Pass et al. (2005) define oligopoly as a type of market structure that is characterized by a few firms and many buyers i.e., the bulk of the market supply is in the hands of a relatively few large firms who sell to many small buyers. For example: Supermarkets in UK wherein TESCO, ASDA, MORRISONS, SAINSBURY and ALDI have the lion share of the total market, Soft drinks manufacturing companies like Coca-Cola and PEPSI form a duopoly and as described in this report, gaming console manufacturing companies viz., Nintendo, Microsoft and Sony.
Economic features of Oligopoly:
Sloman et al. (2010) state that the two key economic features of Oligopoly are:
Barriers to Entry.
Pass et al. (2005) suggest that in an Oligopoly there are high barriers to entry which make it difficult for new firms to enter the market. Heavy capital investment, aggressive brand marketing, economies of scale and dominance of the competitors are some factors which form barriers to entry in an Oligopoly market.
Interdependence of the firms.
OECD Competition Committee (1999) suggested oligopolies as markets where profit maximizing competitors set their strategies by paying close attention to how their rivals are likely to react.
Due to the lack of large number of competitors in an Oligopoly, each firm has to take into account the marketing scale, the pricing strategies of its competition and the market reaction to these strategies. Thus, they are mutually dependent on one another.
In an oligopolistic market, a firm can achieve maximum profits by colluding with its competitors. Aggressive price wars result in decrease in market price of the products while aggressive marketing strategies result in increased production costs. This eats into the profit margins of the sales of the products. Therefore in order to maximize profits, firms need to collude with each other.
A formal collusive agreement is called a cartel (Sloman et al. 2010)
Begg and Ward (2010) state that cartel/collusion is likely to fail when there is:
a large number of firms
Instability in demand and costs.
In case all these conditions are met, then the firms can form cartels and act as a monopoly. Under a monopoly, price wars will not be required. The cartel will then control supply to maintain higher product prices and thereby generate supernormal profits.
Let us take an example of a cartel of 5 firms trying to maximize their profit.
Source: Adopted from (Collusion and Cartels, 2010)
Let us consider that the cartel decides to price the product at the profit maximizing level of say £10 which is now the marginal revenue (MR) for each of the firm. At £10 the industry output stands at 1000. Therefore the firms in the cartel divide the production capabilities of each other such that total units produced are equal to 1000 (each firm produces 200 units). Let us consider the demand curve for firm A.
Source: Adopted from (Collusion and Cartels, 2010)
We know that for Marginal Costs (MC) = Marginal Revenue (MR), the profits are maximized. Therefore for firm A, if the profit maximizing output is at 600 where MC=MR then the firm may be tempted to increase its output from 200 to 600. This would mean that the firm can increase its revenue and maintain the industry quota of 1000 goods by eating into the market share of the other 4 firms in the cartel.
The firm can instead also decrease the price of the unit it sells.
Source: Adopted from (Collusion and Cartels, 2010)
Let us say if the firm reduces its unit price to £8 then the profit will be maximized at output levels of 400 units generated. This can lead to a relatively elastic demand for its product provided the competitors do not reduce the price of their products.
Either way these strategies would be dealt with strong retaliatory response by the other members of the cartel thereby breaking up the cartel.
Once the cartel is broken, firms get into price wars with one another. Most of the firms follow a kinked demand curve in this price war to ensure that they acquire a substantial market share at the expense of supernormal profits.
Kinked Demand Curve:
Begg and Ward (2010) state that the idea behind a kinked demand curve is that price rises will not be matched by rivals but price reductions will be matched.
Figure 4: Kinked Demand Curve
Source: Adopted from (Oligopoly and Strategic Behavior, 2010)
In a kinked demand curve, we see two separate demand curves at a particular price point of P = $6 for which the output quantity sold is 30 units. If a firm increases its price to $8 and if the competitors do not follow this increase, a relative elastic demand curve is seen. The amount of units sold by the firm will reduce drastically to 10 units. If a firm decreases its price to $4, competing firms will decrease their price similarly for which now the quantity sold is relatively inelastic. Due to this, the firms can sell 33 units of good which is just marginally more than at price point of $6.
Gaming Console Manufacturers
Nintendo, Microsoft and Sony dominate the total market share of the gaming consoles worldwide. The products that form this oligopolistic trifecta are Nintendo’s Wii, Microsoft’s Xbox 360 (also called x360) and Sony’s PlayStation 3 (also called PS3).
Figure 5: Gaming console worldwide Market share (as of 20/11/2010).
Source: Adopted from (Vgchartz, 2010)
We can see from the above graph, Nintendo’s Wii is the current market leader in gaming consoles with 46.9% of the market share, followed by Microsoft’s x360 with a 27.8% market share and finally Sony’s PS3 with 25.4% of the market share. Therefore, the 3 firm concentration ratio is 100%.
Features of Oligopoly in Console Manufacturers
The two major features of an Oligopoly and the context with which these features are related to the three console manufacturing companies viz., Nintendo, Microsoft and Sony, are as follows:
Heavy Entry Barriers:
For any console manufacturer, a high investment of capital is required. Huge marketing budgets are allocated to increase demand and improve brand loyalty at the expense of profit maximization. All the three companies generate incredible revenues on their consoles and some of these companies bear heavy losses in order to acquire desired market share (as depicted in Box 1).
Box 1: Sony Losing Almost $250 per Console
Adapted from an article on IGN.COM, 16 November 2006
Sony is losing $306.85 for each 20GB system sold and $241.35 for every 60GB system.
The full production cost for a 20GB system is a whopping $805.85, with the 60 GB coming in at $840.35.
The steep cost of producing PS3s won’t last forever. In general, the longer an item is produced, the cheaper it becomes to manufacture. Over time, the cost of the PS3 will get lower as the cost of parts gets cheaper and production becomes more efficient.
The same article also states that losses will eventually be offset over a substantial period of time. Therefore in the console industry, firms need to make heavy investments and do so with a long term perspective which forms another heavy barrier for incumbent firms.
Another heavy entry barrier is the collaboration with the game developing companies like EA, Activision, Ubisoft, Sega, etc. A new entrant will need substantial period of time to become a leading console manufacturer and then acquire the attention of these game companies.
Interdependence of the three firms:
Since there are only three major players in this oligopolistic market segment, each of the players takes account of the other: they are mutually dependent. Later we will see how some firms depart from their strategy of short term profit maximization and engage in price wars.
Current Pricing Strategies
The three consoles are priced competitively to one another. The market prices (including all the add-ons) of the three consoles are as follows.
S 4 GB
S 250 GB
Slim 160 GB
Slim 320 GB
Figure 6: Price Comparison of the gaming consoles.
Source: Adopted from (Walmart, 2010)
Currently the three companies are locked in a price war and are following a kinked demand curve wherein if one of the company reduces the price of its console then the other companies reciprocate the strategy (as seen in the article described in Box 2).
Box 2: Nintendo drops Wii console price
Adapted from an article on BBC News, 24 September 2009
Nintendo is cutting the price of its popular Wii games console by 20% in the US, UK and Japan. The Nintendo announcements echoes moves by Sony and Microsoft, who have slashed the cost of the PlayStation 3 (PS3) and Xbox 360 as the countdown to Christmas shopping begins.
Price fixing ability of Console Manufacturers
Begg and Ward (2010) state the possibility of failure in collusion if the product is differentiated.
The major problem for the three companies from entering any form of collusive agreement is the existence of heavy product differentiation. PS3 caters to a clientele which is more inclined towards the high quality video playback capabilities of a Blu-Ray format along with a plethora of exclusive game titles for its consoles, an Xbox 360 uses a dual layer DVD format and caters to an audience which is more inclined towards the exclusive x360 titles that the console has to offer (for example fans of the Halo series can only play the game on an Xbox 360 console) and finally a Wii caters to a clientele that is more inclined towards the motion sensing games catalogue that the Wii has to offer.
The possibility of entering a price fixing cartel is also non-existent since price fixing would either negatively impact a particular company’s monetary equilibrium or the product’s strategical positioning in market. Fixing the price to a profit maximizing level which is either closer to Nintendo Wii’s price point or Sony PS3’s price point would lead to more losses on every sale of Sony’s PS3 console or negatively impact the sales of the technically inferior Nintendo Wii respectively. Therefore due to the existence of heavy product differentiation, Nintendo, Microsoft and Sony are not able to form a collusive collaboration with one another and gain supernormal profits.