Microeconomics Research Project

Introduction

A market is a primary and most significant domain of companies’ functioning where they offer their products to sellers and compete with their rivals with account for the relevant market structure, concentration levels, consolidation cycle stage, and other important features. The latter serves as a key driver of the company’s strategic behavior and either encourage it to cooperate with other companies with which it can be interdependent or compete with them aggressively. The latter conduct should be carefully considered in an oligopoly that is different from other market structures based on its key characteristics. In addition to consideration of the key characteristics, companies functioning in an oligopoly and virtually in any other market structure should take into account the level of market consolidation and concentration. They should also employ applicable indexes and measurement instruments to assess their current position in the market and build an effective development strategy. With a perspective to ensuring comprehension of aforementioned aspects, the current paper provides a brief discussion of the issues such as an oligopoly, its key characteristics, relevant product market, market consolidation, and market concentration.

Key Characteristics of an Oligopolistic Market Structure

An Oligopolistic Market Structure significantly differs from other market structures based on its key characteristics. Hence, basic characteristics typical for an oligopoly include the presence of a large number of potential buyers as well as of a few sellers, availability of either a homogenous or a differentiated product, and a relatively small size of buyers as compared to sellers (Besanko and Braeutigam 530). Moreover, an oligopoly may be either pure or impure. In a pure oligopoly, a homogenous product is offered by few sellers to many potential customers. Under this type of market structure, the lack of significant competition may be viewed as the only source of market power. In turn, an impure oligopoly emerges when sellers offer differentiated products, which is the reason for the sources of market power to be the lack of both significant competition and product differentiation.

In addition to the basic characteristics, an Oligopolistic Market Structure has the other ones, including the interdependence of the few selling companies, especially with respect to their decision-making (Kumar). The reason is that under this market structure, a few companies constitute the entire industry and take some influential decisions. For instance, to launch a large-scale advertising campaign or present a new product that will be surely attractive in the market, all other companies should take some actions in response to remain competitive in the industry. Therefore, all companies in an oligopoly are tightly interdependent. Due to this interdependence, they closely monitor the actions and policies of their key rivals as well as using advertising, in particular, aggressive advertising, to win a large market share (Kumar). Under this market structure, advertising often becomes “a life-and-death matter where a firm which fails to keep up with the advertising budget of its competitors may find its customers drifting off to rival products” (Kumar).

Moreover, a key characteristic of an oligopoly is group behavior that may be difficult to predict though it is surely marked by interdependence (Kumar). Hence, there may be a leader in the group; however, other companies may refuse to follow the leader in its decisions. There may also be no leader, and all group members may pursue different goals. Withal, group behavior depends on the industry under this type of market structure. Another characteristic is the presence of “true competition” among the few sellers competing for customers in a tightly interdependent market, which makes monitoring of competitors essential for business functioning (Kumar). Thus, “true competition consists of the life of constant struggle, rival against rival, whom one can only find under oligopoly” (Kumar).

Some other characteristics of an oligopoly include relative price rigidity, indeterminate nature of demand curve, and lack of uniformity among companies. Though short-term barriers to market entry are absent, there are some long-term barriers. Concerning the latter characteristic, any company may enter the oligopolistic market or exit it in the short run whereas, in the long run, most companies face many incentives not to enter this type of the market. For instance, these long-term barriers may be economies of scale enjoyed by already existing large companies in the market. They also may perform lack of access to required peculiar inputs, high capital requirements, absence of some patents or licenses that are in exclusive possession of already represented companies, and unattractiveness of the industry due to unused capacity. Based on the above characteristics, an Oligopolistic Market Structure is obviously a peculiar type of the market that has several essential characteristics to be taken into consideration before entering the market and in the process of functioning in it.

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Characteristics of an Industry as an Oligopoly

Characteristics and definition of an oligopolistic industry are similar to those of an oligopolistic market. Hence, it has a few sellers that offer either a homogeneous or a differentiated product to a large number of potential small buyers. As aforementioned, an oligopoly has a number of essential characteristics that predetermine the behavior of companies in the industry. Withal, all companies in an oligopolistic industry are tightly interconnected and interdependent regarding their behavior, pricing, advertising, and products. That is the reason why they closely monitor each other in order to be able to respond in a timely and efficient manner to changes introduced by key competitors. Moreover, companies in such an industry may either form a group with one determined leader who sets a general direction for all companies or refrains from negotiations and attempts to behave independently. In a homogeneous oligopolistic industry, such as the US glass container one, all companies offer similar products with virtually the same characteristics, attributes, and prices (Besanko and Braeutigam 530). Whereas, a differentiated oligopolistic industry offers differentiated products that differ from each other significantly though they may be deemed as substitutes on the whole (Besanko and Braeutigam 530). An example of this industry in the USA is the soft drinks industry.

Strategic Behavior and Mutual Interdependence

Strategic behavior and mutual interdependence are common for an oligopoly. Thus, strategic behavior primarily concerns pricing behavior within an oligopolistic market structure, whereby companies represented in the market play “a specific game of strategy” (Finance & Economics). All players of the market monitor actions of their competitors and respond to them accordingly. Concerning strategic pricing, companies have two basic choices, namely to increase or to lower prices, but the availability of the choices to all market players create a certain number of combinations of possible strategies for the companies. Companies may adopt a strategic behavior called “collusion” that means cooperation with their key competitors with a view to benefitting all stakeholders (Finance & Economics). In turn, mutual interdependence is a key characteristic of an oligopoly and means that the behavior and actions of one company significantly influence other companies in the market (Nilsson 188). Mutual interdependence exists in an oligopolistic market structure since a few large companies hold significant market shares. That is the reason why it is inevitable that actions, behavior, and pricing of one company will affect all other market players to a varying extent.

Definition of Relevant Product Market

The term ‘relevant product market’ is essential for proper development and application of the competition law since it assists the authorities with assessing mergers and deciding whether they would not infringe upon fundamental legally protected competition norms. Hence, according to the competition law, a relevant product market is defined as the one that “comprises all those products and/or services which are regarded as interchangeable or substitutable by the consumer by reason of the products’ characteristics, their prices and their intended use” (EUR-Lex). It means that consumers do not see an essential difference between the products. For instance, in case of a change in price, they can easily switch from one product to another (for example, from cookies with almonds to cookies with chocolate). Hence, the two products will belong to the same relevant product market. Alternatively, products belonging to the same category of goods while having drastically different characteristics such as relating to a significant price gap cannot be substituted with each other and therefore are not in the same relevant product market.

Consolidation of a Market

Generally, almost all new markets are highly fragmented and consolidate gradually in the process of their maturing. This consolidation occurs in several stages that have been distinguished and studied by researchers from Harvard Business Review on the basis of about 1,400 mergers during the past 13 years in a variety of industries (Deans, Kroeger, and Zeisel). According to their research, all markets undergo a clear consolidation life cycle that is predictable and can assist companies with developing the strategies most appropriate at the current stage of market consolidation. On average, a market takes about 25 years nowadays to consolidate. However, this period was much longer in the past and is predicted to become shorter in the future (Deans et al.). The consolidation cycle consists of four key stages, namely Opening, Scale, Focus, as well as Balance and Alliance (Deans et al.). During Stage 1, the market opens up and has one or few start-ups, yet this 100% industry concentration does not last for long. Another possible scenario of the way the markets may appear concerns newly privatized of deregulated industries. Within a short period of time, combined market share of the top three market players decreases to about 30%-10% while new competitors arise frequently in the market. Examples of markets at this stage internationally include telecommunications, banking, biotechnology, and others (Deans et al.). This stage calls for companies to seek actively competitive advantages and preserve their place in the market, for instance, by building scale and creating entry barriers for new companies. Hence, companies seek to accumulate market share during this stage and should seriously consider future acquisitions to succeed during the subsequent two stages.

Stage 2 concerns building scale in the market, whereby few key market players become evident and start acquiring their major rivals, thus promoting consolidation of the market. During this stage, the top three market players hold about 15-45% of the market share, while the market is characterized by rapid consolidation (Deans et al.). Some of the examples include airlines and pharmaceuticals. This stage is also marked by a huge amount of mergers and acquisitions as top players try to build empires and remain winners on the market.

Stage 3 consists of companies focusing on the ways to expand their businesses and respond to competition in the most effective and efficient way. At this stage, the top three market players together hold about 35-70% of the market, and about 5-12 major players, which consolidation continues, remain in the market (Deans et al.). Some examples of the markets currently at this stage include steep producers and shipbuilders. Companies strive to emerge as market superpowers with large market shares and abilities to win the competition or acquire key rivals.

Finally, while companies reach Stage 4, they focus on the ways to hold their positions in the market and not allow smaller rivals to challenge their market supremacy rather than on further growth. Top three companies at this stage hold about 70-90% of the entire market and tend to create alliances with other large companies to make their role in the market sustainable in the long run (Deans et al.). Thus, companies that have successfully reached this stage do not move through it but rather stay in it, which is an extremely challenging task in most markets. It is a complicated aim as they devise the ways to grow their companies in a mature market or find the methods to enter markets at earlier stages of consolidation. Market consolidation is closely interconnected with mergers and acquisitions of companies that tend to resort to these means for different reasons, for instance, to increase their market share, reduce operating costs, or improve services and goods offered to customers (Taylor). All markets seek to consolidate over time as top players rise to power through growing their core businesses and acquiring or merging with other companies with a view to increasing their market share.

Concentrated Market

In a concentrated market, several companies account for significant market shares, including sales, revenues, and other indicators. In particular, the concentration of the market is measured by the four-firm concentration ratio, which is commonly referred to as 4CR (Besanko and Braeutigam 531). This ratio is used to calculate the share of industry sales generated by four companies with the largest shares in the market. The higher the 4CR is, the more concentrated the market is. For instance, in the USA, markets such as glass containers or guided missile manufacturing are highly concentrated, which means that their 4CR is very high. It also means that several large companies dominate the market and serve as examples of oligopolies.

The Herfindahl-Hirschman Index (HHI) as an Instrument Used to Measure Market Concentration

The Herfindahl-Hirschman Index (HHI) is a widely-accepted instrument used for measuring market concentration. It is usually practiced by the US government as well as by governments and respective authorities of other countries to assess prospective mergers and determine whether they will comply with the competition law. According to the HHI formula, market concentration is calculated by the market share of each company represented in a market being squared (Besanko and Braeutigam 531). Afterward, the resulting numbers are summed up, and the HHI is thus calculated. The HHI can range from almost zero to maximum 10,000. In case the HHI is 10,000, the market may be considered as a monopoly, and the market concentration is high while competition is respectively low. In turn, when the HHI is approaching zero, the market concentration may be regarded as low since there are thousands of companies in the market with insignificant shares while there also exists a nearly perfect competition in the market.

Use of the HHI by the Government in Analyzing Proposed Mergers

The government, and in particular, the Department of Justice, in the US use the HHI to analyze proposed mergers and determine whether they can be allowed. When the HHI of a market is between 1,500 and 2,500, this market is moderately concentrated. However, when the HHI exceeds 2,500 points, a market may be considered as highly concentrated (The United States Department of Justice). The Department of Justice assesses proposed mergers on the basis of the post-merger HHI calculation. In case transactions are likely to increase the HHI by more than 200 points in highly concentrated markets, such a merger can enhance the market power of the companies under analysis, which is unacceptable in line with the Horizontal Merger Guidelines of the Federal Trade Commission and the Department of Justice. Therefore, performing with such circumstances cannot be allowed. In the past, the Department of Justice was prone to reject approval of all mergers that could result in the increase of the HHI above 1,800. However, this requirement has been recently made slightly laxer to grant more freedom of actions to market players.

Reasons the Government Denied the Proposed Merger in 2011 between AT&T and T-Mobile

The HHI was used as the main justification for why the government denied the proposed merger in 2011 between AT& T and T-Mobile. This deal violated antitrust regulations and would have a detrimental impact on competition as well as harming consumers due to an increase in prices and a decline of innovation (Schulz). At the moment of the proposed merger, the companies occupied the second and the fourth position in the market of wireless carriers respectively (Schulz). However, the merger would increase market concentration beyond allowed measures, which is proved by calculations of the post-merger HHI. AT&T was the initiator of the case and did not expect the government to block the merger based on the past experience of oversight lack during the past decade from the side of the government. However, the Department of Justice blocked the deal and provided sound evidence to prove that it was anticompetitive. Though AT&T argued that markets within the US had to be considered on a case-to-case basis and locally, the Department of Justice proved that the post-merger HHI would increase by more than 200 points in 40 top markets, as well as exceeding 2,500 in 96 out of top 100 local markets (Stewart). For instance, in New York, the post-merger HHI would be 3,335 with an increase of 951, and these numbers were similar in all other top markets (Stewart). Hence, since the numbers were off the charts and clearly violated the antitrust law, the deal was blocked. Although the government’s decision was questioned and disputed at the time, the case proved that the government was serious about proper implementation of the antitrust law and monitoring of all markets in order for them to remain competitive and be safe for consumers.

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An Oligopolistic Industry in the US and its HHI

In the US, many industries may be defined as an oligopoly, and the soft drinks industry is one of them. For more than a decade, the industry has been dominated by a few large companies with significant market shares while smaller companies have been either pushed out of the market or acquired by their bigger rivals. Some smaller companies have managed to survive and still operate nowadays, but their market shares are low. Hence, statistically, Coca-Cola, PepsiCo, and Dr. Pepper Snapple are the largest companies within the soft drinks industry accounting for 42.3%, 27.5%, and 17.1% of the market respectively as of the end of the financial year 2014 (Statista). Smaller players include Cott with 4.2%, National Beverage with 2.9%, and other companies holding 6% of the market (Statista). The three companies have been dominant market players since 2004, primarily competing among themselves for the market share and seeking to retain their customers as well as introducing new products to attract new customers. The HHI of the soft drinks industry is above 3,100, which means that this market is highly concentrated (Taub and Weissman). Such a high HHI implies that the market power within the oligopoly comes from the lack of competition from new market entrants and differentiated products. Moreover, the top two companies of the soft drinks industry evidently hold high market power while other companies do not pose a significant threat to them in this respect.

Conclusion

It is evident that market structure such an as oligopoly has several key characteristics that differentiate it from other market structures. In addition, companies functioning in the market should carefully study the state of affairs, especially relating to market concentration and consolidation to be able to plan their growth strategically. However, companies should remember that although the state minimizes its interference with market affairs, it still has some mechanisms aimed at ensuring the freedom of competition and beneficial position of customers. For instance, the HHI is used by the government to assess potential mergers of market players that strive to consolidate the market and increase its concentration, meanwhile winning larger market shares and reaping lucrative profits.