One Sunday afternoon, I was walking along a bare and dusty road in the heat of a summer’s day. Unable to bear the scorching heat, I was raring to grab a refreshing drink. Suddenly, my eyes fell upon a shop nearby and I started to hasten my steps towards it. I asked for a Coca-cola since what can be better than a glass of coke with some ice clinking. But to my dismay, Coca-cola was out of stock. My sadness though was momentary, thanks to Pepsi which came to my rescue. I didn’t even give a second thought and bought a bottle of it to quench my thirst for a fizzy drink. No wonder, Coca-cola and Pepsi are perfect substitutes. When I was a kid, the names of these two well-known giants were synonymous to me. And this comes without any surprise since these two essentially taste the same and have similar pricing. Coca-Cola and Pepsi are actually a classic example of an oligopolistic market structure.
Oligopoly is a market structure with a small number of firms, manufacturing similar or identical products, that dominate the market. None of the firms can keep others from having a significant influence. They are likely to change their prices according to their competitors. For example, if Coca-Cola changes its price, Pepsi is also likely to.
So, How do They Compete?
In an oligopoly, the actions of one seller play a major role in the outcome of the profits made by other sellers. This means that each firm takes decisions keeping in mind the actions of their competitors. This is what is called Game Theory - a study of how people behave in strategic situations; ‘strategic’ referring to a situation where you have to think of other people’s perspectives before carrying out an action.
The model of oligopoly is based on a classic example of game theory - "The Prisoner’s Dilemma". Consider this, Mr X and Mr Y are being suspected of stealing an ancient artefact from a museum and are being interrogated in separate rooms. If both of them confess for the crime, each of them will serve two years in prison. If neither of them confesses, they will get off scot-free. And if one of them confesses and the other do not, the former will be set free and the latter will serve four years in prison. So, what do they do? Since they couldn’t discuss, each of them ends up serving two years in prison. The crux of this dilemma is that even if people/firms rationally follow their own self-interests, the best outcome is hard to reach when they can’t or don’t cooperate.
We shall next see how Prisoner's Dilemma can be related to an oligopoly by creating something called a payoff matrix.
Let us continue with the example of Coca-cola and Pepsi. The optimal outcome is for each business to charge high prices so they both get, say, Rs. 15 million each. Let us assume that they both initially decided to price their bottles at Rs. 50. Then, the level of economic profit expected to be earned by both firms is Rs. 15 million. In other words, the two firms will split the market for the aerated drinks into two halves. Let us now assume that Coca-cola unilaterally lowers its price to Rs. 36 per bottle to earn a greater profit while Pepsi remains at Rs. 50. We can expect that Coca-cola will capture a much larger share of the total market and will thereby increase its profits to, say, Rs. 30 million while Pepsi’s profits will fall to, say, Rs. 5 million. The rationale behind this is that now Coca-cola has more competitively priced drink, therefore, a large percentage of Pepsi’s customers will shift their demand to coke and as a result, few will consume Pepsi. Similar kind of situation will prevail if Pepsi lowers its price while Coca-cola remains at the same price. Finally, seeing this both the firms end up pricing their bottles low, say, to Rs 36. Both firms, in this case, will earn a lower economic profit than they would have if they would have priced their bottles at Rs. 50. They will still split the market into two halves but this time making Rs. 10 million profits each instead of Rs. 15 million or Rs. 5 million. This is the best possible strategic pricing. Now, this is considered as the Nash Equilibrium state for this oligopoly because costs and benefits are now balanced so that none of the two firms wants to break from this group.
Now, the most interesting thing that can be noted is that consequently, an oligopoly has driven cooperation among the untrustworthy business competitors. Also, it is quite clear that in many ways, oligopoly is consumer friendly since as per the payoff matrix, the best strategic price will always be lower.
Oligopolies exist throughout the world and appear to be only increasing.
Yet another classic examples of oligopolies often quoted are of Burger King and McDonald’s and the credit card processing industry, which is dominated by Visa and MasterCard. Similarly, most of the telecommunication in India is dominated by Airtel, Vodafone Idea India, BSNL and Reliance Jio. The petroleum and gas industry likewise, is dominated by Indian Oil, Bharat Petroleum, Hindustan Petroleum, and Reliance Petroleum. The accountancy market is dominated by the Big Four namely, PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu and Ernst & Young.
Here's hoping that the next time when you sip your fizzy drink, you remember to ponder on the riveting “cooperative” market competition bubbling up around it.
Originally published here.
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