14.1 The Prevalence of Oligopoly

At the time of the alleged price-fixing, no one company controlled the Canadian chocolate industry, but there were only a few major producers. An industry with only a few sellers is known as an oligopoly; a firm in such an industry is known as an oligopolist.

An oligopoly is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist.

Oligopolists obviously compete with one another for sales. But neither Nestlé nor Mars was like a firm in a perfectly competitive industry, which takes the price at which it can sell its product as given. Each of these firms knew that its decision about how much to produce would affect the market price. That is, like monopolists, each of the firms had some market power. So the competition in this industry wasn’t “perfect.”

Economists refer to a situation in which firms compete but also possess market power—which enables them to affect market prices—as imperfect competition. As we saw in Chapter 13, there are actually two important forms of imperfect competition: oligopoly and monopolistic competition. Of these, oligopoly is probably the more important in practice.

When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.

The multibillion dollar chocolate business is not the only oligopoly in Canada. Many other goods and services—some familiar, others not—are supplied by only a few competing sellers, which means the industries in question are oligopolies. For example, most air routes are served by only two or three airlines: in recent years, regularly scheduled shuttle service between Toronto and Calgary or Vancouver has been provided only by Air Canada and WestJet. Three firms—Chiquita, Dole, and Del Monte, which own huge banana plantations in Central America—control 65% of world banana exports. Most cola beverages are sold by Coca-Cola and Pepsi. This list could go on for many pages.

It’s important to realize that an oligopoly isn’t necessarily made up of large firms. What matters isn’t size per se; the question is how many competitors there are. When a small town has only two grocery stores, grocery service there is just as much an oligopoly as air shuttle service between Toronto and Calgary.

Why are oligopolies so prevalent? Essentially, oligopoly is the result of the same factors that sometimes produce monopoly, but in somewhat weaker form. Probably the most important source of oligopoly is the existence of increasing returns to scale, which give bigger producers a cost advantage over smaller ones. When these effects are very strong, they lead to monopoly; when they are not that strong, they lead to an industry with a small number of firms. For example, larger grocery stores typically have lower costs than smaller ones. But the advantages of large scale taper off once grocery stores are reasonably large, which is why two or three stores often survive in small towns.

If oligopoly is so common, why has most of this book focused on competition in industries where the number of sellers is very large? And why did we study monopoly, which is relatively uncommon, first? The answer has two parts.

First, much of what we learn from the study of perfectly competitive markets—about costs, entry and exit, and efficiency—remains valid despite the fact that many industries are not perfectly competitive. Second, the analysis of oligopoly turns out to present some puzzles for which there are no easy solutions. It is almost always a good idea—in exams and in life in general—first to deal with the questions you can answer, then to puzzle over the harder ones. We have simply followed the same strategy, developing the relatively clear-cut theories of perfect competition and monopoly first, and only then turning to the puzzles presented by oligopoly.

IS IT AN OLIGOPOLY OR NOT?

In practice, it is not always easy to determine an industry’s market structure just by looking at the number of sellers. Many oligopolistic industries contain a number of small “niche” producers, which don’t really compete with the major players. For example, the Canadian airline industry includes a number of regional airlines like Air Labrador, which flies propeller planes between Goose Bay and other communities in Labrador, Quebec, and Newfoundland; if you count these carriers, the Canadian airline industry contains nearly a hundred sellers, which doesn’t sound like competition among a small group. But there are only a couple of national competitors—Air Canada and WestJet—and on many routes, as we’ve seen, these are the only competitors.

To get a better picture of market structure, economists often use a measure called the Herfindahl–Hirschman Index, or HHI. The HHI for an industry is the square of each firm’s market share summed over the firms in the industry. (In Chapter 12 you learned that market share is the percentage of sales in the market accounted for by that firm.) For example, if an industry contains only three firms and their market shares are 60%, 25%, and 15%, then the HHI for the industry is:

HHI = 602 + 252 + 152 = 4450

By squaring each market share, the HHI calculation produces numbers that are much larger when a larger share of an industry output is dominated by fewer firms. So it’s a better measure of just how concentrated the industry is. This is confirmed by the data in Table 14-1. Here, the indexes for industries dominated by a small number of firms, like the personal computer operating systems industry or the wide-body aircraft industry, are many times larger than the index for the retail grocery industry, which has numerous firms of approximately equal size.

TABLE14-1 The HHI for Some Oligopolistic Industries

The HHI is used in the United States by the Justice Department and the Federal Trade Commission, which have the job of enforcing antitrust policy, a topic we’ll investigate in more detail later in this chapter. Their mission is to try to ensure that there is adequate competition in an industry by prosecuting price-fixing, breaking up economically inefficient monopolies, and disallowing mergers between firms when it’s believed that the merger will reduce competition. According to Justice Department guidelines, an HHI below 1500 indicates a strongly competitive market, between 1500 and 2500 indicates a somewhat competitive market, and over 2500 indicates an oligopoly. In an industry with an HHI over 1500, a merger that results in a significant increase in the HHI will receive special scrutiny and is likely to be disallowed.

However, defining an industry can be tricky, so rough rules of thumb are not appropriate for all situations. As a result, while the Canadian Competition Bureau may study changes in the HHI as a sign of changes in the level of competition, it does not employ rule-of-thumb ranges of “good” or “bad” levels for the index. In 2013, the proposed merger between Telus and the much smaller firm Mobilicity was denied by Industry Minister Christian Paradis. This came as no surprise: the Canadian wireless communications market is highly concentrated, with an HHI of about 2900, and the government had promised that the big carriers would not be allowed to buy the new entrants.

Another consideration when deciding whether an industry is an oligopoly is access to the market by external suppliers. For example, in 2009, sugar manufacturing in Ontario had an HHI of 8569, while for all of Canada the HHI was 4936. Both denote a high degree of market concentration, which might imply low levels of competition. But thanks to imports of sugar produced outside of Canada, the degree of competition is actually much higher than the HHI might imply, resulting in Canadian sugar prices actually being below those in the United States and Mexico.

Quick Review

  • In addition to perfect competition and monopoly, oligopoly and monopolistic competition are also important types of market structure. They are forms of imperfect competition.

  • Oligopoly is a common market structure, one in which there are only a few firms, called oligopolists, in the industry. It arises from the same forces that lead to monopoly, except in weaker form.

  • The Herfindahl-Hirschman index, the sum of the squares of the market shares of each firm in the industry, is a widely used measure of industry concentration.

Check Your Understanding 14-1

CHECK YOUR UNDERSTANDING 14-1

Question 14.1

Explain why each of the following industries is an oligopoly, not a perfectly competitive industry.

  1. The world oil industry, where a few countries near the Persian Gulf control much of the world’s oil reserves

  2. The microprocessor industry, where two firms, Intel and its bitter rival AMD, dominate the technology

  3. The wide-body passenger jet industry, composed of the American firm Boeing and the European firm Airbus, where production is characterized by extremely large fixed cost

  1. The world oil industry is an oligopoly because a few countries control a necessary resource for production, oil reserves.

  2. The microprocessor industry is an oligopoly because two firms possess superior technology and so dominate industry production.

  3. The wide-body passenger jet industry is an oligopoly because there are increasing returns to scale in production.

Question 14.2

The accompanying table shows the Canadian market shares for mobile phone operating systems in April 2014.

  1. Calculate the HHI in this industry.

  2. If Android and BlackBerry were to merge, what would the HHI be?

  1. The HHI in this industry is 422 + 392 + 142 + 52 = 3506.

  2. If Android and BlackBerry were to merge, making their combined market share 39% + 14% = 53%, the HHI in this industry would be 532 + 422 + 52 = 4598.