Contrast the features of perfect competition with those of oligopoly. (10)
The comparison between perfect competition and oligopoly will be based on the following: number of buyers and sellers, nature of product, and barriers to entry of firms.
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Number of buyers and sellers
Perfect competition is a market structure that is characterised by many buyers and sellers with each firm’s output representing an insignificant proportion of the total output. Hence, sellers cannot influence prices by changing its level of output. Thus, they accept the market price as given i.e they are price takers. Each firm then faces a perfectly elastic demand curve as shown in fig 1a.
An example of a market that comes close to the perfectly competitive model is that of agricultural farming. How much the farmer sells his wheat for will depend on the prevailing price of wheat in the market.
On the other hand, an oligopolistic firm produces a significant amount of the total market output. The seller can either influence the price or output. It can sell more by lowering price or increase price but sell less. This indicates that the firm’s demand curve is downward sloping.
In addition, due to the small number of firms prevalent in the market, each firm now makes its decisions based on the reaction of other firms in the same industry. No firm can afford to ignore the actions and reactions of other firms in the industry. For example, there are only a few car manufacturers in the US such as Chrysler, GM and Ford Motors. If Ford Motors wants to increase sales, it can lower the price of its cars so that some buyers will switch from either Chrysler or General Motors but the increase in quantity demanded will be insignificant given that Chrysler and General Motors will follow the cut in price. This behaviour can be summarized by the kinked demand curve.
Nature of product
In perfect competition, each seller produces an identical product, thus they are perfect substitutes for each other. Since consumers think that the products are the same, they will not show any preference towards the goods of one firm over another. This means that sellers are not able to arbitrarily raise their prices for fear that consumers switch to other firms. Firms in perfect competition are price takers, and the demand for their goods are perfectly price elastic, hence the horizontal demand curve. In oligopoly, firms may either be producing a homogenous product or a differentiated product. When the product is differentiated, the oligopolist can increase the price and the output would not fall significantly. This implies substantial market power for the firms in an oligopoly. Even when the good is homogenous like steel or aluminium, the firm is likely to differentiate in terms of the services and terms of conditions, hence the downward sloping demand curve.
Barriers to entry
There are no barriers to entry or exit in a PC industry so the markets will consist of a large number of small sellers. The implication of this is that the firms in perfectly competitive industry will earn normal profits in the long run as supernormal profit earned by the firms in the short run will be depleted by the entry of the new firms into the industry. It is relatively easy to lease a plot of land to grow wheat and in the event that the farmer chose to give up wheat farming, he could easily terminate his lease with the landlord. The start up cost is low as all he needs are some simple tools and seedlings. In oligopoly, there are significant entry and exit barriers. For example, in car production, there are very high initial fixed costs such as the setting up of the assembly line and only if the firm produces a very large output level will the average cost fall significantly. The lower cost associated with a big output serves as an entry barrier for new firms as their initial demand is usually low. Exit is also difficult, as it is not easy to dispose of the firm’s fixed assets. Other forms of barriers could be patent rights, exclusive ownership of certain raw materials and legal barriers. So the oligopolist can earn supernormal profits even in the long run.
2b. Discuss why oligopoly is a more common type of market structure compared to perfect competition. (15)
Perfect competition is an ideal model and so it is difficult to find markets that have all these characteristics. There are some markets in the real world that approximates perfect competition. Examples of such markets are farming, the stock exchange market and the foreign currency market. These markets possess some of the characteristics of PC as explained in part (a). However, even in such markets, some of the characteristics are hard to fulfil. For instance, buyers and sellers may not be price takers. In the stock exchange market, there are some individuals or institutions that can influence the price of shares through their large holdings of a particular company’s shares. The product is also not homogenous if stock of different companies are considered., Thus, if they were to sell their shares, price will fall. Knowledge is not perfect either. Although buyers and sellers do have easy access to information through their brokers and the Internet, there are some who do have insider information and use that to their advantage. Moreover, managers tend to reveal more information about their companies to financial specialists rather than to small investors.
In the real world, most industries do not have that many firms. In fact, in industries such as automobiles, air-craft manufacturing industry, oil industry, steel industry, supermarket chains and pharmaceutical industry, the industry is dominated by a few large firms. Most firms would rather face less competition so that their market power can be consolidated and secured. Oligopoly is thus a more desired form of market structure as far as sellers are concerned.
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Oligopoly is a more common market structure. It can be attributed mainly to the high entry barriers. Barriers to entry refer to any impediments that prevent new firms from competing on an equal basis with existing firms in an industry. An effective barrier for new firms to enter the industry is substantial economies of scale. The production of some goods involves very high initial fixed costs. Good examples are the petroleum industry and the manufacturing of aircrafts. For example, Airbus and Boeing must construct huge expensive structures to build the A380. Thus, for the production of such goods, the larger the output the greater is the economies of scale enjoyed by the firm. Such industries have very large Minimum Efficient Scale, and hence, only a few firms exist in such industries.
Economies of scale are not the only source of barrier to entry. Other barriers to entry can be the possession of superior technical knowledge or sterling reputation for quality or efficiency. Take for example, high end sports cars like the Ferrari is such well known brand names that it is quite impossible for any new auto firms to replicate them. For years, they are the symbol of quality and luxury, an image that the carmakers have painstakingly cultivated. Production of such cars also requires superior technical knowledge, which is jealously guarded by the manufacturers. Thus it is not easy for new firms to enter such industries. In addition, existing firms could have spent millions on advertising to build and maintain brand loyalty. It will require a substantial period of high advertising costs and low revenues for new entrants if they want to establish themselves. Also, they can spend large amounts on advertising to make it difficult for a new entrant to differentiate its product.
With the high entry barriers, firms are able to earn supernormal profits in the long run and have the financial strength to block the entry of new firms. Such firms can also adopt predatory pricing to further keep out competitors. Their huge profits allow them to cut prices drastically to drive out competitors. They can maintain excess production capacity as a signal to a potential entrant that with little notice, they could easily saturate the market and leave the new entrant with little or no revenue.
Besides, huge profits allow firms to spend generously on R&D. The discovery of new and better products allows them to compete more effectively in the market and also keep out other firms. For instance, in the pharmaceutical industry, millions of dollars are required to discover a new vaccine or a new drug. Hence the presence of high entry barriers results in many oligopolies.
Globalisation and liberalization
With increased globalisation, many domestic firms are threatened by the entry of big foreign firms or MNCs. Bigger firms have a competitive advantage in terms of pricing. Domestic firms can survive as long as there is government legislation to prevent the entry of foreign firms. But most governments are liberalizing their domestic industries. In order to compete with foreign firms, domestic firms have to merge. A merger would safeguard their survival as well as to allow them to compete more effectively. For instance, the merger of DBS bank with POSB and UOB with OUB , are all meant to expand the size of each bank so as to better compete with other international banks such as Citibank and Standard Chartered etc when MAS liberalize the financial sector to encourage competition. Hence globalisation has increased the tendency for mergers and the formation of oligopolies.
There are not many industries in the real world that satisfy the characteristics of the perfectly competitive model given it is an ideal model. On the other hand, the characteristics of an oligopoly are more easily met. The nature of production is more favourable to an oligopolistic kind of market. There are many advantages to being big. Some firms are big due to high entry barriers – natural or man-made, while others expand internally or externally through mergers and acquisition in response to a changing external environment. The main reason for oligopoly being a common market structure can be attributed to benefits of economies of scale which gives firms the incentive to merge and be large. It will lower their costs and give them higher returns to meet potential competition and as a consequence, they have huge incentives to erect barriers to deter entry by new firms, and to consolidate their position.