The Benefits of Oligopolies
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The Wall Street Journal has recently published an elegiac list:
"Twenty years ago, cable television was dominated by a patchwork of thousands
of tiny, family-operated companies. Today, a pending deal would leave three
companies in control of nearly two-thirds of the market. In 1990, three big
publishers of college textbooks accounted for 35% of industry sales. Today they
have 62% ... Five titans dominate the (defense) industry, and one of them,
Northrop Grumman ... made a surprise (successful) $5.9 billion bid for (another)
TRW ... In 1996, when Congress deregulated telecommunications, there were eight
Baby Bells. Today there are four, and dozens of small rivals are dead. In 1999,
more than 10 significant firms offered help-wanted Web sites. Today, three firms
dominate."
Mergers, business failures, deregulation, globalization, technology,
dwindling and more cautious venture capital, avaricious managers and investors
out to increase share prices through a spree of often ill-thought acquisitions -
all lead inexorably to the congealing of industries into a few suppliers. Such
market formations are known as oligopolies. Oligopolies encourage customers to
collaborate in oligopsonies and these, in turn, foster further consolidation
among suppliers, service providers, and manufacturers.
Market purists consider oligopolies - not to mention cartels - to be as
villainous as monopolies. Oligopolies, they intone, restrict competition
unfairly, retard innovation, charge rent and price their products higher than
they could have in a perfect competition free market with multiple participants.
Worse still, oligopolies are going global.
But how does one determine market concentration to start with?
The Herfindahl-Hirschmann index squares the market shares of firms in the
industry and adds up the total. But the number of firms in a market does not
necessarily impart how low - or high - are barriers to entry. These are
determined by the structure of the market, legal and bureaucratic hurdles, the
existence, or lack thereof of functioning institutions, and by the possibility
to turn an excess profit.
The index suffers from other shortcomings. Often the market is difficult to
define. Mergers do not always drive prices higher. University of Chicago
economists studying Industrial Organization - the branch of economics that deals
with competition - have long advocated a shift of emphasis from market share to
- usually temporary - market power. Influential antitrust thinkers, such as
Robert Bork, recommended to revise the law to focus solely on consumer welfare.
These - and other insights - were incorporated in a theory of market
contestability. Contrary to classical economic thinking, monopolies and
oligopolies rarely raise prices for fear of attracting new competitors, went the
new school. This is especially true in a "contestable" market - where entry is
easy and cheap.
An Oligopolistic firm also fears the price-cutting reaction of its rivals if
it reduces prices, goes the Hall, Hitch, and Sweezy theory of the Kinked Demand
Curve. If it were to raise prices, its rivals may not follow suit, thus
undermining its market share. Stackleberg's amendments to Cournot's Competition
model, on the other hand, demonstrate the advantages to a price setter of being
a first mover.
In "Economic assessment of oligopolies under the Community Merger Control
Regulation, in European Competition law Review (Vol 4, Issue 3), Juan Briones
Alonso writes:
"At first sight, it seems that ... oligopolists will sooner or later find a
way of avoiding competition among themselves, since they are aware that their
overall profits are maximized with this strategy. However, the question is much
more complex. First of all, collusion without explicit agreements is not easy to
achieve. Each supplier might have different views on the level of prices which
the demand would sustain, or might have different price preferences according to
its cost conditions and market share. A company might think it has certain
advantages which its competitors do not have, and would perhaps perceive a
conflict between maximising its own profits and maximizing industry profits.
Moreover, if collusive strategies are implemented, and oligopolists manage to
raise prices significantly above their competitive level, each oligopolist will
be confronted with a conflict between sticking to the tacitly agreed behaviour
and increasing its individual profits by 'cheating' on its competitors.
Therefore, the question of mutual monitoring and control is a key issue in
collusive oligopolies."
Monopolies and oligopolies, went the contestability theory, also refrain from
restricting output, lest their market share be snatched by new entrants. In
other words, even monopolists behave as though their market was fully
competitive, their production and pricing decisions and actions constrained by
the "ghosts" of potential and threatening newcomers.
In a CRIEFF Discussion Paper titled "From Walrasian Oligopolies to Natural
Monopoly - An Evolutionary Model of Market Structure", the authors argue that:
"Under decreasing returns and some fixed cost, the market grows to 'full
capacity' at Walrasian equilibrium (oligopolies); on the other hand, if returns
are increasing, the unique long run outcome involves a profit-maximising
monopolist."
While intellectually tempting, contestability theory has little to do with
the rough and tumble world of business. Contestable markets simply do not exist.
Entering a market is never cheap, nor easy. Huge sunk costs are required to
counter the network effects of more veteran products as well as the competitors'
brand recognition and ability and inclination to collude to set prices.
Victory is not guaranteed, losses loom constantly, investors are forever
edgy, customers are fickle, bankers itchy, capital markets gloomy, suppliers
beholden to the competition. Barriers to entry are almost always formidable and
often insurmountable.
In the real world, tacit and implicit understandings regarding prices and
competitive behavior prevail among competitors within oligopolies. Establishing
a reputation for collusive predatory pricing deters potential entrants. And a
dominant position in one market can be leveraged into another, connected or
derivative, market.
But not everyone agrees. Ellis Hawley believed that industries should be
encouraged to grow because only size guarantees survival, lower prices, and
innovation. Louis Galambos, a business historian at Johns Hopkins University,
published a 1994 paper titled "The Triumph of Oligopoly". In it, he strove to
explain why firms and managers - and even consumers - prefer oligopolies to both
monopolies and completely free markets with numerous entrants.
Oligopolies, as opposed to monopolies, attract less attention from
trustbusters. Quoted in the Wall Street Journal on March 8, 1999, Galambos
wrote: "Oligopolistic competition proved to be beneficial ... because it
prevented ossification, ensuring that managements would keep their organizations
innovative and efficient over the long run."
In his recently published tome "The Free-Market Innovation Machine -
Analysing the Growth Miracle of Capitalism", William Baumol of Princeton
University, concurs. He daringly argues that productive innovation is at its
most prolific and qualitative in oligopolistic markets. Because firms in an
oligopoly characteristically charge above-equilibrium (i.e., high) prices - the
only way to compete is through product differentiation. This is achieved by
constant innovation - and by incessant advertising.
Baumol maintains that oligopolies are the real engines of growth and higher
living standards and urges antitrust authorities to leave them be. Lower
regulatory costs, economies of scale and of scope, excess profits due to the
ability to set prices in a less competitive market - allow firms in an oligopoly
to invest heavily in research and development. A new drug costs c. $800 million
to develop and get approved, according to Joseph DiMasi of
Tufts University's Center for the Study of Drug Development, quoted in The wall
Street Journal.
In a paper titled "If Cartels Were Legal, Would Firms Fix Prices",
implausibly published by the Antitrust Division of the US Department of Justice
in 1997, Andrew Dick demonstrated, counterintuitively, that cartels are more
likely to form in industries and sectors with many producers. The more
concentrated the industry - i.e., the more oligopolistic it is - the less likely
were cartels to emerge.
Cartels are conceived in order to cut members' costs of sales. Small firms
are motivated to pool their purchasing and thus secure discounts. Dick draws
attention to a paradox: mergers provoke the competitors of the merging firms to
complain. Why do they act this way?
Mergers and acquisitions enhance market concentration. According to
conventional wisdom, the more concentrated the industry, the higher the prices
every producer or supplier can charge. Why would anyone complain about being
able to raise prices in a post-merger market?
Apparently, conventional wisdom is wrong. Market concentration leads to price
wars, to the great benefit of the consumer. This is why firms find the mergers
and acquisitions of their competitors worrisome. America's soft drink market is
ruled by two firms - Pepsi and Coca-Cola. Yet, it has been the scene of
ferocious price competition for decades.
"The Economist", in its review of the paper, summed it up neatly:
"The story of America's export cartels suggests that when firms decide to
co-operate, rather than compete, they do not always have price increases in
mind. Sometimes, they get together simply in order to cut costs, which can be of
benefit to consumers."
The very atom of antitrust thinking - the firm - has changed in the last two
decades. No longer hierarchical and rigid, business resembles self-assembling,
nimble, ad-hoc networks of entrepreneurship superimposed on ever-shifting
product groups and profit and loss centers.
Competition used to be extraneous to the firm - now it is commonly an
internal affair among autonomous units within a loose overall structure. This is
how Jack "neutron" Welsh deliberately structured General Electric. AOL-Time
Warner hosts many competing units, yet no one ever instructs them either to curb
this internecine competition, to stop cannibalizing each other, or to start
collaborating synergistically. The few mammoth agencies that rule the world of
advertising now host a clutch of creative boutiques comfortably ensconced behind
Chinese walls. Such outfits often manage the accounts of competitors under the
same corporate umbrella.
Most firms act as intermediaries. They consume inputs, process them, and sell
them as inputs to other firms. Thus, many firms are concomitantly consumers,
producers, and suppliers. In a paper published last year and titled "Productive
Differentiation in Successive Vertical Oligopolies", that authors studied:
"An oligopoly model with two brands. Each downstream firm chooses one brand
to sell on a final market. The upstream firms specialize in the production of
one input specifically designed for the production of one brand, but they also
produce he input for the other brand at an extra cost. (They concluded that)
when more downstream brands choose one brand, more upstream firms will
specialize in the input specific to that brand, and vice versa. Hence, multiple
equilibria are possible and the softening effect of brand differentiation on
competition might not be strong enough to induce maximal differentiation" (and,
thus, minimal competition).
Both scholars and laymen often mix their terms. Competition does not
necessarily translate either to variety or to lower prices. Many consumers are
turned off by too much choice. Lower prices sometimes deter competition and new
entrants. A multiplicity of vendors, retail outlets, producers, or suppliers
does not always foster competition. And many products have umpteen substitutes.
Consider films - cable TV, satellite, the Internet, cinemas, video rental shops,
all offer the same service: visual content delivery.
And then there is the issue of technological standards. It is incalculably
easier to adopt a single worldwide or industry-wide standard in an oligopolistic
environment. Standards are known to decrease prices by cutting down R&D
expenditures and systematizing components.
Or, take innovation. It is used not only to differentiate one's products from
the competitors' - but to introduce new generations and classes of products.
Only firms with a dominant market share have both the incentive and the
wherewithal to invest in R&D and in subsequent branding and marketing.
But oligopolies in deregulated markets have sometimes substituted price
fixing, extended intellectual property rights, and competitive restraint for
market regulation. Still, Schumpeter believed in the faculty of "disruptive
technologies" and "destructive creation" to check the power of oligopolies to
set extortionate prices, lower customer care standards, or inhibit competition.
Linux threatens Windows. Opera nibbles at Microsoft's Internet Explorer.
Amazon drubbed traditional booksellers. eBay thrashes Amazon. Bell was forced by
Covad Communications to implement its own technology, the DSL broadband phone
line.
Barring criminal behavior, there is little that oligopolies can do to defend
themselves against these forces. They can acquire innovative firms, intellectual
property, and talent. They can form strategic partnerships. But the supply of
innovators and new technologies is infinite - and the resources of oligopolies,
however mighty, are finite. The market is stronger than any of its participants,
regardless of the hubris of some, or the paranoia of others.
About the Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and
"After the Rain - How the West Lost the East". He is a columnist in "Central
Europe Review", United Press International (UPI) and ebookweb.org and the editor
of mental health and Central East Europe categories in The Open Directory,
Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor
to the Government of Macedonia.
His web site: http://samvak.tripod.com
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Article Published/Sorted/Amended on Scopulus 2007-11-04 00:08:13 in Economic Articles
