete participation of the sellers

in the industry. There is a formal or tacit agreement
among sellers affecting prices and outputs, but not
all members of the industry are parties to the
agreement or even nominal adherents to it
 Interdependent action without agreement. There is
no formal agreement and really not a sufficiently
sustained uniformity of action over time to permit
influence of a tacit agreement.
*From the graph, there are three prices: and three
corresponding outputs . Each firm charges different
prices and produces output as it sees fit. Each firm, theoretically
would maximize profits at the point where the marginal cost
intersects the industry marginal revenue.
The Centralized Cartel
- its purpose is monopolistic maximization of the
industry profits by the few firms in the industry.

- individual firms in the industry have surrendered the

power to make price and output decisions to a
central association.

- Quotas to be produced, distribution problems are

determined by the association
The OPEC Oil Cartel

• This carte hits the headlines in late 1973 when its

members precipitated a crisis in the United States
and the rest of the world by announcing a cutback in
oil experts.

• Then it attracted further attention by taking a series

of actions resulting in very large increase in price
crude oil.
• OPEC consists of 12 major oil producing countries,
including Saudi Arabia, Iran, Venezuela, Libya, and Nigeria.
The OPEC countries impose and excise tax of so many
cents per barrel.

• These taxes are well publicized and, like any excise tax,
they are treated as a cost of production by any of the
international oil companies.

• Thus, by increasing these taxes, the OPEC countries can

increase the price of crude oil, since no company can afford
to sell oil for less than its production costs plus the tax.
• A cartel must either control output or detect and
prevent “cheating” in the form of under the counter
price reductions.

• The OPEC tax system results in the publication by

every important OPEC nation of its level of taxes per
barrel. Since, they are a matter of public record, the
price floor of taxes plus cost is safe, once the taxes
are approved by the companies and the
government.
Some Problems Concerning Cartels

• As noted, the OPEC countries formed a cartel to fix the price

of oil. At the 19997 OPEC meetings, most OPEC countries
argued for substantial increases in the price of oil.

• Saudi Arabia has until now at these meetings, consistently

held out for no price increase or at least for very small
increase. The other countries have largely gone along, but
they have been unhappy with the small price increase.
• Editorial writers have explained the situation:

1. Saudi Arabia is a good friend of the US and Western

Europe and because of past good relations does not wish to
“gouge” the west.

2. The Saudi Arabia is so rich that it cannot absorb all the

income into the economy; therefore, it does not need any
more profit.

A logical explanation, based upon economic analysis as well as

some evidence, is that Saudi Arabia is the dominant firm in
OPEC. Its production and reserves are by far the largest.
The Kinked Demand Curve

• A traditional feature of oligopoly stressed by many countries

since the 1930’s is the prevalence of rigid of “sticky” prices in
industries characterized by oligopoly. Oligopolistic prices are
normally sticky downwards, meaning, firms in oligopoly normally
do not lower their prices.
• It was assumed that competitive industries and monopolistic
firms adapted to changes in the environment by changing prices
and output.
• A well-known theory designed to explain the rigidity of prices in
oligopolistic markets was advanced by Paul Sweezy in 1939, he
asserted that if an oligopolist cuts its price, it can be pretty sure
that its rivals will meet the reduction.
Sales and Profits of Oligopolies

• A market characterized by monopoly is the most desirable for

the producer. In a monopoly, there is only one producer, thus,
profits are exclusively his.

• On the other hand, profits can still be maximized but then

there are several firms who share the market , thus, profits are
shared.

** Table 24 shows the 40 largest companies in the Philippines

from the point of gross revenues.
The U.S. Experience

• From the point of view of sales, the car companies

are in the forefront.

• General Motors and Ford are among the top 10

corporations in the U.S.

• The oil companies like Exxon Mobil, and Chevron

Texaco are also among the top corporations in the
U.S.
Barriers to Entry
• Barriers to the entry of new firms may be inherent in
the nature of the industry. These are called natural
barriers and artificial barriers.

One of the most important natural barriers to entry

consists if the difficulty of putting up a large and
complex plant.

Government regulations, patent rights are among the

most important artificial barriers to entry.
• A second artificial barrier to prospective entrants is
the control by the firms already in the field of strategic
sources of raw materials necessary for producing the
product.

• These barriers will be the greatest importance where

raw material sources are highly concentrated
geographically, or at least where the better sources
are highly concentrated.

• Product differentiation may form an artificial barrier to

entry.
The Welfare Effects of Oligopoly

• Oligopolistic market structures, as compared with purely

competitive market structures, would be expected to have
adverse effects on consumer welfare.

Efficiency of the Firm

• The maximum potential economic efficiency for individual
firms in the production of particular products is realized when
those firms are induced to build most efficient sizes of plant
and operate them at most efficient rates of output.
• The firm’s output depends upon its quota, its market share, or
its anticipations with regard to its marginal costs.

• Individual firms are not induced to produce at their maximum

efficiency plant sizes.

• Outputs are restricted and prices are increased above the

levels of costs, since product price tends to be higher than
marginal cost.
Output Restriction

• An oligopolistic firm ordinarily faces a demand curve for its

output that is downward-sloping to the right, or that is less
than perfectly elastic.

• Marginal revenue at each level of sales is less than the price;

and since the profit maximizing firm produces the output level
at which marginal revenue equals marginal cost, marginal
cost will be less than the product price.
Range of Products

• Differentiated oligopoly provides each consumer with a broader

range of products among which to choose than does either pure
competition or pure monopoly.

• Consequently the opportunities for allocating income among

different producers may be so enhanced that the consumer can
achieve a higher level of want satisfaction than would otherwise
be possible.

• In addition, product differentiation enables a consumer to give

vent to individual tastes and preferences with regard to
alternative designs for a particular product.
San Miguel: The Giant Gets Bigger

• Food and beverage giant San Miguel Corp. (SMC) remains a

giant – the biggest Philippine corporation – with consolidated
sales of ₱249.65 billion in 2006, up 10% from 226.74 billion
in 2005. net income increased by 17% to ₱10.6 billion.

• The company, which has occupied the no.1 position in the

annual BNA Top 1000 corporations for the last four years, is
fortifying its position by diversifying into other businesses that
are expected to generate more revenues and profits – power,
mining, infrastructure, water, other utilities and property.
• San Miguel is going through an evolution. Soon, it will no longer
be just a beer, beverage or food company. With its forays in
new businesses, the company will be more properly known as
the San Miguel Group, a true conglomerate.

• Beer is an old-economy business, being a 100-year-old product.

San Miguel was established in 1890, the original Philippine
multinational.

• It began exporting the world-famous brew in 1914, to Shanghai,

Hong Kong and Guam. It put up or brought breweries abroad, in
Hong Kong in 1948 and much later in other places like Spain,
Indonesia, China, Vietnam, Thailand, and Australia.
• But margins from beer have thinned, from as high as 70% 20
years ago to as low as near-single digit, while demand has
remained flat, if not declining. When it was a monopoly, beer
provided as much as 70% of San Miguel’s total profit.

• SMC Chairman-CEO Eduardo Cojuangco Jr. and President

Ramon S. Ang expressed confidence that the company’s
planned ventures into “new engines of growth” will deliver
optimum value of shareholders who will reap the benefits of
higher earnings potential for San Miguel.

• San Miguel Corp. is about to be parceled out into various

operating units, each of them independent corporations.
Terms to Remember

 Oligopoly – a market structure in which only few

sellers offer similar or identical products

 Collusion – an agreement among firms in a market

about prices to charge and quantities to produce

 Cartel – an example of collusion in its most

complete form