The Wall Street Journal has recently published an elegiac
list:
"Twenty years ago, cable television was dominated by a
patchwork of thousands of tiny, family-operated
companies. Today, a pending deal would leave three
companies in control of nearly two-thirds of the market.
In 1990, three big publishers of college textbooks
accounted for 35% of industry sales. Today they have
62% ... Five titans dominate the (defense) industry, and
one of them, Northrop Grumman ... made a surprise
(successful) $5.9 billion bid for (another) TRW ... In
1996, when Congress deregulated telecommunications,
there were eight Baby Bells. Today there are four, and
dozens of small rivals are dead. In 1999, more than 10
significant firms offered help-wanted Web sites. Today,
three firms dominate".
Mergers, business failures, deregulation, globalization,
technology, dwindling and more cautious venture capital,
avaricious managers and investors out to increase share
prices through a spree of often ill-thought acquisitions -
all lead inexorably to the congealing of industries into a
few suppliers. Such market formations are known as
oligopolies. Oligopolies encourage customers to
collaborate in oligopsonies and these, in turn, foster
further consolidation among suppliers, service providers,
and manufacturers.
Market purists consider oligopolies - not to mention
cartels - to be as villainous as monopolies. Oligopolies,
they intone, restrict competition unfairly, retard
innovation, charge rent and price their products higher
than they could have in a perfect competition free market
with multiple participants. Worse still, oligopolies are
going global.
But how does one determine market concentration to start
with?
The Herfindahl-Hirschmann index squares the market
shares of firms in the industry and adds up the total. But
the number of firms in a market does not necessarily
impart how low - or high - are barriers to entry. These are
determined by the structure of the market, legal and
bureaucratic hurdles, the existence, or lack thereof of
functioning institutions, and by the possibility to turn an
excess profit.
The index suffers from other shortcomings. Often the
market is difficult to define. Mergers do not always drive
prices higher. University of Chicago economists studying
Industrial Organization - the branch of economics that
deals with competition - have long advocated a shift of
emphasis from market share to - usually temporary -
market power. Influential antitrust thinkers, such as
Robert Bork, recommended to revise the law to focus
solely on consumer welfare.
These - and other insights - were incorporated in a theory
of market contestability. Contrary to classical economic
thinking, monopolies and oligopolies rarely raise prices
for fear of attracting new competitors, went the new
school. This is especially true in a "contestable" market -
where entry is easy and cheap.
An Oligopolistic firm also fears the price-cutting reaction
of its rivals if it reduces prices, goes the Hall, Hitch, and
Sweezy theory of the Kinked Demand Curve. If it were to
raise prices, its rivals may not follow suit, thus
undermining its market share. Stackleberg's amendments
to Cournot's Competition model, on the other hand,
demonstrate the advantages to a price setter of being a
first mover.
In "Economic assessment of oligopolies under the
Community Merger Control Regulation, in European
Competition law Review (Vol 4, Issue 3), Juan Briones
Alonso writes:
"At first sight, it seems that ... oligopolists will sooner or
later find a way of avoiding competition among
themselves, since they are aware that their overall profits
are maximized with this strategy. However, the question
is much more complex. First of all, collusion without
explicit agreements is not easy to achieve. Each supplier
might have different views on the level of prices which
the demand would sustain, or might have different price
preferences according to its cost conditions and market
share. A company might think it has certain advantages
which its competitors do not have, and would perhaps
perceive a conflict between maximising its own profits
and maximizing industry profits.
Moreover, if collusive strategies are implemented, and
oligopolists manage to raise prices significantly above
their competitive level, each oligopolist will be confronted
with a conflict between sticking to the tacitly agreed
behaviour and increasing its individual profits by
'cheating' on its competitors. Therefore, the question of
mutual monitoring and control is a key issue in collusive
oligopolies".
Monopolies and oligopolies, went the contestability
theory, also refrain from restricting output, lest their
market share be snatched by new entrants. In other words,
even monopolists behave as though their market was fully
competitive, their production and pricing decisions and
actions constrained by the "ghosts" of potential and
threatening newcomers.
In a CRIEFF Discussion Paper titled "From Walrasian
Oligopolies to Natural Monopoly - An Evolutionary
Model of Market Structure", the authors argue that:
"Under decreasing returns and some fixed cost, the market
grows to 'full capacity' at Walrasian equilibrium
(oligopolies); on the other hand, if returns are increasing,
the unique long run outcome involves a profit-maximising
monopolist".
While intellectually tempting, contestability theory has
little to do with the rough and tumble world of business.
Contestable markets simply do not exist. Entering a
market is never cheap, nor easy. Huge sunk costs are
required to counter the network effects of more veteran
products as well as the competitors' brand recognition and
ability and inclination to collude to set prices.
Victory is not guaranteed, losses loom constantly,
investors are forever edgy, customers are fickle, bankers
itchy, capital markets gloomy, suppliers beholden to the
competition. Barriers to entry are almost always
formidable and often insurmountable.
In the real world, tacit and implicit understandings
regarding prices and competitive behavior prevail among
competitors within oligopolies. Establishing a reputation
for collusive predatory pricing deters potential entrants.
And a dominant position in one market can be leveraged
into another, connected or derivative, market.
But not everyone agrees. Ellis Hawley believed that
industries should be encouraged to grow because only size
guarantees survival, lower prices, and innovation. Louis
Galambos, a business historian at Johns Hopkins
University, published a 1994 paper titled "The Triumph of
Oligopoly". In it, he strove to explain why firms and
managers - and even consumers - prefer oligopolies to
both monopolies and completely free markets with
numerous entrants.
Oligopolies, as opposed to monopolies, attract less
attention from trustbusters. Quoted in the Wall Street
Journal on March 8, 1999, Galambos wrote:
"Oligopolistic competition proved to be beneficial ...
because it prevented ossification, ensuring that
managements would keep their organizations innovative
and efficient over the long run".
In his recently published tome "The Free-Market
Innovation Machine - Analysing the Growth Miracle of
Capitalism", William Baumol of Princeton University,
concurs. He daringly argues that productive innovation is
at its most prolific and qualitative in oligopolistic markets.
Because firms in an oligopoly characteristically charge
above-equilibrium (i.e., high) prices - the only way to
compete is through product differentiation. This is
achieved by constant innovation - and by incessant
advertising.
Baumol maintains that oligopolies are the real engines of
growth and higher living standards and urges antitrust
authorities to leave them be. Lower regulatory costs,
economies of scale and of scope, excess profits due to the
ability to set prices in a less competitive market - allow
firms in an oligopoly to invest heavily in research and
development. A new drug costs c. $800 million to develop
and get approved, according to Joseph DiMasi of Tufts
University's Center for the Study of Drug Development,
quoted in The wall Street Journal.
In a paper titled "If Cartels Were Legal, Would Firms Fix
Prices", implausibly published by the Antitrust Division
of the US Department of Justice in 1997, Andrew Dick
demonstrated, counterintuitively, that cartels are more
likely to form in industries and sectors with many
producers. The more concentrated the industry - i.e., the
more oligopolistic it is - the less likely were cartels to
emerge.
Cartels are conceived in order to cut members' costs of
sales. Small firms are motivated to pool their purchasing
and thus secure discounts. Dick draws attention to a
paradox: mergers provoke the competitors of the merging
firms to complain. Why do they act this way?
Mergers and acquisitions enhance market concentration.
According to conventional wisdom, the more concentrated
the industry, the higher the prices every producer or
supplier can charge. Why would anyone complain about
being able to raise prices in a post-merger market?
Apparently, conventional wisdom is wrong. Market
concentration leads to price wars, to the great benefit of
the consumer. This is why firms find the mergers and
acquisitions of their competitors worrisome. America's
soft drink market is ruled by two firms - Pepsi and Coca-
Cola. Yet, it has been the scene of ferocious price
competition for decades.
"The Economist", in its review of the paper, summed it up
neatly:
"The story of America's export cartels suggests that when
firms decide to co-operate, rather than compete, they do
not always have price increases in mind. Sometimes, they
get together simply in order to cut costs, which can be of
benefit to consumers".
The very atom of antitrust thinking - the firm - has
changed in the last two decades. No longer hierarchical
and rigid, business resembles self-assembling, nimble, ad-
hoc networks of entrepreneurship superimposed on ever-
shifting product groups and profit and loss centers.
Competition used to be extraneous to the firm - now it is
commonly an internal affair among autonomous units
within a loose overall structure. This is how Jack
"neutron" Welsh deliberately structured General Electric.
AOL-Time Warner hosts many competing units, yet no
one ever instructs them either to curb this internecine
competition, to stop cannibalizing each other, or to start
collaborating synergistically. The few mammoth agencies
that rule the world of advertising now host a clutch of
creative boutiques comfortably ensconced behind Chinese
walls. Such outfits often manage the accounts of
competitors under the same corporate umbrella.
Most firms act as intermediaries. They consume inputs,
process them, and sell them as inputs to other firms. Thus,
many firms are concomitantly consumers, producers, and
suppliers. In a paper published last year and titled
"Productive Differentiation in Successive Vertical
Oligopolies", that authors studied:
"An oligopoly model with two brands. Each downstream
firm chooses one brand to sell on a final market. The
upstream firms specialize in the production of one input
specifically designed for the production of one brand, but
they also produce he input for the other brand at an extra
cost. (They concluded that) when more downstream
brands choose one brand, more upstream firms will
specialize in the input specific to that brand, and vice
versa. Hence, multiple equilibria are possible and the
softening effect of brand differentiation on competition
might not be strong enough to induce maximal
differentiation" (and, thus, minimal competition).
Both scholars and laymen often mix their terms.
Competition does not necessarily translate either to
variety or to lower prices. Many consumers are turned off
by too much choice. Lower prices sometimes deter
competition and new entrants. A multiplicity of vendors,
retail outlets, producers, or suppliers does not always
foster competition. And many products have umpteen
substitutes. Consider films - cable TV, satellite, the
Internet, cinemas, video rental shops, all offer the same
service: visual content delivery.
And then there is the issue of technological standards. It is
incalculably easier to adopt a single worldwide or
industry-wide standard in an oligopolistic environment.
Standards are known to decrease prices by cutting down
R&D expenditures and systematizing components.
Or, take innovation. It is used not only to differentiate
one's products from the competitors' - but to introduce
new generations and classes of products. Only firms with
a dominant market share have both the incentive and the
wherewithal to invest in R&D and in subsequent branding
and marketing.
But oligopolies in deregulated markets have sometimes
substituted price fixing, extended intellectual property
rights, and competitive restraint for market regulation.
Still, Schumpeter believed in the faculty of "disruptive
technologies" and "destructive creation" to check the
power of oligopolies to set extortionate prices, lower
customer care standards, or inhibit competition.
Linux threatens Windows. Opera nibbles at Microsoft's
Internet Explorer. Amazon drubbed traditional
booksellers. eBay thrashes Amazon. Bell was forced by
Covad Communications to implement its own technology,
the DSL broadband phone line.
Barring criminal behavior, there is little that oligopolies
can do to defend themselves against these forces. They
can acquire innovative firms, intellectual property, and
talent. They can form strategic partnerships. But the
supply of innovators and new technologies is infinite - and
the resources of oligopolies, however mighty, are finite.
The market is stronger than any of its participants,
regardless of the hubris of some, or the paranoia of others.