Oligopoly

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Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Oligopolies can be identified using concentration ratios, which measure the proportion of total market share controlled by a given number of firms. When there is a high concentration ratio in an industry, economists tend to refer this industry as an oligopoly.

Industries where oligopoly exists are Oil companies, steel manufacturer, rail roads, air lines.  If oligopolies compete hard, they end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolies collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit, it is called a cartel.

In this article we will understand the concept of Oligopoly, why do we classify OPEC as an Oligopoly cartel and how pricing is decided in this market structure.

Organisation of petroleum exporting counties (OPEC) is an example of an oligopoly market where the cartel generates approximately 44 percent of the world’s total crude oil production, and more than 20 percent of the world’s natural gas production. Moreover, OPEC owns more than four-fifths of total global crude oil reserves, and nearly 48 percent of global natural gas reserves.

The graph below shows the OPEC production of crude Oil from 1998 to 2017 and the average annual crude oil price from 1998 to 2017, its interesting to note how the production over the years have remained almost same as compared to drastic price changes by the cartel.

Characteristics of an Oligopoly market:

  1. Few Sellers: Only few firms dominate the market and enjoy a considerable control over the price of the product.

 

  1. Interdependence of the firm: in an oligopoly market firms are dependent upon each other in sharing the profits and cannot act independently of each other. This concept of interdependence of firms can be understood with the help of “Prisoner’s Dilemma“  or “Game Theory”.

 

The prisoner’s dilemma is a scenario in which the gains from cooperation/cartel are larger than the rewards from pursuing self-interest. If each of the firm in oligopoly cooperates in holding down output, then high monopoly profits are possible. However, each firm must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits.

Let’s understand this with the help of an example- suppose there are just 2 firms in an oligopoly market: Firm X and Firm Y. If Firms X and Y both agree to hold down output, they are acting together as a monopoly and will each earn Rs.1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn Rs.400 in profits.

 

Example Firm Y
Holds down output (cooperates) Does not hold down output (no cooperation)
Firm X Holds down output (cooperates) X gets Rs. 1,000,

Y gets Rs. 1,000

X gets Rs. 200,

Y gets Rs. 1,500

Does not hold down output (no cooperation) X gets Rs. 1,500,

Y gets Rs. 200

X gets Rs. 400,

Y gets Rs. 400

 

Hence, nations that are members of the Organization of Petroleum Exporting Countries (OPEC), have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, are not legally enforceable.

Because oligopoly cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging.

 

  1. Barriers to entry: Firms in Oligopoly maintain their position of dominance in a market because it is too costly or difficult for potential rivals to enter the market. Some of the barrier that make entry for a new firm difficult in such markets are: Economies of large scale-hence the price benefit, High set-up cost, High R&D cost.

 

Pricing Strategy in an Oligopoly market:

Once a price has been determined in an oligopoly market, it will stick. This is largely because firms cannot pursue independent strategies. For example, if one of the Oil producing nations raises the price of its barrel from $50 to $75, rivals will not follow suit and the oil producing nation will lose revenue – the demand curve for the price increase is relatively elastic. Rivals have no need to follow suit because it is to their competitive advantage to keep their prices as they are.

However, if the nation lowers its price, rivals would be forced to follow suit and drop their prices. Again, the nation will lose sales revenue and market share. The demand curve is relatively inelastic in this case.

The diagram above suggests that a change in marginal cost still leads to the same price, because of the kinked demand curve.  Profit maximization occurs where MR = MC at Q1.

On December 3rd,2018 Qatar declared that it would be leaving the OPEC cartel on January 1st, 2019. Qatar produces around 600,000 barrels of oil per day, which is less than 2 per cent of OPEC’s total production of 32.9 million barrels in October, 2018. Saudi Arabia, the world’s biggest oil exporter and OPEC’s biggest producer, pumped over 10.5 million barrels as of October,2018. (source: www.statista.com)

As a result of which, even with Qatar moving out of the cartel as there has been no marginal decline in the supply of the crude oil being produced,hence there was no change in the international price of the crude oil barrel.

Qatar is the world’s biggest exporter of LNG and sits on the world’s third largest gas reserves after Russia and Iran. Qatar began to strategically cultivate its natural gas sector in 1987 at a time when many in the industry hardly saw any potential in gas. This decision has paid dividends many times over and Qatar has emerged as the world largest exporter of LNG, GTL (Gas-to-Liquids) and helium (as of December,2018 data). The revenue from the natural gas sector has propelled its economy and has given it special importance globally.

Therefore, this movement can also be sighted as a good long-term economic strategy. What defines the country’s energy sector is not its oil production, but its capacity and global presence in the natural gas sector.

Stay tuned for more interesting articles!!!

 

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