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M A I N T A I N I N G A N D E N H A N C I N G B R A N D L O Y A L T Y I N M O N O P O L I S T I C C O M P E T I T I O N

Incumbent firms purchase advertising and other promotional activities, while new entrants may have to spend substantially more in order to gain a foothold in the market. Advertising is one example of non-price competition and it is a major feature of this type of market structure. By spending on advertising, firms not only want to gain new customers but also keep existing customers; that is they want to make their customer’s demand curves more inelastic. Yet advertising is expensive so firms must balance the perceived benefits of advertising against the actual costs of advertising.

How do firms do this? They continue to spend on advertising so long as the additional (marginal) revenue the advertising brings in exceeds the additional (marginal) cost of the advertising. Firms’ profits increase as long as MRadvertising >

MCadvertising. Advertising exhibits diminishing marginal returns, such that more and more advertising will yield less and less revenue so eventually MRadvertising = MCadvertising and the firm’s advertising adds nothing to profits.

6.3.5OLIGOPOLY

The final type of market structure considered is oligopoly.

The underlying assumptions of oligopoly are:

•Few sellers exist in the market – each taking account of the decisions of their competitors.

•Products of each firm are similar but not identical.

•Each firm produces a substantial amount of output and so has market power.

•Barriers to entry exist.

Oligopolies occur where a market has ‘room’ for a few large firms. This could be because of cost advantages through scale economies or through economies of scope.

Economies of scope exist when a firm produces many products and can share resources across them such that the unit costs of each product is lower than if they were produced by separate firms. Shared marketing or distribution costs may be sources of economies of scope.

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In industries where mergers and acquisitions are commonplace (such as the

car industry discussed in	Chapter 4) the number of competitors decline as
firms’ business strategies	guide them to ‘grow’ not by expanding the mar-

ket, which is becoming saturated, but by buying up rivals, which may reduce competitive behaviour and allow for increasing profit margins once barriers to entry exist.

The essence of oligopoly markets is that firms’ decisions are interdependent. When making decisions on output, for example, each firm takes account of how their rivals are likely to respond, as this will affect the profitability of such decisions. This complicates firms’ decision-making processes because it can be very difficult to predict how each rival will respond and precisely how such responses will impact on the firm. Very often firms will seek out a ‘simpler’ solution. For example, instead of trying to guess how a rival will respond, firms may wish to seek agreements with their rivals on output (or other decisions) so as to maximize the profitability with the minimum of risk. With few firms in an industry this is not as difficult as it may first seem. Yet at the same time there are incentives for each firm to ‘go it alone’ so that it can get one step ahead of its rivals. This inherent conflict in oligopoly markets make for fascinating study.

Formal collusion by firms can take the form of a cartel where firms make explicit output agreements, for example, with the intention of maintaining a high price for the product.

A cartel is an agreement between firms to cooperate in restricting the amount of output they produce, thereby influencing the price.

OPEC (the Organization of Petroleum Exporting Countries) is possibly the most well-known cartel and its agreements on levels of oil production (or extraction) for each country effectively controls the price of oil on world markets (this example is discussed in terms of its effects on international inflation in Chapter 8). However, there are two problems with cartels that inhibit their usefulness. First, cartels tend to be unstable because of each member’s incentive to cheat on the agreement and make extra profits in the short term. When other firms see the agreement breached they would follow suit and, in the case of OPEC, increase oil production, thereby causing the world price to fall. Second, in a lot of countries, including Europe and the USA, cartels are illegal and any such agreements are prohibited under competition law.

As a result firms may engage in less obvious forms of collusion.

Implicit collusion may take the form of price leadership, where either

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•a dominant firm in the industry sets price and all others follow and set their price with this information at hand; or

•a well-established firm becomes the ‘leader’ in the industry and is trusted with setting the price that all firms will charge.

Such a leader has usually gained the respect of the other firms and has a lot of experience in the industry. All types of implicit collusion are also illegal and therefore firms may not readily engage in such activities, despite the potential business benefits.

Oligopoly and game theory

Without collusion in oligopoly markets, firms make assumptions on how rivals react. Such interdependence can be analysed using game theory.

Game theory is a microeconomic approach or tool of analysis applied to understand the behaviour of individuals and firms. Pay-offs generated by following different strategies can be compared.

In game theory, a firm makes assumptions on how the other firm(s) will react and then chooses its best option. In such games the firm seeks a dominant strategy.

A dominant strategy is one that provides one firm with the best outcome, irrespective of the strategy another firm (or firms) chooses.

Firm interdependence and dominant strategies can be illustrated using the example shown in Table 6.1. Here we have two firms; A has two strategic options, X or Y , and

T A B L E 6 . 1 G A M E T H E O R Y :

S T R A T E G I C O P T I O N S A N D

D O M I N A N T S T R A T E G Y

	Firm B’s strategic options
		I (high)	II (low)
Firm A’s	X (high)	(3, 4)	(2, 5)
strategic	Y (low)	(4, 3)	(4, 5)

options

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firm B has two strategic options, I and II . For firm A, Strategy X could be to set a high price and strategy Y to set a low price while for Firm B, Strategy I is high price and II is low price. By examining the pay-offs from each strategy we can analyse if a dominant strategy exists.

Here, if firm A chooses strategy X (high price) and firm B chooses strategy I (high price), then A earns £3 in profits and B earns £4. If A chooses strategy Y

(low price) while firm B still chooses strategy I (high price), then A earns £4 and B earns £3 since lower prices entice consumers to buy more from firm A. When firm B chooses I (high), strategy Y (low) earns firm A higher profit.

When firm B chooses strategy II (low), firm A earns £2 with strategy X (high) and £4 with strategy Y (low). Again strategy Y earns Firm A higher profits. Therefore strategy Y is a dominant strategy for firm A; no matter what strategy firm B chooses, firm A will always do best by choosing strategy Y .

Similarly for firm B, no matter what strategy firm A chooses, firm B always does best by choosing strategy II , so II is B’s dominant strategy.

The equilibrium outcome in this game has firm A choosing strategy Y and firm

Bchoosing strategy II . This outcome earns £4 for firm A and £5 for firm B. Dominant strategies for either one or both firms result in a relatively easy

determination of the outcome. However, dominant strategies do not exist for all cases.

Consider the Game in Table 6.2. Firms A and B again have two strategic options but with different pay-offs. In this game no firm has a dominant strategy. The firms are faced with two possible options:

•Option 1: Firm A chooses X and firm B chooses I – each firm earns £10 profit.

•Option 2: Firm A chooses Y and firm B chooses II – each firm earns £5 profit.

T A B L E 6 . 2 G A M E T H E O R Y :

S T R A T E G I C O P T I O N S W I T H N O

D O M I N A N T S T R A T E G Y

		Firm B’s strategic options
		I	II
Firm A’s	X	(10, 10)	(0, 0)
strategic	Y	(0, 0)	(5, 5)

options

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This is an example of a game with two Nash equilibria (after John Nash, the Nobel Prize winner in economics, 1994), where each firm is doing the best it can, given the strategy being pursued by the other firm.

A Nash equilibrium exists when each player in a game chooses their best strategy given the strategies followed by other players.

The two remaining options are less likely since both firms earning zero profits. Therefore, it is crucial that each firm chooses either option 1 or 2 and option 1 is preferable to option 2 for the firms concerned. But how can the firms ensure that either of these options will prevail? Collusion would ensure they do not end up with the worst outcome of £0 profits each.

In the absence of collusion there is still a way for the firms to achieve the better outcome. If one firm invests in a commitment of resources that will make it clear to all other firms that it intends to pursue one particular strategy, then this can guide the second firm in its strategy decision. For example, if firm A invests in a system of production that makes it clear it must pursue strategy X , then firm B, will do best by choosing strategy I and the resulting profit outcome for both firms is £10. Such an investment must be both visible and irreversible in order to convince firm B that strategy Y will be the strategy pursued by firm A. Pay-offs as before.

To make this example more tangible, consider that strategy X (and I ) involve abiding by an agreement to restrict output and strategy Y (or II ) represent cheating on such an agreement. If both firms abide by the agreement, they both earn £10; if they both cheat, they earn £5. Any deviations from these two strategies will result in zero profits for both, due to, for example, resulting price wars. To achieve the best possible outcome one firm could invest in machinery, or a production line, which is capacity-constrained – only a certain capacity can be produced. Such a firm could credibly commit a certain level of production. An agreement could then be made to set this level of production to maximize their profits.

Prisoner’s Dilemma

An interesting outcome unfolds if the pay-offs to this game were as shown in Table 6.3. Such a game is an example of the Prisoner’s Dilemma.

A Prisoner’s Dilemma exists when the equilibrium from a game generates a sub-optimal outcome for all parties involved. With commitment (or a binding contract) between the firms, higher pay-offs could be achieved to the benefit of both players.

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T A B L E 6 . 3 G A M E T H E O R Y :

S T R A T E G I C O P T I O N S W I T H

S U B - O P T I M A L S T R A T E G Y

		Firm B’s strategic options
			I	II
Firm A’s	X	(10,	10)	(3, 15)
strategic	Y	(15,	3)	(5, 5)
options

High price (or low output) strategies are X and I in Table 6.3, while low price (high output) strategies are Y and II . If both firms have low price strategies (Y and II ), industry output is high and profits are relatively low at £5 per firm. With both firms following high price strategies resulting in low industry output, profits rise to £10 per firm. Firms’ profits are maximized at £15 if one firm follows a low price (high

T A B L E 6 . 4 S U M M A R Y O F M A R K E T S T R U C T U R E C H A R A C T E R I S T I C S

		No. of		Power of	Barriers	Non-price
	Type of product	firms	Examples	firm: price	to entry	competition
Perfect	Homogeneous	Many	None	None	None	None
competition
Monopolistic	Differentiated	Many	Retailing,	Some	Low	Advertising
competition			building			and product
			and			differentia-
			restaurant			tion
			trades
Oligopoly	Standardized	Few	Steel, car	Some	High	Advertising
	or		and com-			and product
	differentiated		puter			differentia-
			industries			tion
Monopoly	Unique	One	Microsoft	A lot	Very	Advertising
					high

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output) strategy when the other firm adopts the alternative strategy (earning £3); combined profits of £18 would be generated.

If firm A thinks B will select strategy I (high price), A’s best option is to choose

Y(low price) since its profits of £15 > £10. If B selects II , A’s best option remains

Ysince £5 > £3. Similarly, B’s best option is to select strategy II . Hence, when no co-operation is possible between firms a non-cooperative equilibrium emerges with pay-offs of £5 to each firm. This is sub-optimal when both could earn £10.

Some co-operation such as a binding commitment or a contract between the firms could generate an incentive for them both to simultaneously choose X and I

(where profits of £20 shared equally are possible). This would be an example of a

co-operative equilibrium.

Summary of market characteristics

To sum up this section, the main differentiating characteristics of each market structure are presented in Table 6.4.

6 . 4 A U S T R I A N A N D T R A D I T I O N A L

P E R S P E C T I V E S : A C O M P A R I S O N

The previous two sections present very different perspectives on competition, i.e. the Austrian ‘competition as a process’ view and the perspective of competition as a timeless state of events. Competition is a dynamic process in the former and a static process in the latter.

Knowledge and its use are key issues distinguishing the traditional view of competition from the Austrian view. In perfect competition, knowledge is ‘perfect’ or available to all. Decision-making becomes a problem not so much of making choices, but one of maximizing a series of price possibilities from a given set of resources. Individuals are in a sense ‘programmed’ to select a transaction that is a ‘maximum’ outcome attainable. Since knowledge is given, in effect, there is nothing to compete over. All producers and consumers know what is to be known about products and prices and there is no need to compete for anything.

In reality, characteristics of goods and what makes them scare and valuable are not known in advance and these are some of the issues that the events we call competition attempt to discover. In perfect competition, the decision-maker does not exercise genuine choice; everything is known in advance so there are no choices to be made. Consequently, it is assumed that no errors are made in this decision-making/maximization process.

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To many consumers and producers the ‘perfect competition’ dramatization of the marketplace is not realistic. In making decisions, individuals rank objectives and available resources and in this process new knowledge is gained. This new knowledge becomes, in turn, part of future ranking processes. In addition, outcomes are not known in advance; instead individuals are confronted with choices to be made.

The Austrian perspective acknowledges the experience and learning of individuals where knowledge is not only limited, it is also constantly developing over time. Knowledge is crucial and central to the process of competition itself. It not only emerges from competition but also creates competitive forces. Every player in the market possesses different degrees of knowledge and can use it in exchanges to maximize their utility, the more specific in nature is the knowledge (as discussed in Chapter 2). This approach is intuitive from our own experiences as consumers. When we purchase goods we do not, and cannot, know everything there is to know about the good we are buying, the number of sellers of that good and the prices charged in different markets. Yet we do not need to know all this information in order to trade. We simply assess the amount of value or utility that we can derive from the product and decide whether the price subjectively represents good value to us.

Another feature of the perfect competition model is that no one firm can gain market power. Firms do not interact, they are price takers and accept given ‘world’ prices. Yet in business we see many firms with market power and they achieve this through, for example, superior use of knowledge or resources.

Microsoft has become a very large and successful firm by developing a useful operating system for personal computers. In the process it displaced IBM, the previous leader in the industry. The amount of knowledge and, in particular, the use of knowledge that each firm had discovered allowed this situation to emerge.

Equilibrium, central to the traditional model of competition is considered in the Austrian approach as contradictory to the whole notion of competition. Equilibrium, by its very nature, assumes a steady state where the market has absorbed all relevant information and is in a position of stability from where there is no tendency to move – there is no more competition. As we can see from our discussion of the Austrian perspective, though, this can never be the case as knowledge constantly changes. Therefore equilibrium not only does not exist, moreover it cannot exist.

A further point that sets the Austrian perspective apart from the traditional model is that markets are unpredictable. Competition is more like a game of chance rather than a set of predictable moves and counter moves. This unpredictability