This is “Competing in Tight Oligopolies: Nonpricing Strategies”, section 7.7 from the book Managerial Economics Principles (v. 1.0).
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Oligopoly firms also use a number of strategies that involve measures other than pricing to compete and maintain market power. Some of these strategies try to build barriers to entry by new entrants, whereas the intention of other measures is to distinguish the firm from other existing competitors.
AdvertisingA means of increasing the likelihood a firm's product or service is among those actually considered by consumers.. As we noted in Chapter 3 "Demand and Pricing", most firms incur the expense of advertising. To some extent, advertising is probably necessary because buyers, particularly household consumers, face a plethora of goods and services and realistically can actively consider only a limited subset of what is available. Advertising is a means of increasing the likelihood a firm’s product or service is among those services actually considered.
When the firm is an upstream seller in a value chain with downstream markets, advertising may be directed at buyers in downstream markets. The intent is to encourage downstream buyers to look for products that incorporate the upstream firm’s output. An example of such advertising is in pharmaceuticals, where drug manufacturers advertise in mass media with the intent of encouraging consumers to request a particular drug from their physicians.
In tight oligopolies, firms may boost the intensity of advertising well beyond the amount needed to inform buyers of the existence of their goods and services. Firms may advertise almost extravagantly with the idea of not only establishing brand recognition but making strong brand recognition essential to successful competition in the market. Once strong brand recognition takes hold in the market, new firms will need to spend much more to establish brand recognition than existing firms spend to maintain brand recognition. Hence new entrants are discouraged by what is perceived as a high startup fee, which is a type of barrier to entry.
Excess capacityA means of competing in which a firm invests in a very high production volume in order to convince other firms that a lower price tactic will not succeed.. Ordinarily a firm will plan for a capacity that is sufficient to support the production volume. Because capacity is often planned in advance and actual production volume may vary from period to period, the firm may have some excess capacity in some periods. And since there is inherent uncertainty in future demand, firms may even invest in capacity that is never fully utilized.
However, firms in oligopolies may invest, or partially invest, in capacity well beyond what is needed to cover fluctuations in volume and accommodation of uncertainty as a means of competing. If the sellers in an oligopoly have been successful in collectively holding back on quantity to drive up the price and profits, since the price is well above average cost, there is an opportunity for one firm to offer the product at a lower price, attract a sizeable fraction of the new customers attracted by the lower price, and make a sizeable individual gain in profit. This gambit may come from a new entrant or even an existing seller. This tactic may work, at least for a time, if the firm introducing the lower price does it by surprise and the other firms are not prepared to ramp up production rapidly to match the initiator’s move.
One way to protect against an attack of this nature is to have a significant amount of excess capacity, or at least some additional capacity that could be upgraded and brought online quickly. The firm doing this may even want to clearly reveal this to other sellers or potential sellers as a signal that if another firm were to try an attack of this nature, they are prepared to respond quickly and make sure they take advantage of the increased sales volume.
Reputation and warrantiesA strategy in which a firm uses advertising to make an ongoing presence in a market desired by customers so as to distinguish themselves from short-term sellers.. As a result of fluctuations in cost or buyer demand, being a seller in a market may be more attractive in some periods than others. During periods that are lucrative for being a seller, some firms may be enticed to enter on a short-term basis, with minimal long-term commitments, enjoy a portion of the spoils of the favorable market, and then withdraw when demand declines or costs increase.
Firms that intend to remain in the market on an ongoing basis would prefer that these hit-and-run entrants not take away a share of the profits when the market is attractive. One measure to discourage this is to make an ongoing presence desired by the customer so as to distinguish the product of the ongoing firms from the product of the short-term sellers. As part of advertising, these firms may emphasize the importance of a firm’s reputation in providing a quality product that the firm will stand behind.
Another measure is to make warrantiesA promise to repair or replace a product that is only of value to the buyer if the seller is likely to be available when the buyer makes a claim on the promise. a part of the product, a feature that is only of value to the buyer if the seller is likely to be available when a warranty claim is made. Like high-cost advertising, even the scope of the warranty may become a means of competition, as is seen in the automobile industry where warranties may vary in time duration, number of driven miles, and systems covered.
Product bundlingFirms take advantage of natural production economies of scope by selling complementary products together at a lower cost.. In Chapter 3 "Demand and Pricing", we discussed the notion of complementary goods and services. This is a relationship in which purchasers of one good or service become more likely to purchase another good or service. Firms may take advantage of complementary relationships by selling products together in a bundle, where consumers have the option to purchase multiple products as a single item at lower total cost than if the items were purchased separately. This can be particularly effective if there are natural production economies of scope in these complementary goods. If competitors are unable to readily match the bundled product, the firm’s gain can be substantial.
A good example of successful product bundling is Microsoft Office. Microsoft had developed the word processing software Word, the spreadsheet software Excel, the presentation software PowerPoint, and the database software Access. Individually, each of these products was clearly outsold by other products in those specialized markets. For example, the favored spreadsheet software in the late 1980s was Lotus 1-2-3. When Microsoft decided to bundle the packages and sell them for a modest amount more than the price of a single software package, customers perceived a gain in value, even if they did not actively use some of the packages. Since all the components were software and distributed on floppy disks (and later on CDs and via web downloads), there was a strong economy of scope. However, when Microsoft introduced the bundle, the firms selling the leader products in the individual markets were not able to match the product bundling, even though some attempted to do so after Microsoft has usurped the market. Consequently, not only was the product bundle a success, but the individual components of Microsoft Office each became the dominant products.
One impact of network effects is that industry standards become important. Often network effects occur because the products purchased need to use compatible technologies with other products. In some markets, this may result in some level of cooperation between firms, such as when appliance manufacturers agree to sell units with similar dimensions or connections.
However, sometimes multiple standards emerge and firms may select to support one standard as a means of competing against a firm that uses another standard. Sellers may group into alliances to help improve their success via network effects. In the once-vibrant market for VCR tapes and tape players, the initial standard for producing tapes was called Betamax. This Betamax standard was developed by Sony and used in the VCR players that Sony produced. Soon after Betamax was introduced, the electronics manufacturer JVC introduced the VHS standard. Consumers first had to purchase the VCR player, but the value of the product was affected by the availability and variety of tapes they could acquire afterward, which was determined by whether their player used the Betamax standard or the VHS standard. Eventually the VHS standard prevailed, favoring JVC and the other firms that allied with JVC.
Up until the videotape was eclipsed by the DVD, the VCR industry moved to using the VHS standard almost exclusively. This illustrates a frequent development in a market with strong network effects: a winner-take-all contest. Another example of a winner-take-all situation can be seen with operating systems in personal computers. Although there were multiple operating systems available for PCs in the 1980s, eventually Microsoft’s MS-DOS and later Windows operating systems achieved a near monopoly in personal computer operating systems. Again, the driver is network effects. Companies that produced software saw different markets depending on the operating system used by the buyer. As MS-DOS/Windows increased its market share, companies were almost certain to sell a version of their product for this operating system, usually as their first version and perhaps as their only version. This, in turn, solidified Microsoft’s near monopoly. Although other operating systems still exist and the free operating system Linux and the Apple Macintosh OS have succeeded in some niches, Microsoft Windows remains the dominant operating system.