B. Oligopoly and Firm Architecture

1.  Characteristics

a.  Few sellers

b.  Homogeneous or differentiated product

c.  Entry is difficult

• Firms are interdependent

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2.  Classification

• Duopoly - only two sellers

• Pure oligopoly - homogeneous product sold

• Differentiated oligopoly - differentiated product sold

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3.  Sources of oligopoly

a.  Huge capital investments and specialized inputs required

b.  Patents

c.  Brand loyalty

d.  Control of raw materials or other inputs

e.  Government franchises

f.  Economies of scale

• Economies of scale large relative to market demand => small number of large firms

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4.  Measures of market power

a.  Concentration ratios

• Percentage of total sales by the 4, 8, 12, or 20 largest firms in the industry

• Oligopoly if 4-firm concentration ratio > 50%

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b.  Herfindahl Index

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c.  Theory of contestable markets

• If entry is free and costless, monopolies and oligopolies may act like competitive markets

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5.  Oligopoly models

a.  Cournot model

• Firm assumes competitor will hold output constant

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b.  Kinked demand curve model

• Explains why price doesn't change even when costs change

• Assumes competitors will match price decrease, ignore price increase

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• No evidence that price increases are ignored

• Doesn't explain how the equilibrium price is determined in the first place

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c.  Cartel arrangements

• Collusion - firms coordinate actions

• Illegal in the U.S.

• Market-sharing cartels - each member has the exclusive right to operate in a geographic area

• Centralized cartel - formal agreement to set monopoly price, allocate output among members, and determine how profits are shared

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d.  Price leadership

• Leader sets price, others follow

• Leader is the largest firm, low-cost firm, or any other firm (barometric firm)

• Dominant firm price leadership model:

- Dominant firm sets price to maximize profits

- Other firms (followers) sell all they want at that price

- Dominant firm supplies the rest of the market

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6.  Profitability and efficiency implications of oligopoly

a.  Porter's strategic framework (Five Forces)

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• Rivalry (competition) is less the greater the

(1) concentration in the market

(2) nonprice vs. price competition

(3) exit barriers

(4) ratio of fixed costs to total costs

(5) switching costs

(6) growth rate of the industry

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b.  Efficiency implications

(1) Problems

(a) Price too high, profits can persist in long run

(b) Do not produce at lowest point of LAC

(c) P > LMC at equilibrium => not enough of the product is produced

(d) Differentiated product leads to resources used for advertising and model changes

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(2) Benefits

(a) Economies of scales preclude production under perfect competition

(b) Large size and profits allow funds for research and development

(c) Advertising provides information to consumers

(d) Product differentiation satisfies different consumers' tastes

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7.  Sales maximization model

• Alternative to profit maximization

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• Benefits of sales maximization (larger firm):

a.  Firm may feel more secure

b.  Better deals on inputs

c.  Lower interest rates when borrowing money

d.  Better image with consumers, employees, and suppliers

e.  May have a relationship between executive salaries and sales

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8.  Architecture of the ideal firm

• Way firm is organized, operates, and responds to changes in the market

a.  Concentrates on core competencies and outsources all other activities

• Design, advertising, taking orders in house, assembly and distribution outsourced

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b.  Is a learning organization

• Learn how to deepen core competencies and develop new ones

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c.  Operate extremely efficient factories and plants

• Smaller, more flexible, able to shift production quickly

• Decentralized, closer to market

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d.  Seamlessly combines physical with virtual

• Integrates bricks and mortar with Internet

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e.  Real-time enterprise

• Able to react instantaneously to changes in busines

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9. Miscellaneous topics

a.  Global oligopolists

• World's largest corporations getting bigger due to internal growth and mergers

• Globalization allows bigger companies due to international economies of scale

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b.  The creative company

• Emphasis is on creativity as opposed to efficiency

• Need to compete by designing and creating new products

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c.  The virtual corporation

• Temporary network of independent companies that come together to take advantage of an opportunity

• May be difficult for a single firm to have the in-house expertise to launch products in diverse markets

• May lose control of core technology, may not be able to manufacture on own when network dissolves

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d.  Relationship enterprises

• Networks of independent firms that form strategic alliances

• Longer-term, more stable, and broader than virtual corporations

• Try to exploit complementary capabilities of firms

• Entered into because mergers between foreign companies may not be allowed, resources may not be available for the merger, or there may not be a desire for a merger

• Other advantages are they are not directly accountable to shareholders, avoid risk of owning a subsidiary, more value created, more efficiency, less capital needed by individual company