Market Structures and UK Supermarket Oligopoly Analysis

Introduction

Classifying an industry within a particular economic market system is essential to understanding it clearly. Without such classification, it is not possible to analyze the market in the way it should be analyzed. This paper discusses the market, its types, and their impacts on the decisions of companies operating within them as those companies pursue their goals. It then examines the UK supermarket industry and analyzes why the oligopolistic nature of that sector has come under investigation by competition commissions and antitrust authorities.

The economic market system is normally defined as a self-adjusting system that operates on its own, requiring no controlling body for day-to-day operations. Because of ongoing human activities and changing needs, the economic system itself adjusts supply according to demand and production according to consumption. This self-adjustment process is flexible, automatic, and responsive to different factors and situations (Williamson, 1981).

Market Structures Overview

Competition does not always increase total welfare, however, because it can create a coordination problem. There can be multiple equilibria because the two firms' innovation levels are, in most circumstances, strategic substitutes. This is due to a market-share effect: the more a rival innovates, the larger its market share becomes and the smaller the share of the other firm, thereby reducing that firm's incentive to innovate.

Market is defined in many different ways by different scholars. It can be defined as a place where buyers and sellers meet to conduct a transaction or exchange of goods or services. It can encompass any of the systems, institutions, procedures, social relations, and infrastructure through which parties engage in exchange. This exchange can take a barter form — where goods are exchanged for other goods — or a monetary form, where goods are exchanged through currency. Most markets expect sellers to offer goods and services (including labor) in exchange for money from buyers (Fehr and Gachter, 2000).

Depending on the number of buyers and various other features, markets can be classified into four categories: perfect competition, monopolistic competition, oligopoly, and monopoly.

Perfect competition can be defined as a market in which a large number of companies sell identical products to a large population of buyers, with no barriers to entry (Lancaster, 1990). In such a market, established firms possess no advantage over new entrants (apart from experience, which is not strictly an economic factor), and buyers and sellers are well informed about market prices as determined by market equilibrium. The most distinctive feature of perfect competition is the identical nature of products; there is little or no differentiation among the offerings of different firms.

In a perfectly competitive market, the goal of companies is to maximize economic profit — that is, total revenue minus total cost. The optimal level of production can be determined through marginal analysis: the profit-maximization point is where marginal revenue equals marginal cost.

Effect of Perfect Competition on Firm Decisions: Since differentiation is minimal in perfect competition, there is very little room to earn more than ordinary profit. In the short run, a company must make two critical decisions. First, it must determine whether to continue production or shut down. If economic profit is equal to or greater than expected profit, the firm will continue; otherwise it must shut down. Second, if it continues, the firm must identify the optimal quantity to produce — the quantity at which economic profit is maximized (Rubinstein, 1982).

In the long run, the company must decide whether to expand or reduce the size of its production capacity. If there is room to earn greater economic profit by moving toward the optimal output level, the firm should consider expanding. Conversely, if optimal output requires a reduction in scale, the plant size should be decreased. The second long-term decision is whether to remain in the industry at all. As the definition implies, entry and exit in perfect competition are easy, since a firm can recover its full investment through the sale of its plant.

In terms of the number of producers, monopolistic competition resembles perfect competition: there are large numbers of companies competing with one another, and firms are free to enter or leave the market (Bulow, 1982). The differences arise for two reasons. First, products are differentiated — a differentiated product is a close substitute for similar products offered by other firms, but cannot be used as a perfect substitute. Second, because products are differentiated, there are differences in quality, price, and marketing. Companies face a significant trade-off between quality and price: a firm producing a higher-quality product can charge a much higher price than one producing lower-quality goods. These differences emerge from distinct approaches and the targeting of different market segments with different ideas.

The goal remains maximizing economic profit. To achieve the highest economic profit, the firm must produce the quantity at which marginal profit equals marginal cost. Profit maximization in monopolistic competition can also be framed as loss minimization.

In the short run, a firm in monopolistic competition can earn economic profit, but in the long run this profit tends toward zero. Because there are no barriers to entry, any competitor can replicate an idea, increasing supply and driving prices down. This process continues until no economic profit remains (Nishimori and Ogawa, 2002).

Innovation and Product Development: Innovation and product development are critical issues in monopolistic competition. Companies cannot differentiate their products without ongoing innovation and development — making this function essential (Tirole, 1986). However, its costs must not be overlooked. Firms need to conduct a cost–benefit analysis for product innovation: if the cost of innovation and development generates at least equivalent revenue, the firm will continue to invest in it.

Oligopoly and Its Influence on Firms

Advertising and Marketing: To promote a differentiated product, a company must communicate with its customers in distinctive ways and convey the benefits its products offer that competitors do not. This is achieved through advertising and marketing. Two considerations are critical when advertising. First, the costs of advertising must be weighed through a cost–benefit analysis that yields positive results. Second, demand and optimal production must be aligned. The firm should advertise only enough to reach the optimal output level; beyond that point, additional advertising costs not only become surplus expenditure but also generate an economic loss if output exceeds the optimum.

Oligopoly sits between the two extremes of perfect competition and monopoly, and is very similar to monopolistic competition. Like monopolistic competition, firms in an oligopoly may produce similar products and compete solely on price, or they may produce differentiated products and compete on price, quality, innovation, and marketing. The key difference lies in entry conditions: oligopoly markets possess natural or legal barriers to entry that exclude new firms (Caves and Porter, 1978). As a result, only a limited number of firms compete within an oligopolistic structure.

Natural barriers include limited demand for the product. If an additional company enters an industry in which existing companies are already meeting demand, the resulting additional supply will cause prices to fall, pushing all firms into economic loss. Oligopolies can also be named according to the number of firms — for example, a duopoly for two firms.

In an oligopoly, firms are highly dependent on one another's decisions (Mazzeo, 2002). If one firm lowers its price, its market share increases, reducing demand for the other firms and causing them to incur economic losses. Effective communication among firms in an oligopoly is therefore essential. This interdependence creates a temptation to cooperate, which can lead firms to form a cartel in order to increase profits collectively. Building cartels is illegal, but they persist in some markets.