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Thursday, May 22, 2008, 9:24 PM
Conditions for an Oligopolistic Market
Oligopoly is the least understood market structure; consequently, it has no single, unified theory. Nevertheless, there is some agreement as to what constitutes an oligopolistic market. Three conditions for oligopoly have been identified. First, an oligopolistic market has only a few large firms. This condition distinguishes oligopoly from monopoly, in which there is just one firm. Second, an oligopolistic market has high barriers to entry. This condition distinguishes oligopoly from perfect competition and monopolistic competition in which there are no barriers to entry. Third, oligopolistic firms may produce either differentiated or homogeneous products. Examples of oligopolistic firms include automobile manufacturers, oil producers, steel manufacturers, and passenger airlines.
Cartel Theory of Oligopoly
A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum-exporting countries (OPEC) is perhaps the best-known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.
Oligopolistic firms join a cartel to increase their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will charge. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oil-producing firms form a cartel like OPEC to determine their output and price, they will jointly face a downward-sloping market demand curve, just like a monopolist. In fact, the cartel's profit-maximizing decision is the same as that of a monopolist, as Figure 1 reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel's profits are equal to the area of the rectangular box labeled abcd in Figure 1. Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.
Figure 1
Profit maximization by oligopolistic cartel
Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel's profits. Hence, there is a built-in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist.
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Motives behind merger and acquisition
These motives are considered to add shareholder value:
Synergy: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit.
Increased revenue/Increased Market Share: This motive assumes that the company will be absorbing a major competitor and thus increase its power (by capturing increased market share) to set prices.
Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products.
Economies of Scale: For example, managerial economies such as the increased opportunity of managerial specialization. Another example are purchasing economies due to increased order size and associated bulk-buying discounts.
Taxes: A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an acquiring company.
Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below).
Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.
These motives are considered to not add shareholder value:
Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.
Manager's hubris: manager's overconfidence about expected synergies from M&A which results in overpayment for the target company.
Empire building: Managers have larger companies to manage and hence more power.
Manager's compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders); although some empirical studies show that compensation is linked to profitability rather than mere profits of the company.
Vertical integration: Companies acquire part of a supply chain and benefit from the resources. However, this does not add any value since although one end of the supply chain may receive a product at a cheaper cost, the other end now has lower revenue. In addition, the supplier may find more difficulty in supplying to competitors of its acquirer because the competition would not want to support the new conglomerate.
source
http://en.wikipedia.org/wiki/Merger
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