Imperfect Competition: Large Companies and Oligopoly
Introduction: From Perfect Competition to Imperfect Competition
This post is about one form of imperfect competition, oligopoly. Oligopoly is a market structure where a small number of large companies account for a large percent of industry sales. A later post describes a special type of oligopoly called bilateral oligopoly.
It seems that running or owning a business in a perfectly-competitive industry is not much fun. Managers and owners have virtually no control over their business, the risk of failure is high, and profit margins are minimal. What could a manager do to have more control, reduce risk and increase profits?
The basic idea is to pursue strategies that change competition from accepting and reacting to changes in the industry price to include other, controllable factors. Some of them are listed in Competition, Perfect and Imperfect. Another set of strategies is to grow the company through innovation – developing or adopting new technology, new products and production processes, and organizational innovation. These strategies will change the industry structure from perfect competition to imperfect competition.
One way is through technological innovation in production that leads to economies of scale. Suppliers of capital equipment and production systems, including informational technology, are under constant competitive pressure to improve the equipment, software and services they sell to manufacturers. This is a major source of increased productivity and innovation in our economy. Companies that buy the latest capital equipment and management information systems often can increase the size (scale) and complexity (scope) of their operations and reduce their unit costs. This dynamic leads to an industry dominated by a small number of large producers relative to the size of the market. This is the definition of an oligopoly.
Three Questions
Economic theory, to be relevant, has to answer questions:
How are large companies created?
Why are most industries oligopolies?
How do large corporations continue to dominate markets?
Different Concepts of Competition
The definition of competition is central to understanding a capitalist economic system. Competition is also what differentiates capitalism from socialism.
There are two definitions of competition. One is competition in economic theory; the other is competition in the real world. The first is taught in economics courses; the second in business courses. Economics talks about price competition. Business courses discuss types of non-price competition.
Basic economic theory concentrates on competition among industries with commodities. This is called perfect competition. In perfect competition, there is no price competition among the companies in an industry. Every company produces exactly the same product and charges the same price. Every company is too small relative to the size of the market to influence price. Other forms of competition such as marketing are assumed away.
In economic theory, there is also imperfect competition. In monopoly, one company and the industry are the same. Otherwise, there is competition among companies within an industry. In a modern, industrialized economy, industries and markets tend to be dominated by large corporations that have developed and adopted production and marketing technology. Large scale, capital intensive production leads to economies of scale. Using communication technology creates economies of scale in marketing. Together, they often lead to concentrated industries and markets.
If there are any sources of economies or new technology leading to falling unit cost, there is no equilibrium market price. If there is concentrated markets or differentiated products, there is probably multiple prices and price discrimination (different prices for different groups of consumers for the same product or service).
Economic theory tries to explain market and economy-wide equilibrium. Equilibrium, by itself, would tend to stability or stagnation. This does not happen because there is a third form of competition – competition based on innovation. This creates new types of competition.There are new challengers to established companies, often based on creating new technology or new applications. This process of creative disruption never stops; the economy is dynamic. It never reaching a permanent market equilibrium or economic stability.
Competition through innovation also occurs among existing companies. In many industries, it is the primary long-run form of competition. Some examples are health care, fashion merchandising, entertainment, the capital goods sector, and the IT sector. But all industries innovate to some extent - buying capital equipment and IT systems from outside suppliers (available to all), internal innovation, and adapting outside innovation. Proprietary knowledge, the result of innovation, is the ultimate basis of economic profit beyond the cost of capital. And economic profit provides the funds for further investment and innovation for corporate growth and development.
There are two general types of innovation - technological (production) and organizational. Both are necessary, sometimes occurring together. Historically, corporate growth depended on eliminating internal information bottlenecks to growth and expansion. This made possible new, larger organizational structures with increased management oversight and control.
Past and continuing innovation causes corporate growth and resulting macroeconomic growth, and especially growth in real per capita income.
Both economic theory of imperfect competition and business courses usually focus on competition among companies in an industry or market. But companies in an industry are also competing (and cooperating) with suppliers and corporate customers. There is price competition across supply chains, not just within a market or industry or against substitutes in other markets. Prices and terms are often negotiated by corporate professionals like sales reps and purchasing agents in large corporations. They are negotiating how profits are divided.
While economics talks about the interaction (negative feedback) of supply and demand, the dynamics of a capitalist economy is on the supply side. Innovators (and marketers of established companies) create demand. Aggregate demand for existing products and services can be temporarily increased through the creation of money and borrowing for consumption. Without innovation, this eventually leads to inflation and no growth. Innovation creates lower prices and economic growth over time.
The Creation of Large Companies
Large companies and the resulting industry structure of oligopoly are often the result of technology and how organizations use technology to generate growth. Large companies institutionalize technology and innovation.
In the past, the main reason for the creation of the modern large corporation was to exploit the profitable economies of capital-intensive production. Large amounts of capital were needed to purchase the land, build the plants, purchase and install machinery and production systems, buy material inputs, and create the organizational and informational hierarchy to manage it all.
There are now potential new sources for corporate development and rapid growth - the ability of acquiring new customers at very low or zero marginal cost through applications on the Internet.
Large corporations are the result of past innovations and profitable improvement and marketing through organizational development. Innovation in organizational development is necessary to fully exploit technological innovations and improvements.
Mature Large Companies
Mature large companies are a combination of competitive market capitalism and internal economic planning. Price flexibility and competitive pressure to innovate and improve are retained. Managers of large companies must worry about potential new entrants. But companies must be big enough to efficiently use large-scale production technology to realize economies of scale. Economies of scale (size) and scope (complexity) are a result of all forms of innovation.
A large corporation in an oligopoly combines many of the features of competitive capitalism and central planning. If socialism is a way to “nationalize” monopolies and large company oligopolies, large company oligopolies is a way to “privatize” central planning. More than a socialist economic system, private oligopolies keep competition, innovation, and profits as a way to measure performance.
Large corporations are a combination of competition and planning, of order and innovation. Internally, large companies should attempt to find the optimal combination of innovation and stability. This may be a function of the company’s information and control systems, as implied by Hayek.
Large companies are organizations of opposites. This creates internal tensions of:
Competitive capitalism and central planning
Defensive (mature) and aggressive (innovative, attacking)
Specialization and diversity
Short run diminishing returns and long run increasing returns
Order and stability vs. chaos and disruption
The growth and survival of large corporations depends on how successful they are in allocating resources and investment between these opposites.
Large Corporations and Economic Development
Large companies that dominate their markets managed most of the economy’s resources. They rely mostly on increased real income of consumers for internal growth (the demand curves for their products shift outwards as real income increases). So the average growth rate of large companies, especially those that sell to consumers, will be about equal to the growth of real income over time. Most industries grow at about the same rate as the whole economy.
What if two or more companies begin at about the same time with slightly different products or services, and all the companiesdiscover increasing returns? Many food processors used similar mass production and packaging technology to create different food and beverage products. They solidified positions in market niches with marketing such as branding and advertising using new mass information channels including magazines aimed at women and radio. All can survive and grow if they develop different specialized products and market niches.
If there were only diminishing returns, small companies with homogeneous or differentiated products that could be easily copied would probably dominate the economy. If there were only increasing returns, the economy and most markets would be controlled by monopolies. Successful large companies tend to create increasing returns at the early stages of new technology applications and then experience diminishing returns later. A large company is also often amix of diminishing returns in some parts or processes of a company and increasing returns in other parts or processes.
A small number of large companies provide order and stability, with some flexibility of adjustment, to market niches, markets, and the whole economy. They do this in an environment in flux. They do it without their markets ever reaching equilibrium.
Large companies contribute to economic growth when they reduce unit costs and prices. Lower prices raise real income even if there is no growth in real wages. This increases demand for a company’s products anddemand for other companies’ products and services due to increased real income.
Internal innovation mostly supports and preserves existing businesses. A common strategy is to reduce unit costs and increase productivity. Fortunately, because of intense competition based on innovation, the price of many investment goods (capital and IT inputs) fall over time.
Mature large corporations are consumers (buyers and adopters) of new technology. Mature companies are not just the targets of innovators (“creative destruction”) but also major customers of innovative companies.
But they are not passive buyer of inputs. Internal innovation adapts inputs to the specific requirements of the company. They modify and customize outside (purchased) inputs into “firm-specific” assets. This creates proprietary knowledge, the basis for asymmetric information, competitive advantage, and profit margins above the cost of capital.
Large Company Market Dominance: Marketing and Market Niches
The usual strategy of large companies to maintain market dominance, especially companies that sell to final consumers, is marketing. Marketing is the way to manage demand. The emphasis is on strategies to preserve market share rather than risker strategies to innovate products or enter new markets to increase growth rates and profits.
It is very common in imperfectly competitive markets for companies to practice price discrimination, the strategy of charging different groups of customers different prices. For some companies, like Amazon, they have collected so much data on customers that they can pick a price for each individual customer. Facebook probably has even more information about its users. Facebook sells this information to third parties so they or their clients can design highly focused marketing and advertising campaigns.
A large company may have a large share of a broadly defined industry but close to a monopoly position in specialized market niches within the industry. An example is the airlines industry. Mergers continue to reduce the number of airlines and increase concentration in the domestic markets. There are four big national airlines, down from six a few years ago. One airline controls most of landing slots at many airports, including large ones. Examples include United Continental in Newark (former competitors) and Delta in Atlanta.
Strategies of Large Corporations
The objectives of most mature large corporations are order, control and stability to generate high and steady profits and dividends.
Strategies, including most innovation adoption, are mostly defensive – geographic expansion of existing business, new capital equipment to reduce unit costs, product line extension, organizational development, and high levels of marketing and advertising of existing products.
There are two types of dangers – attack from within industry from new companies or new products and development of competing technology or products outside the industry. Also, changes in demand (consumer preferences), sometimes because of shift in spending income to buy new products or services.
A company has to find the optimal combination of market competition and internal planning. Related to optimal combination of innovation and stability. The effectiveness of corporate planning and mangement control may be a function of internal information and control systems, as implied by Hayek.
Large mature companies have to find the optimal combination of defensive strategies and innovative strategies. Defensive strategies support the existing business and can usually be implemented with little risk. The company possesses a large amount of internal information, including experience, about its existing businesses. This information can be used to make reasonably accurate forecasts of sales, prices and costs of new marketing or cost reduction strategies.
Innovative strategies are riskier, with a higher probability of failure because of uncertainty. A company has to search for and create new proprietary information to create and develop innovative products or services.
Companies become vulnerable if there is too much internal order and stability and not enough attention to external threats and internal innovation. On the other hand, conglomerates often become chaotic because of too much diversity. They become unmanageable and disintegrate.
A suggestive model (or metaphor) from evolutionary biology on how to think about combining these two strategies is that of “rugged landscapes.” (See Stuart Kauffman, At Home in the Universe)
Mergers and Acquisitions (M&A)
In addition to the development of innovations and internal growth as a source of growth for corporations and the formation of oligopolies,large corporations are often formed through mergers and acquisitions.
"Merger Mania" in the late 19th century, often promoted by J. P. Morgan and culminating in 1895-1904, created many of America's largest companies. Many would continue to dominate their industries well into the late 20th century.
One indication of the continuing impact of mergers among large companies and acquisition of smaller companies is the decrease in the number of publicly traded companies. In the mid-1990s, there were around 8,000 publicly traded companies in America. In 2016, the number had fallen to 3,627.
For many years recently, America’s corporations have spent more than $1 trillion a year on mergers and acquisitions. Globally, M&A is around $3 trillion a year. Some of the largest mergers recombined companies that were broken up in earlier anti-trust cases. Cross-border and cross-regional mergers and acquisitions are creating global companies, called multinational corporations (MNCs).
The result is increasing concentration. Two finance professors at the University of Southern California estimate that nearly a third of American industries were highly concentrated in 2013, up from a quarter of all industries in 1996.
America’s 500 largest corporations spend more money every year on mergers and acquisitions than on capital investment.
Why? What are they buying?
Some mergers are between large corporations to reduce combined costs, reduce competition, merge related product lines or realize some economies of scale. Many large companies acquire smaller companies to eliminate potential competition, acquire new technology, acquire more innovative managers and employees, expand product line, or expand markets to other countries. While the United States and other countries have anti-trust laws, they are seldom used to block mergers or acquisitions. Governments often tolerate or even encourage mergers, believing larger companies are necessary to compete in regional (EU) or global markets.
While most merger and acquisitions do not make financial sense – they do not earn the companies' cost of capital – they may make sense from a strategic point of view by eliminating actual or potential competition.
Acquisitions of competitors or new companies that have specialized knowledge or are perceived as a current or potential threat is another defensive strategy to preserve market positions over time. Acquisitions, seldom a good investment, are the cost corporations pay for stability and long-term survivial.
Oligopoly – The Dominant Market Structure of Imperfect Competition
An oligopoly is an industry or market dominated by large companies. A small number of companies account for a large percent of industry sales.
In an industrialized economy, it is the dominant type of market structure.
A small number of large companies dominate the American economy. About 5,000 companies out of a total of around 20 million account for about half of total output (GDP).
Many of these companies are also an important part of the global economy as they have become multinational corporations. For the companies in the S&P 500 (the 500 public-owned companies with the highest market value), overseas sales account for about 37% of total corporate sales (2017). The 100 largest companies in the S&P 500 obtain over 45% of their sales and earnings from outside the United States. Foreign operations have accounted for most of these companies' growth in sales and profits.
In a perfect competition (PC) world, industries compete with industries. In the imperfect competition world like oligopoly, companies compete with companies. Parts of companies compete with parts of other companies in many different markets. Companies compete with companies in market niches (specialized markets) across industries and markets.
It is difficult to define an imperfect competition industry or market with differentiated products and services. The boundaries of such an industry, especially in information technology, are in flux as new products and services are brough to market. It is sometimes more useful to concentrate on more narrowly defined market niches.
A word about economic theory. Equilibrium price and output are determined by total industrysupply and demand. But in an oligopoly with differentiated products there is no unique supply curve. Thus, no unique equilibrium price and output.
Concluding Remarks
A few comments on how the economic system actually works. Maybe the most important is that only the innovative survive in an industry or market with changing technology and tastes. Even mature companies defending current positions in stable markets must buy and create new production processes, better marketing, and more efficient organizational management to stay competitive.
Competition is dynamic; companies must constantly adapt to a changing economic and technological environment. Merging and downsizing sometimes buys time to become more competitive. Often, however, the most innovative employees are the ones who leave.
In the long run, the major advantage of being a large corporation is being large. But the largest corporations have a high failure rate. Being a big company isn’t worth much when trying to control market or make economic profit. I will go further, based on my corporate and academic experience analyzing industries and markets. When technology and consumer tastes are changing, being an established large company may put the company at a competitive disadvantage. Large companies are committed to existing technologies, existing products, existing distribution channels, and the internal thinking and routines of the past. Again and again, I saw new, small companies come into an industry or market and clobber an entrenched dominant firm. Think about what has happened to iconic companies like General Motors, Sears, IBM, GE, RCA and former hi-tech companies like Xerox, Polaroid, and Kodak. All are companies that lost large market share or even left markets they once dominated. Most of the 500 largest public corporations of 30 years ago have gone bankrupt, been acquired or are a much smaller company.
Eventually, most large corporations are replaced by successful small companies that become the new dominating corporations. Small companies succeed because they:
• are quicker to buy or develop new technology that gave them a cost advantage over existing firms.
• develop new products or services, or improve existing products or services, that met consumer needs better than existing products.
• take advantage of new methods of marketing or new marketing channels. Amazon vs. "big box" store retailers.
• provide higher quality or higher value products or services.
This is how a very small percent of today's small companies will become tomorrow's big companies.
As Wee Willie Keeler, small but one of the best hitters in the history of baseball, said, “Hit them where they ain’t.”
Comments
Post a Comment