Economic Analysis and Competition in Oligopolistic Firms

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Table of Contents

Introduction
Economic analysis
Economic feasiblity analysis
The economic impact analysis
Oligopoly
Effects of competition in oligopolies
Conclusion
Reference List

Introduction

In the world of business, there are various structures that are used to organize the various establishments according to the extents of their involvement. Oligopolies are one such classification and these are well present in countries all over the world. This essay seeks to illustrate how elements of economic analysis can be used to explain the competitive aspects of business entities that take the form of oligopolies.

To this end, a description of the term economic analysis and what it entails shall be provided alongside a complete detailing of all aspects of oligopolies. A section of the paper shall be dedicated to explore the possible impacts of long term strategic commitments on the competitive position of an oligopolistic firm. Finally a conclusion shall be provided and which shall serve as a summation of the arguments presented.

Economic analysis

Because of the scarcity of resources, the basic human needs and desires tend to be limited by a number of factors including the purchasing power and the pricing of commodities and services. Economic analysis is the process of assessing the supply and demand patterns as well as the options which customers are exposed to and the incentives that drive them to make certain purchases (Boulding 1966).

This is therefore an analysis of how resources are utilized by a certain group of people. The field of economic analysis is divided into two main categories. These are economic feasibility analysis and economic impact analysis. These two are briefly explained below:

Economic feasiblity analysis

Business establishments and state organisations tend to go through periods of uncertainty where great risk-taking measures are required particularly when it comes to the decision making process regarding long-term strategies such as the introduction of new products (Schermerhorn 1978). For a proper economic feasibility analysis to be carried out, it is imperative that the individuals involved in conducting the study commit themselves to ensuring accuracy in the prediction of demand.

To this end, it is necessary that the economic patterns as well as the purchasing power of consumers be taken into account (Schermerhorn 1978). Once the demand aspects have been dealt with, then the supply requirements can be studied and in this regard the firs have to find out which resources would be required for them to achieve their objectives. The feasibility study must also include an analysis of competitors and their basic business strategies.

The economic impact analysis

This refers to intense research processes carried out with an aim of providing an estimation of the economic impact of a business establishment to the region in which it is based (Pleeter 1980). The consequence of an economic occurence is a total of the cumulative direct and indirect effects on the population. These effects are estimated by studying the levels of taxation rates, spending chains and saving patterns. These are elements that can only be analysied through scientific surveys in the target populations.

Oligopoly

An oligopoly is a type of market structure where a number of large enterprises exercise dominance in the market (Friedman 1983). The business establishments in this type of market are usually big companies which have a lot of resources for investment and which generally tend to command larger market values.

Such companies are also very well known in the world market because they tend to spend a huge percentage of their profits on marketing and advertising. There are two main types of oligopolies. These are the impure oligopoly and the pure oligopoly (Peeples 1989). The impure oligopoly mainly deals in a variety of products or services while the pure oligopoly mainly deals in the type of product that has no major difference from those produced by other companies in the same line of business (Friedman 1983).

Such homogeneous products include the likes of steel and wheat. In an oligopoly, there are very few sellers gunning for the biggest share of the market and this is primarily because they tend to invest a lot of resources in their daily operations. On average, most oligopolies tend to have between three and four key players (Baye 1999).

The primary feature that characterizes oligopolies is the aspect of interdependence between the companies involved. A basic oligopoly will tend to be made up of very few large enterprises (Friedman 1983). Each player in the oligopoly plays a very distinct role such that any of its actions will have a significant impact on the market conditions. Economic analysis comes in handy to explain the influences of various companies in the oligopoly especially in the view of the fact that the other companies in competition are fully aware of their rivals’ market actions (Peeples 1989). This means that in order for an enterprise to pursue a particular market action, the institution has to consider all the possible counter-reactions by each and every member of the oligopoly.

This sort of strategization likens decision making in an oligopoly to a chess game in which an player has to analyze all the possible moves and countermoves by his/her opponent before establishing a plan for attaining his/her objectives. For instance a company intending to reduce its pricing structure in order to woo more clients has to take into consideration that competitors in the same market might counter the move by reducing the prices even further.

A good example is the ongoing price war between the largest mobile telephony providers in the East African country o Kenya (Zain and Safaricom) where Zain out of nowhere cut all calling rates by 50%, a situation that forced their rivals, Safaricom to cut down their charges as well. This kind of interdependent competition has the negative effect of reducing the price to ruinous levels. Economic analysis helps understand the difference between oligopolies and monopolies in this respect of interdependence.

Economic analysis helps provides an understanding of profit maximization strategies. In oligopoly markets the companies involved are generally fully aware of their competitors’ weak points. As such, the enterprises in competition will tend to exploit such weaknesses to their own advantage regardless of the fact that such actions could spark instances of unfair competitive practices.

Economic analysis helps scholars understand is aspect of competition by illustrating how oligopolies raise their profit levels by ensuring production happens at the point where marginal costs and expenditures intersect (Baye 1999). It is also through market analysis that it is easy to understand that oligopolies are able to sustain great profits by the companies acting as price setters as opposed to price takers.

In some instances, firms in an oligopoly can join forces in a secret association that would see them control the market and retain the prices at an all time high (Hirschey 2009). Such cartels result in consequences similar to those of monopolies since they tend to discourage competitive tendencies (Hirschey 2009). Economic analysis comes through to provide explanations to how certain companies in the cartels conduct themselves especially since disagreements in such arragements can result in price wars breaking out.

Once an oligopoly has been well established, it assumes the form of an elitist club where new entrants have to go to extensive lengths to prove their worth (Puu and Shusko 2002). In other words there are very many barriers to entry. Economic analysis helps further understand this aspect of entry by laying emphasis on the primary barriers which include economies of scale and idea licensing.

Similarly, concepts of economic analysis will contribute to understanding further why the enterprises that have already established ground in the oligopoly will make all necessary efforts to ensure that nascent companies are discouraged or destroyed.

In this regard, the incumbent firms can easily maintain long-run large profits by ensuring that no sideline companies enter the market to cause a split in the profits. For the sake of economic security, governments have also been known to deny some companies entry into certain lucrative business ventures. Economic analysis also explains that consumers generally tend to have limited information as regards the pricing structure and therefore will fall victims to the oppressive prices established by oligopolies (Baumol and Blinder 2008).

Leaving the market is equally as challenging as the entry and from the principles of economic analysis it has been established that this is due to the fact that such an exit can end up causing a lot of economic challenges for the economy of the country where the firm is located (Puu and Shusko 2002).

Effects of competition in oligopolies

The primary effect of competition by oligopolies is unending rivalry among the companies involved (Puu and Shusko 2002). This rivalry mainly arises from price wars necessitated by firms cutting down prices with an aim of getting an unfair advantage on their competitors.

However, their are other forms of competition which dont necessarily involve the pricing structures, top on the list being advertising and differentiation (Hirschey 2009). Big companies tend to invest huge amounts of money in promotional campaigns which tend to work in their advantage mainly because they already have secured their own portions of the market.

It is however easier for companies to lose this portion of the market than to gain bigger portions and this is the main reason why firms have to constantly make the consumer aware of their presence. Advertising remains the primary way for established companies to maintain their competitive lead. In the field of economic analysis non-price competition is considered to be one of the key oligopoly models and this is because of the benefiting effects that it gives companies (Fudenberg and Tirole 2002).

As far as the price wars are concerned, one economic analysis model that can be used to explain market phenomena is the kinked demand curve model (Fudenberg and Tirole). This model is based on the fact that oligopolists tend to appreciate that when one firm lowers its prices, other enterprises will follow suit for fear of losing their market share (McEachern 2008).

When prices are decreased by a relatively large percentage, the effect is a comparatively small rise in sales; a phenomena known as inelastic demand (Baumol and Blinder 2008). However, when one firm decides to raises its prices, other firms will generally tend to ignore this and hope that the can take advantage of the situation to attract customers who will basically tend to go for the lower prices. A relatively small rise in price will come with a sharp decline in sales; a condition referred to as elastic demand (Baumol and Blinder 2008).

Even in the most competitive oligopolies, their tends to be one company that commands the biggest share of the market and as such tends to set the price for the rest of the market. This aspect is explained by an economic analysis model called price leadership where the rest of the companies in the circle have to wait for the dominant firm to set the price for them to follow (Fudenberg and Tirole 2002).

This is a very common model because companies generally have the tendency to match prices with the largest enterprise in the business. As such when this large player decides to drop the prices to ridiculous levels, the other enterprises have no option but to drop theirs as well.

As far as long term strategic commitments on the competitive position of an oligopolistic firm are concerned, there are two basic outcomes that can be arrived at. First, is that the market will gradually align itself to accord such companies superseded advantage over their competitors (Baye 1999). For instance, if a company decides to suddenly reduce the prices of its products by 40%, there is a chance that the competing oligopolies will reduce their prices to match this figure or to an even lower figure.

However, due to the fact that the reduction is of high proportions, other companies may not have the financial potential to drop their prices to such extents and consequently the firm that dropped its prices will gradually gain in terms of customer drain from competitors and will hope to retain these customers in the long-term. The other effect of long term strategic commitments is that the desired effect may not be attained and the company ends up losing heavily (McEachern 2008).

Drawing from the above example of a 40% price reduction, customers may not be interested in shifting their loyalty from the other competitors in the oligopoly because of the quality of service they have been getting. Under these circumstances, the company which dropped its prices may not be in a position to break even and because of pride issues, the company will not be in a position to raise its prices once its plan backfires.

Conclusion

This essay has extensively analysed the importance of economic analysis in explaining certain behaviours of oligopolies. Various analytical models have been used to provide logical explanations as to the behaviours of companies in this business structure. Aside from this, a section of the presentation has been used to elaborate on the impact of strategic commitments on the competitive positions of companies.

In conclusion, it is worth noting that oligopoly is a very common market structure which tends to come with difficulties in evaluation. With companies getting bigger and acquiring more power and with the world becoming a global village on a daily basis it is almost guaranteed that this structure will in the coming years be the basic market structure.

Reference List

Baumol, W.J. & Blinder, A.S., 2008. Economics: Principles and Policy. Connecticut: Cengage Learning.

Baye, M.R., 1999. Oligopoly. Greenwich, CT: JAI Press.

Boulding, K.E., 1966. Economic analysis. United States: Harper & Row.

Friedman, J.W., 1983. Oligopoly theory. Cambridge: CUP Archive.

Fudenberg, D. & Tirole, J., 2002. Dynamic models of oligopoly. United Kingdom: Routledge.

Hirschey, M., 2009. Managerial economics. Connecticut: Cengage Learning.

McEachern, W.A., 2008. Economics: A Contemporary Introduction. Connecticut: Cengage Learning.

Peeples, J.V., 1989. Oligopoly. New Mexico: New Mexico State University.

Pleeter, S., 1980. Economic impact analysis: methodology and applications. Boston: Martinus Nijhoff Publishers.

Puu, T. & Shusko, I., 2002. Oligopoly dynamics: models and tools. New York City: Springer.

Schermerhorn, R.W., 1978. Economic feasibility analysis: what is it and how should it be done. Hawaii: University of Hawaii Cooperative Extension Service.

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