The Meaning of Oligopoly

What we have learned about both perfect competition and monopoly is relevant to oligopoly. But, oligopoly also raises some entirely new issues. Among other things, firms in an oligopoly are often tempted to engage in the kind of behavior that gets them into trouble with the law. A classic example is the case of the Archer Daniels Midland Corporation (ADM) and its Japanese competitor Ajinomoto.

On October 25, 1993, executives from ADM and Ajinomoto met at the Marriott Hotel in Irvine, California, to discuss the market for lysine, an additive used in animal feed. In this and subsequent meetings, the two companies joined with several other competitors to set targets for the market price of lysine, a behavior called price-fixing. Each company agreed to limit its production in order to achieve those targets. What the participants in the meeting didn’t know was that the FBI had bugged the room and was filming them with a hidden camera.

What these companies were doing was illegal. To understand why it was illegal and why the companies were doing it anyway, we need to examine the issues posed by industries in which there are only a few sellers, otherwise known as an oligopoly. A firm in such an industry is known as an oligopolist.

The Prevalence of Oligopoly

Oligopolists obviously compete with one another for sales. But neither ADM nor Ajinomoto were 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. There are actually two important forms of imperfect competition: oligopoly and monopolistic competition. Of these, oligopoly is probably the more important in practice.

Although lysine is a multibillion-dollar business, it is not exactly a product familiar to most consumers. However, many familiar goods and services 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 New York and either Boston or Washington, D.C., has been provided only by Delta and US Airways. 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 New York and Washington.

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.

Understanding Oligopoly

How much will a firm produce? Up to this point, we have always answered: the quantity that maximizes its profit. Together with its cost curves, the assumption that a firm maximizes profit is enough to determine its output when it is a perfect competitor or a monopolist.

When it comes to oligopoly, however, we run into some difficulties. Indeed, economists often describe the behavior of oligopolistic firms as a “puzzle.”

A Duopoly Example Let’s begin looking at the puzzle of oligopoly with the simplest version, an industry in which there are only two producing firms—a duopoly—and each is known as a duopolist.

Going back to our opening story, imagine that ADM and Ajinomoto are the only two producers of lysine. To make things even simpler, suppose that once a company has incurred the fixed cost needed to produce lysine, the marginal cost of producing another pound is zero. So the companies are concerned only with the revenue they receive from sales.

Table 8-2 shows a hypothetical demand schedule for lysine and the total revenue of the industry at each price–quantity combination.

If this were a perfectly competitive industry, each firm would have an incentive to produce more as long as the market price was above marginal cost. Since the marginal cost is assumed to be zero, this would mean that at equilibrium lysine would be provided free. Firms would produce until price equals zero, yielding a total output of 120 million pounds and zero revenue for both firms.

However, surely the firms would not be that stupid. With only two firms in the industry, each would realize that by producing more, it drives down the market price. So each firm would, like a monopolist, realize that profits would be higher if it and its rival limited their production.

So how much will the two firms produce?

One possibility is that the two companies will engage in collusion—they will cooperate to raise their joint profits. The strongest form of collusion is a cartel, an arrangement between producers that determines how much each is allowed to produce. The world’s most famous cartel is the Organization of Petroleum Exporting Countries (OPEC). As its name indicates, it’s actually an agreement among governments rather than firms. There’s a reason this most famous of cartels is an agreement among governments: cartels among firms are illegal in the United States and many other jurisdictions. But let’s ignore the law for a moment (which is, of course, what ADM and Ajinomoto did in real life—to their own detriment).

So suppose that ADM and Ajinomoto were to form a cartel and that this cartel decided to act as if it were a monopolist, maximizing total industry profits. It’s obvious from Table 8-2 that in order to maximize the combined profits of the firms, this cartel should set total industry output at 60 million pounds of lysine, which would sell at a price of $6 per pound, leading to revenue of $360 million, the maximum possible. Then the only question would be how much of that 60 million pounds each firm gets to produce. A “fair” solution might be for each firm to produce 30 million pounds with revenues for each firm of $180 million.

But even if the two firms agreed on such a deal, they might have a problem: each of the firms would have an incentive to break its word and produce more than the agreed-upon quantity.

Collusion and Competition Suppose that the presidents of ADM and Ajinomoto were to agree that each would produce 30 million pounds of lysine over the next year. Both would understand that this plan maximizes their combined profits. And both would have an incentive to cheat.

To see why, consider what would happen if Ajinomoto honored its agreement, producing only 30 million pounds, but ADM ignored its promise and produced 40 million pounds. This increase in total output would drive the price down from $6 to $5 per pound, the price at which 70 million pounds are demanded. The industry’s total revenue would fall from $360 million ($6 × 60 million pounds) to $350 million ($5 × 70 million pounds). However, ADM’s revenue would rise, from $180 million to $200 million. Since we are assuming a marginal cost of zero, this would mean a $20 million increase in ADM’s profits.

But Ajinomoto’s president might make exactly the same calculation. And if both firms were to produce 40 million pounds of lysine, the price would drop to $4 per pound. So each firm’s profits would fall, from $180 million to $160 million.

Why do individual firms have an incentive to produce more than the quantity that maximizes their joint profits? Because neither firm has as strong an incentive to limit its output as a true monopolist would.

Let’s go back for a minute to the theory of monopoly. We know that a profit--maximizing monopolist sets marginal cost (which in this case is zero) equal to marginal revenue. But what is marginal revenue? Recall that producing an additional unit of a good has two effects:

1. A positive quantity effect: one more unit is sold, increasing total revenue by the price at which that unit is sold.
2. A negative price effect: in order to sell one more unit, the monopolist must cut the market price on all units sold.

The negative price effect is the reason marginal revenue for a monopolist is less than the market price. In the case of oligopoly, when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not those of its fellow oligopolists. Both ADM and Ajinomoto suffer a negative price effect if ADM decides to produce extra lysine and so drives down the price. But ADM cares only about the negative price effect on the units it produces, not about the loss to Ajinomoto.

This tells us that an individual firm in an oligopolistic industry faces a smaller price effect from an additional unit of output than does a monopolist; therefore, the marginal revenue that such a firm calculates is higher. So it will seem to be profitable for any one company in an oligopoly to increase production, even if that increase reduces the profits of the industry as a whole. But if everyone thinks that way, the result is that everyone earns a lower profit!

Until now, we have been able to analyze producer behavior by asking what a producer should do to maximize profits. But even if ADM and Ajinomoto are both trying to maximize profits, what does this predict about their behavior? Will they engage in collusion, reaching and holding to an agreement that maximizes their combined profits? Or will they engage in noncooperative behavior, with each firm acting in its own self-interest, even though this has the effect of driving down everyone’s profits? Both strategies sound like profit maximization. Which will actually describe their behavior?

Now you see why oligopoly presents a puzzle: there are only a small number of players, making collusion a real possibility. If there were dozens or hundreds of firms, it would be safe to assume they would behave noncooperatively. Yet when there are only a handful of firms in an industry, it’s hard to determine whether collusion will actually materialize.

Since collusion is ultimately more profitable than noncooperative behavior, firms have an incentive to collude if they can. One way to do so is to formalize it—sign an agreement (maybe even make a legal contract) or establish some financial incentives for the companies to set their prices high. But in the United States and many other nations, you can’t do that—at least not legally. Companies cannot make a legal contract to keep prices high: not only is the contract unenforceable, but writing it is a one-way ticket to jail. Neither can they sign an informal “gentlemen’s agreement,” which lacks the force of law but perhaps rests on threats of retaliation—that’s illegal, too.

In fact, executives from rival companies rarely meet without lawyers present, who make sure that the conversation does not stray into inappropriate territory. Even hinting at how nice it would be if prices were higher can bring you an unwelcome interview with the Justice Department or the Federal Trade Commission. For example, in 2003 the Justice Department launched a price-fixing case against Monsanto and other large producers of genetically modified seed. The Justice Department was alerted by a series of meetings held between Monsanto and Pioneer Hi-Bred International, two companies that account for 60% of the U.S. market in maize and soybean seed. The two companies, parties to a licensing agreement involving genetically modified seed, claimed that no illegal discussions of price-fixing occurred in those meetings. But the fact that the two firms discussed prices as part of the licensing agreement was enough to ensure action by the Justice Department.

Sometimes, as we’ve seen, oligopolistic firms just ignore the rules. But more often they find ways to achieve collusion without a formal agreement, as we’ll discuss later in the chapter.

Bitter Chocolate?

Millions of chocolate lovers around the world have been spending more and more to satisfy their cravings, and regulators in Germany, Canada, and the United States have become suspicious. They are investigating whether the seven leading chocolate companies—including Mars, Kraft Foods, Nestle, Hershey, and Cadbury—have been colluding to raise prices. The amount of money involved could well run into the billions of dollars.

Many of the nation’s largest grocery stores and snack retailers are convinced that they have been the victims of collusion. They claim that the chocolate industry has responded to stagnant consumer sales by price-fixing, an allegation the chocolate makers have vigorously denied.

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In 2010, one of those stores, Supervalu, filed a lawsuit against Mars, Hershey, Nestle, and Cadbury, who together control about 76% of the U.S. chocolate market. Supervalu claimed that the confectioners had been fixing prices since 2002, regularly increasing prices by mid-single to double-digit amounts. Supervalu also claimed that grocers who resisted or refused to raise prices were systematically penalized with delayed or insufficient product deliveries. In 2012, the Associated Wholesale Grocers, a retailer-owned co-op, filed a similar suit, alleging these firms colluded on three occasions between 2002 and 2008 by artificially raising chocolate prices.

Are chocolate makers engaging in price-fixing?

istockphoto/thinkstock

What’s clear is that chocolate candy prices have been soaring. Chocolate makers defend their actions, contending that they were simply passing on increases in their costs. The price of cocoa, the main ingredient in chocolate, more than doubled between 2005 and early 2011. While cocoa prices then fell in 2011 and stabilized in 2012, chocolate manufacturers continued to push through price increases. Furthermore, critics claim that the price of cocoa was stable from 2003 to 2007 and that sugar prices were similarly stable during that time, except for a brief spike in 2005, a time period in which chocolate prices were rising.

But, as antitrust experts point out, price collusion is often very difficult to prove because it is not illegal for businesses to increase their prices at the same time. To prove collusion, there must be some evidence of conversations or written agreements.

Such evidence has emerged in our chocolate case. According to the Canadian press, 13 Cadbury executives voluntarily provided information to the courts about contacts between the companies, including a 2005 episode in which a Nestle executive handed over a brown envelope containing details about a forthcoming price hike to a Cadbury employee. And, according to affidavits submitted to a Canadian court, top executives at Hershey, Mars, and Nestle met secretly in coffee shops, in restaurants, and at conventions to set prices.

Critics of the chocolate makers may soon get some sweet vindication.