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Monopolistic Competition and Oligopoly
(Part G)
by
Charles Lamson
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Oligopoly and Economic Performance
How well do oligopolies perform? Should they be regulated or changed? Are they efficient, or do they lead to an inefficient use of resources? On balance, are they good or bad? With the exception of the contestable market model, all the models of oligopoly we have examined lead us to conclude that concentration in a market leads to pricing above marginal cost and output below the efficient level. When price is above marginal cost at equilibrium, consumers are paying more for the good than it costs to produce that good in terms of products forgone in other industries. To increase output would be to create value that exceeds the social cost of the good, but profit-maximizing oligopolists have an incentive not to increase output. Entry barriers in many oligopolistic industries also prevent new capital and other resources from responding to profit signals. Under competitive conditions or in contestable markets, positive profits would attract new firms and increase production. This does not happen in most oligopolistic industries. The problem is most severe when entry barriers exist and firms explicitly or tacitly collude. The results of collusion are identical to the results of a monopoly. Firms jointly maximize profits by fixing prices at a high level and splitting up the profits. Product differentiation under oligopoly presents us with the same dilemma that we encountered in monopolistic competition. On the one hand, vigorous product competition among oligopolistic competitors produces variety and leads to innovation in response to the wide variety of consumer tastes and preferences. It can thus be argued that vigorous product competition is efficient. On the other hand, product differentiation may lead to waste and inefficiency. Product differentiation accomplished through advertising may have nothing to do with product quality, and advertising itself may have little or no information content. If it serves as an entry barrier that blocks competition, product differentiation can cause the market allocation mechanism to fail.  Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons. First, profit-maximizing oligopolists are likely to produce above marginal cost. When price is above marginal cost, there is underproduction from society's point of view---in other words, society could get more for less, but it does not. Second, strategic behavior can lead to outcomes that are not in society's best interest. Specifically, strategically competitive firms can force themselves into deadlocks that waste resources. Finally, to the extent that oligopolists differentiate their products and advertise, there is the promise of new and exciting products. At the same time, however, there remains a real danger of waste and inefficiency. Industrial Concentration and Technological Change One of the major sources of economic growth and progress throughout history has been technological advance. Innovation, both in methods of production and in the creation of new and better products, is one of the engines of economic progress. Much innovation starts with research and development efforts undertaken by firms in search of profit. Several economist's, notably Joseph Schumpeter and John Kenneth Galbraith, argued in works now considered classics that industrial concentration actually increases the rate of technological advance. As Schumpeter put it in 1942: As soon as we . . . inquire into the individual items in which progress was most conspicuous, the trail leads not to the doors of those firms that work under conditions of comparatively free competition but precisely to the doors of the large concerns . . . and a shocking suspicion dawns upon us that big business may have had more to do with creating that standard of life than keeping it down.
 This caused the economics profession to pause and take stock of its theories. The conventional wisdom had been that concentration and barriers to entry insulate firms from competition and lead to sluggish performance and slow growth. The evidence concerning where innovation comes from is mixed. Certainly, most small businesses do not engage in research and development, and most large firms do. When R&D expenditures are considered as a percentage of sales, firms in industries with high concentration ratios spend more on research and development than firms in industries with low concentration ratios. Oligopolistic companies such as AT&T have done a great deal of research. AT&T Bell Laboratories (now a separate company called Nokia Bell Labs) has probably done more important research over the last 5 decades than any other organization in the country (Case & Fair, p 289). It has been estimated that Bell Labs conducted 10 percent of all the basic industrial research in the United States during the 1970s. IBM, which despite its problems over the years set the industry standard in personal computers, has certainly introduced as much new technology to the computer industry as any other firm. However, the "high-tech revolution" grew out of many tiny startup operations. Companies such as Sun Microsystems, Cisco Systems, and even Microsoft barely existed only a generation ago [Case & Fair (2004)]. The new biotechnology firms that are working miracles with genetic engineering started with research done by individual scientists and University Laboratories. As with the debate about product differentiation and advertising, significant ambiguity on this subject remains. Indeed, there may be no right answer. Technological change seems to come in fits and starts, sometimes from small firms and sometimes from large ones.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 298-299* end |
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