Economics Project on Oligopoly

OLIGOPOLY 5-Sep-09

PROJECT REPORT ON OLIGOPOLY IFIM B-SCHOOL, BANGALORE Section B,

Group Members: Names: 1. Avesh Araya 2. Prasun Kundu 3. Rakesh Roshan 4. Snehashis Goswami 5. Shweta Rani 6. Yatindra Singh

Roll No. 09 21 27 40 39 59

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OLIGOPOLY

CONTENTS

ACKNOWLEDEGMENT……………………………...3 INTRODUCTION………………………………………4 IMPERFECT COMPETETION……………………….4 CHARACTERISTIC OF AN OLIGOPOLY MKT…..5 EXAMPLE OF OLIGOPOLY………………………….6 CASE STUDY…………………………………. ………6 CONCLUSION…………………………………………9

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OLIGOPOLY

ACKNOWLEDGEMENT

We would like to express our sincere gratitude to all those who have been instrumental in the preparation of this project report. We would like to thank Mrs. Kavita Mathad, Professor Economics Department, for her guidance and support in our project. We are deeply thankful to IFIM B-School and its Management for its support in the project. Last but not least, we would like to thank The Almighty, our parents and friends for their help and support that has largely contributed to the successful completion of the project.

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OLIGOPOLY

INTRODUCTION An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from the Greek oligo 'few' plus -opoly as in monopoly and duopoly. Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion. Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil. Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development. There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be a real communication between companies) - for example, in some industries, there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership. In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater than when there are more firms in an industry if, for example, the firms were only regionally based and didn't compete directly with each other. MANAGERIAL ECONOMICS

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OLIGOPOLY

IMPERFECT COMPETETION Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers. Types of Imperfectly Competitive Markets Oligopoly: Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition: Many firms selling products that are similar but not identical. CHARACTERISTICS OF AN OLIGOPOLY MARKET • Few sellers offering similar or identical products • Interdependent firms • Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost • There is a tension between cooperation and self-interest. There is no single theory of how firms determine price and output under conditions of oligopoly. If a price war breaks out, oligopolists will produce and price much as a perfectly competitive industry would; at other times they act like a pure monopoly. But an oligopoly usually exhibits the following features: 1. Product branding: Each firm in the market is selling a branded (differentiated) product 2. Entry barriers: Significant entry barriers into the market prevent the dilution of competition in the long run which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on market prices and output 3. Interdependent decision-making: Interdependence means that firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. In perfect competition and monopoly, the producers did not have to consider a rival’s response when choosing output and price. 4. Non-price competition: Non-price competition s a consistent feature of the competitive strategies of oligopolistic firms.

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Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and the kink point.

EXAMPLE: INDIAN OIL AND GAS SECTOR

Key Players Analyzed Oil India Ltd., Oil and Natural Gas Commission, Indian Oil Corporation, Hindustan Petroleum Corporation Ltd., Bharat Petroleum Corporation Ltd., Gas Authority of India Ltd., and Reliance Industries Ltd. CASE STUDY:

In 2007-08, India’s five largest companies were oil companies. Four out of five were government owned. The sales of the sixth—Essar Oil—were negligible. Reliance’s share of sales was 17%, but 60% of its output was exported. It does not require much analysis to conclude that the Indian oil industry is an oligopoly, and MANAGERIAL ECONOMICS

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OLIGOPOLY that it is dominated by government firms. The retail market for petrol and diesel is almost entirely a government monopoly. This monopoly also affects exploration and production as a number of companies that have struck oil or gas cannot find a domestic market because of the government’s monopoly of distribution. How can this situation be changed, and competition be introduced? All hydrocarbon products are tradeable, although their transport costs vary greatly —the more valuable a refined product, the lower proportionally are transport costs. So the most expeditious way of introducing competition is freeing imports. There cannot be competition in refining unless crude is freely importable. The next condition is tax parity of imports and domestic production. This means that whatever domestic taxes are levied should be applicable to imports. Import duties may be levied; but unless there is a reason to protect exploration and production beyond the size to which they would grow without protection, crude imports should be duty-free, so that there is maximum incentive to invest in refining. There will inevitably be taxation of refined products, since some of them are considered inputs into luxuries (e g, aviation fuel and petrol), and are in fact sources of prolific revenue. Duties on domestic production must be matched by equal import duties, so that there is no discrimination in favour of exports. Typically, a refinery’s margin might be 10%, and crude might account for 80-90% of its costs. Since some refinery products are considered luxuries and others necessities, taxes on them will be different; and the average tax on refined product will be high. In the circumstances, the tax system can be simplified and competition in refining intensified by not taxing crude at all, and concentrating all taxation on refined products. Next, we come to entry restrictions. It should be borne in mind that the attractiveness of exploration is closely dependent on the ease of entry in refining and distribution. It is difficult to conceive of completely free entry into exploration because it involves access to land and governments have a role in allocation. So some form of exploration licensing is unavoidable. The high proportion of concessions granted to ONGC would suggest otherwise, but there is no overt discrimination against foreign companies or exclusion of any companies other than on such self-evident criteria. However, the government’s insistence that discovered oil and gas must be used in India—its implicit export ban—reduces the potential value of finds and probably leads to fewer bids and lower revenue for the government; now that the balance of payments is no longer a policy problem, this domestic use requirement is outdated. Another area of concern is the inconsistency in government policies as in many instances the government did not stick to contractual agreement and its regulatory framework remained uncertain. For instance, Directorate General of Hydrocarbons’ renegotiation of conditions embodied in the model production MANAGERIAL ECONOMICS

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OLIGOPOLY sharing contracts issued at the time of announcement of earlier rounds after bidders had invested money and found oil or gas. Refining and distribution segments cry out more for reforms. In 2002, the government abolished the Administered Price Mechanism (APM) and also the Oil Coordination Committee, which administered the price controls. However, even after dismantling the APM, government continues to regulate prices of petroleum products. Government gives subsidies but at the time when international crude prices were soaring it did not increase subsidies. All the state-owned companies were selling petrol, diesel, kerosene and cooking gas below the cost. Government’s discriminatory policy of subsidising petrol and diesel sold out of its companies’ pumps, but not subsidising private competitors put private players at a disadvantage. Therefore, private players like Reliance and Essar could not find retail sales profitable. This lack of a level playing field between private and public players has caused the former to withdraw from the retail market, leaving the entire retail market to public players. Second, when allowing private entry, the government has insisted that new entrants must set up a minimum proportion of pumps in ‘backward’ or ‘rural’ areas. Ideally, there should be no such condition; if the government wants more petrol pumps in certain areas, it must give them subsidies until they reach a certain minimum turnover. The government has a service tax; it can be applied to petrol pumps, and a cut-off point may be set below which there would be no tax. It is possible to introduce competition in distribution alone, without any changes in refining. The first condition for this would be to abolish licensing of pumps. Licensing creates rampant corruption, which reaches right up to the minister. Second, there should be free imports of products. There should be no canalisation of product imports, and no quantitative restrictions. The oil production and distribution chain requires large capital investments with long gestation lags. If the government is serious about competition, it must accept and announce self-restraint on its freedom to make and change policies. Finally, transportation affects competition in an important way. For all hydrocarbons, pipelines are the cheapest medium of transport. Currently, all pipelines in India are owned by gas or oil companies, thus insulating them from competition. If all the pipelines were common carriers and carried oil, gas or products for all customers without discrimination at pre-announced prices, then refineries and gas-based plants would spread out more evenly across the country, and there would be greater competition amongst them. The best solution now would be to nationalise all existing pipelines and give them to a new company to run as a public utility on a cost-plus basis. MANAGERIAL ECONOMICS

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OLIGOPOLY The conclusions we have reached have implications for the CCI. It is for the Competition Commission to decide at what level to frame its interventions. Quite a few of government obstructions to competition that are found in the oil industry are present in other industries as well; the Competition Commission would have to take a view on whether to take an industry-specific approach or to take up more general issues of policy.

CONCLUSION The Indian oil & gasoline industry is an oligopoly. An oligopoly is a market form in which a market or industry is dominated by a small number of sellers. The word is derived from the Greek for few sellers. Because there are few participants in this type of market, in this case we have four major govt.owned oil companies and one private company (Reliance).Each oligopolist is aware of the actions of the others. The decisions of firm influence, and are influenced by the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion.

BIBLOGRAPHY Financial Express Newspaper. http://www.google.com MANAGERIAL ECONOMICS

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OLIGOPOLY http://www.wikipedia.com “Microeconomics “ by BERNHEIM & WHINSTON

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