Strategic interactions of players in Oligopoly Markets

The strategic interaction between players in the oligopoly markets gives its study a tint of dynamism. This interdependence nature of oligopolies brings about the concept of conjectural behaviour, a situation whereby the actions and decisions of firms in the markets depends on the actions and decisions of the others. This brings about many of the theoretical problems in modelling oligopolistic behaviour (Waterson 1984, pg 17). An extension of such problem is borne on the willingness of firms to gain market power, and most cases; it is done through integration into lines of business that are related. Literature varies with respect to the theoretical aspect of integrating related firms with unrelated ones, as there has been mixed results in the area of profitability. Rumelt found out that firms that are not vertically integrated are more profitable (Rumelt 1976). Whereas, the situation was different with Luffman and Reed, who argued that vertically integrated firms are more profitable (Luffman and Reed 1984). Policy actions is said to cause a loss in social welfare rather than the actions of the firms themselves, and that integration is used strategically to achieve anticompetitive effects (Cowling and Mueller 1978).

This study assesses the measurement of monopoly profit in a collusive oligopolistic market and also deals with the estimation of welfare loss in the distribution aspect of the British film industry. It will also deal with whether vertical integration contributes adversely to consumers’ welfare or not. The analysis is carried out using the gross profit, general selling administrative expenses and after tax profits of the distributors in the British film industry for the past 20 years, ranging from 1990 – 2009. As is in the treatment of oligopolies, there are different ways of measuring the game theory. It is either the use of Bertrand equilibrium (which focuses on the manipulation of price to gain market power) is employed, or the Cournot model (which talks about the adjustment of quantity) is used. In other cases, there is the use of intermediate models which deals with the combination of price and quantity adjustment to achieve competitive edge over other players in the industry. In this analysis, Cowling and Mueller’s (1978) model will be employed. Their method is based on the Cournot-Nash equilibrium model. The distributors involved in this analysis will be divided into two categories as is the industrial structure. There will be a set that is involved in integration of the production and or exhibition aspect into the business of distribution, while the other set is basically the independent distributors, that is, those involved only in the business of distribution without recourse to other aspect of the industry.

The next section will deal with a discussion into the industry. This will involve the history of the industry, the basic structure, size of the industry, how concentrated the industry is and a look into the recent development in the industry. A descriptive statistics into the distribution aspect of the industry will also be discussed. Chapter 3 (i.e. literature review) will deal with the approaches used in the analysis of the behaviour of oligopolies that collude in other to gain monopoly profits. The section will start with a brief review of the oligopoly theories as it affects the industry. The main model in this work, the Cournot-Nash model, will be reviewed before the discussion of the complications in the work of Cowling and Mueller (1978). The assumption that welfare loss is enhanced through vertically integration will then be reviewed. The methodology chapter (i.e. chapter 4) will be based on how the analysis is to be carried out. There will be the description of data, the methods used and the problems encountered during the analysis. Chapter 5 will be based on the findings of the work. It will involve the presentation and discussion in the findings. The final section, chapter 6, will be a conclusion on the work and policy recommendation, if any.

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Chapter 2

The Industry

The British film industry, over several years, can be classified as undulating, with its high and low peaks. The industry is characterised by volatility and persistent instability, and due to such inconsistencies, has attracted government intervention. There are catastrophic cycles in the history of British film. Fluctuations in cinema attendance and the degree of American dominance in the industry were major factors that influenced the industry. Despite these cycles, the industry is said to be the second largest in the world, next to that of US. This section would look at the history of the industry, the industrial structure (i.e. the key distinct but related sectors in the industry; production, distribution and exhibition), size and concentration. This would involve focusing on the pertinent issues that have contributed to the development of the industry over the years. After this, a discussion into recent developments of the industry would be done.

History

The emergence of the film industry can be attributed to the series of innovations encountered in the nineteenth century in the US, France and UK. Shortly after the UK dominance in the American market (accounting for about 15% share of the market), there was a slum in their dominance as a result of America’s expensive and heavily marketed productions, which resulted into the loss of indigenous followership to less than 10% (Bakker 2005). Despite this, the home audience increased prompting the government to introduce the Entertainment Tax in 1916. This is based on the premises that the industry is a sleeping giant, thereby including other forms of entertainment, like music hall and theatre in the tax. However, the tax was abolished in 1960 (Murphy 2004).

The dominance of the American film market was unprecedented in the 1920s that the government had to intervene by the establishment of the Cinematograph Films Act in 1927. The act was to encourage the production of films indigenously and also set the criteria for the distribution and exhibition of films in the home industry. It was believed that the industry could help stimulate the exports of other goods and services in the British economy, and that it would help wade off American dominance in the industry. This act recorded significant success, as more production companies sprang up, among which are Warner’s, Fox and British International Pictures. The production of films in the UK doubled as a result. However, the criticism faced by the act has to do with the production of low quality films and low cost of the films, in order to meet the quota requirement set out by the Act. In 1936, the act was reviewed and it allocated quotas to both the distribution and exhibition sector of the industry. Also, quality test was also included in the act. This was to encourage competitiveness in the international market for the industry. Financial institutions were also encouraged to participate in the industry through the provision financial assistance to firms in the industry.

At the end of World War II, the industry experienced a boom, which saw cinema attendance soar. Of worthy mention is the existence of the Rank Organisation, a vertically integrated firm, involved in the production, distribution and exhibition of films in the industry. The firm dominated the industry in the 1940s, and was the largest film distributor at the time (UK Film Council Research and Statistics Unit 2009). The British government enhanced their role in the administration of the industry when it was realised the American film industry is taking over the home market, through the establishment of the National Film Finance Corporation (NFFC) and the Eady Levy in 1950. The Eady levy was a law enforcing the ploughing back of a percentage of the film profits back into the development of the industry (UK Film Council, 2009).

In the early 1980s when Margaret Thatcher came into power, there was an attempt to create a free market in all industries, with the use of a deregulation policy. This was in view of breaking up monopolies, thereby, enhancing competitiveness in the economy. However, there was criticism that there would be a preference for profit maximisation of firms rather than the welfare of people (BFI Institute 2005, pg 1). In line with this deregulation policy, the Eady Levy was abolished in 1985 and the 25% tax break for film investors was removed. The withdrawal of government support in these areas made getting involved in the film business more risky. At the time, the only hope from the state was also privatised thereby curtailing financial assistance. The Rank Organisation failed at this time. Despite this, the industry still witnessed unprecedented growth. In the words of Leonard Quart, in his work ‘The religion of the market’ cited in Friedman (1993), “despite the Thatcher government’s unwillingness to aid the film industry, it did establish a general mood that encouraged economic risk-taking and experimentation with new and more innovative business practices” (Friedman 1993, pg 25). Cannon Group became the dominant player in the industry and was involved not only in the financing of films, but was also engaged in the production, distribution and exhibition. But due to over expansion, the group became bankrupt.

Structure, Size and Concentration

The industry is characterised basically by activities in three areas, which include the production, the distribution and the exhibition of films. These activities are unique but are related in that the films produced are given to distributors, who market to the exhibitors that show it to the final audience. Thus from the process of production till the final stage where the films are screened, there is distributors who serve as middle – men, who helps realise the potential of the film.

Production

The industry is production led. By production expenditure, the market is the fifth largest and is the eleventh largest with respected to the number of films produced as at 2008. The production sector is heavily dependent of inward investments, basically from the United States. This was attributed to the availability of tax relief, the high quality of workforce and the strength of the exchange rate. The fall of the UK pound contributed significantly to the rebound in the production of films. The total expenditure appreciated to about 20 per cent in 2009 when compared to that of the preceding year. Based on the UK Film Council Statistics in 2008, the sector has about 202 active production companies, with few large ones making films of substantial budgets and others producing mainly low budget films (UK Film Council 2009).

Distribution

Distribution has to do with the management of the release of films produced in order to earn revenue. The main function of the distributor is to convince the exhibitor in renting or booking each film after production. This is a value chain and it involves negotiation with exhibitors, sequencing of the various windows at which to screen the films, advertisement of the films produced and printing production of the films. However, there is also a weakness in this arm as most of the firms are dominated by the UK subsidiaries of American studios. As at 2008, these subsidiaries accounted for 78 per cent of the market power and the top distributors, numbering up to ten, were responsible for 95 per cent of the market share. The largest indigenous distributor in the industry in terms of gross box office is Entertainment Plc. It was responsible for 8 per cent of the market share in 2008. However, the distribution arm of the industry is taunted by audiovisual piracy, which contributed largely to most of the losses experienced by firms involved. The marginal profit encountered are as a result of retail sale of DVDs and showing on television, with the Video on demand (VOD) market relatively underdeveloped, contributing marginally to the total revenue.

The focus of this analysis is on the distribution aspect of the industry. Based on the characteristics of the sector, it is highly concentrated with few firms assuming a greater control of the market share. Unfortunately, this aspect of the British film industry has been given less attention in the past by state regulations, with more emphasis being given to production rather than distribution. However, the bulk of the profit generated in the industry is greatly enhanced by the activities of distributors as they are involved in the promotion and distribution of the work of the producers, helping achieve the full potential of the films. As stated earlier, this is because they act as intermediaries between film makers, exhibition outlets and the final audience. Due to their indispensable role, there absence in the industry would create a situation where there is neither reinvestment in film production nor the display of viable movies to the final consumers. Also, in their absence, the industry would be open to exploitation from external market, such as the domination in existence in the production aspect of the industry. There are several independent distributors who are UK-based operating in the sector and are basically divided into small and large independent distributors. Even though the large distributors are involved in the release of fewer titles in comparison with smaller ones, they still have control of the market share.

Exhibition

Exhibition has to do with the display of films to the final audience through theatre screening. The market is dominated by few large numbers, as is the case of the distributors, of firms. But these firms are not predominantly owned by foreign firms. In 2008, majority of the screens were controlled by firms; Odeon, Cineworld and Vue, two of which were owned by private equity firms.

Recent Development

Insert The industry contributed a total of GBP2.5bn to the economy in 2007, with production cropping up a large chunk of 48 per cent, distribution responsible 36 per cent and exhibition taking up the remaining 16 per cent. The industry also contributed to other aspects of the economy like exports and employment. In 2007, the balance of payment surplus accruing to the industry was estimated to about GBP232m. According to the Labour Force Survey conducted by the Office of National Statistics, there were over 35,000 jobs in the industry. There were over 7000 firms in the industry as at 2008 and these were mainly concentrated in the production arm of the industry. However, the concentration of activities in the distribution arm of the industry is concentrated in the hand of few.

The contribution of distributors to the industry, and ultimately to the economy, makes it interesting for a study into how they contribute to welfare loss and how vertical integration affects the accumulation of monopoly profits/losses.

Chapter 3

Literature Review

From previous studies carried out by researchers, there were mixed results as regards the loss in social welfare by firms trying to gain the bulk of the market share in various industries. In the case of Harberger, he found out that the loss of welfare in the United States is at 0.1 of 1 per cent of the Gross National Product (GNP) (Harberger 1954). This finding confirmed that the loss of social welfare as a result of monopolistic tendencies is insignificant. This idea was also backed by others, even with the use of varying assumptions. However, this was under attack by Bergson (1973) who criticised the partial equilibrium framework employed. Bergson employed the general equilibrium approach, which assumed that social welfare can be captured through a social indifference curve. According to Cowling and Mueller (1978), it was argued that such assumptions brings about discrepancy between the variations in the price cost margins and the supposed constant elasticities of demand (Cowling and Mueller 1978).

Thus, this analysis will employ the use of the partial equilibrium approach, following the work of Cowling and Mueller, which was based on the Cournot-Nash equilibrium approach. The next section deals with the brief review of oligopoly theories, the review of the model used, discussion of the complications of the Cowling-Mueller model, and how it affects the

industry.

Review of oligopoly theories

The main feature of an oligopoly is the reliance of firms on the actions of the others, which makes it difficult to assume the simple solutions of a monopoly or perfect competition. There are two main forms clearly distinguished under the classical oligopoly theory, both being majorly determined by either price or quantity (Tasnadi 2006). In order to study the oligopoly markets, economists make use of the game theory in modelling their behaviours. There is the Bertrand competition, which relies on the manipulation of prices as a way of competition. On the other hand is the Cournot – Nash competition, which describes the industry with oligopolistic tendency, as one in which companies compete on the amount of goods produced, with the assumptions of homogenous goods, no collusion, existence of market power, and rationality. There is no single model describing the workings of an oligopolistic market. This is because companies compete on varying platforms such as price, quantity, marketing, reputation, technological innovations, etc (Colander 2008).

The Bertrand model of oligopolies focuses on price. The model illustrates the interactions between the firm (one who sets the price) and the customer (one who chooses the quantity to buy at the price given by the firm). The working of the model is based on the assumptions that goods are undifferentiated, no collusion and prices are set at the same time. Given the rationality of consumers, they buy from the firm who offers the lowest prices and if all the firms give the same price, they choose the firms to buy from at random. Assuming there is no capacity restriction, if a firm raises the price of its goods, it becomes likely that such firm would lose most or all its customers. In the same light, if the firm reduces prices below its marginal cost, it would lose money on every unit sold (Binger and Hoffman 1998). Thus, under the Bertrand model, the equilibrium is where the price is equals to marginal cost, resulting in ‘zero-profit’ for the participating firms. However, relaxing the assumption of capacity restrictions results in a situation where equilibrium is not achieved.

The Cournot-Nash Model

While the Bertrand model focuses on price, Cournot-Nash model emphasises the importance of quantity adjustment. The model assumes the existence of Cournot conjecture; that firms compete based on quantity rather than prices and that the behaviour of firms are stable. Equilibrium is reached at a point where neither firm desires to change what it produces based on its knowledge on what other firms produces. This is regarded as the Cournot-Nash equilibrium (Kreps 1990). Traditionally, the model considers two firms with the assumption that their marginal costs are linear but not necessarily identical. Each firm is believed to have the ability to decide on the level to produce in other to maximize profit, given the output level of the other firm and this is called the reaction function. In the case of N-number of firms, overall industry production curve is based on the reaction functions of other firms with respect to what the market leader produces. As in the game theory, each firm decides on the best response function that helps maximize their profit, and if followed at all times results into the Nash equilibrium (Fulton 1997). In general, the Cournot theorem states that as the number of firms in the industry grows to infinity, it brings about competitive tendencies and pushes price towards marginal cost.

In perfect competition, allocative efficiency requires that prices to be set equal to the marginal costs of production throughout the economy. If firms are able to restrict output in order to maintain price above the marginal costs this leads to a misallocation of resources and loss of economic welfare. The monopolist is able to raise his price above the level of marginal cost, as he is a price maker. This situation can be compared with the benchmark case of perfect competition where firms are price takers and cannot sell any unit of goods produced at a price higher than the marginal cost and cannot earn supernormal/abnormal profits.

Fig 1: Welfare effect of Competition and Monopoly profits

Figure 1 compares the welfare effects or performance of perfect competition and monopoly. It depicts the neoclassical case against monopoly. Theorists have formulated the ‘welfare loss concept’ which measures the potential gain of a movement away from monopoly to perfect competition. The analysis shows the basic deadweight loss model used by Harberger (1954). In order to simplify the analysis, the assumption that costs are constant is used. If the industry is competitive, the firms cannot set price above MC (P=MC), thus the quantity produced is Qc. In figure 1, under perfect competition price would be at Pc and output Qc. Marshall stated that consumer surplus is the difference between what a consumer is willing to pay for a good and the amount actually paid for it. It is a measure of the benefits to a consumer of trading in a market. It is shown by the triangle between price and demand. Market demand is refered to as D (the amount consumers are willing to pay for an additional unit of the product). Thus, consumers pay a price Pc for all units purchased. Any marginal increase in output below Qc generates a difference between the price actually paid and the price consumers are willing to pay. This is the consumer surplus, represented by the larger triangle above marginal cost, depicting an absence of abnormal profit.

Given a monopoly facing an equivalent demand and costs conditions, the maximisation of profit may be achieved through output reduction, which is at a point where MC=MR. Here, the price shifts to Pm, thereby setting price above MC, and quantity produced falls to Qm. The triangle above Pm is referred to as the surplus due to consumers in a monopolistic setting. The shaded portion A in the diagram is the supernormal profit due for a monopoly, which signifies the redistribution of wealth from consumers to firms. Thus, the decrease in consumer surplus, as a result of a competitive entity moving to monopoly is represented by the addition of the two shaded portions A and B. However, the net social loss accruing as a result of the existence of monopoly power is represented by the shaded part B (Sawyer 1981). In the work of Harberger, he argued that this triangle is really tiny and is nothing to worry about. Posner, in describing the net social loss, stated that:

‘When market price rises above the competitive level, consumers who continue to purchase the sellers’ product at the new, higher price suffer a loss exactly offset by the additional revenue that the sellers obtain at the higher price. Those who stop buying the product suffer a loss not offset by any gain to the sellers. This is the “deadweight loss” from supracompetitive pricing and in traditional analysis its only social cost, being regarded merely as a transfer from consumers to producers’ (Posner 1975, pg. 807).

Complications of the Cowling – Mueller Model

Observing the mark-up of price on marginal cost helps define the implied price elasticity of demand with the assumption of a profit maximizing behaviour, which also applies to a colluding oligopoly or pure monopoly. Following the work of Cowling and Mueller (1978), in defining a firm’s implied elasticity of demand, assumed that welfare loss will be estimated from their cost margins.

(1)

where we have as the price elasticity of demand for the industry; as the price given by firm i; and as the marginal cost of firm i. The estimates derived would help explain the amount of welfare loss (the single firm’s decision to set price above marginal cost) realised from the reaction functions of firms. The assumption that each firm in the industry possesses some degree of monopoly power is employed and will be applied on a firm by firm basis. This enables them to charge prices higher than the marginal cost of production, given there is perfect competition. This is to help in estimating the relative importance of the variations in each firm’s outputs. This draws more light on the interdependence of observed price distortions (dp) and changes in output (dq), as seen in the work of Cowling and Mueller (1978). Based on this assumption, the welfare loss of the firms can be derived from the partial equilibrium formula for welfare loss; ½dpdq. In a situation where the firm’s expectations about the behaviour of other competing firms are borne out, it is assumed that

= and = =1. Hence the equations;

(2)

(3)

Following the assumption of constant marginal costs, monopoly profit term can be incorporated into the equation, thereby, resulting into

(4)

Harberger (1954) equated the elasticity of demand to be unitary, i.e. η = 1. This depicts that if dpi/pi is small, the social cost of monopoly would be insignificant. He argued that representing the elasticity of demand with a value of 1 was an attempt at compensating for the demerits of using a partial equilibrium measure of welfare loss to examine a structural change in the general equilibrium, and that this would not be so if individual firms cannot act as monopoly in terms of price manipulation. However Cowling and Mueller (1978) refuted this assumption by referring to it as ‘…a very awkward way of handling the problem which answers the criticisms raised by Bergson (1973) against the partial equilibrium approach’ as regards the interdependence of price distortions and change in output (pg. 730), even though their analysis was based on the so criticised partial equilibrium approach. Wenders (1967), as cited in Cowling and Mueller (1978), questioned Harberger’s position, but were erroneous in their calculations due to ignorance in assuming that the degree of collusion is a variable. Thus, the assumption of joint profit maximization need not be used. Based on this, there is need for proper definition of the methodology involving the partial equilibrium approach, so as to derive plausible estimates from it (to be done later on in this discussion).

In measuring the monopoly profits, the excess of actual profits over the long – run competitive returns (which are the profits that are compatible with the long – run survival in an equilibrium economy) is determined, after adjustment is made for the accommodation of risk, as in the case of Worcester (1973). He used a median profit rate of 90% in allowing for biasness: a rather ad hoc adjustment. The divergence of actual rates of profits and the mean rates was the root of monopoly profits in earlier studies, following that of Harberger. These studies treated industries whose profit is in the range of 5% above or below the mean profit as those that have created welfare loss. However, this will result in a downward biasness of the monopoly welfare estimate as it underestimates the level of monopoly returns. It is not feasible to lean one’s analysis on the premises of equal effects on welfare loss by monopolists and firms in perfect competition. Even if the assumption holds, the problem of how to handle firms experiencing loss would arise. Rather, it is plausible to argue that these firms are in disequilibrium and as such, have costs above the competitive levels. Hence, in deriving the social cost of monopoly, the firms experiencing loss will be dropped. This is in line with the work of Cowling and Mueller, who assumed that the firms would return to their normal profits or would disappear, thereby, creating no long – run loss to the economy.

The role of vertical integration

The effect of the firms trying to gain market power is also a contributory factor into the loss of social welfare. Vertical integration carves out niches for monopolistic possibilities in product and geographical areas. Vertical integration is divided into upstream (backward, deals with the production of basic inputs) and downstream (forward, deals with the production of finished or nearly finished products). When two or more operations are vertically integrated, there is a natural bias towards internal procurement of components even in the presence of inefficiency. Bounded rationality also has its role in the diseconomies effect of vertical integration. It would basically take place where it is mutually beneficial to do so and not necessarily when it is cheaper.

According to Greenhut and Ohta (1976), vertical integration does not increase integrator’s monopoly power, but rather, eliminates transitional twist caused by increasing mark-ups. Not only does it eliminate such distortions, it improves the provision of differentiated goods. Carlton (1979) assumes the prevalence of downstream over upstream in an integrated world. Hence, integration is socially undesirable since the downstream firms cannot absorb risk as efficiently as the upstream. The market is less to be contestable if integration is embarked upon by established firms. This is because the possibility of a potential entrant having the know-how and the economies of scale in the successive stages of production is very slim. There is likely to be sunk costs, which may be too expensive for the new entrant, thereby raising entry barrier. However, the ability to discriminate hinges on being able to identify groups of customers having different demand elasticities, then being able to prevent them from price discrimination. This firm structure helps to prevent leakages between markets if the collusive oligopoly, engaging in the upstream successive stage of production, integrates into one or more downstream markets, while still possibly allowing sales of the upstream product to unintegrated firms for specific uses (Waterson 1984).

In general, the vertical integration accrues to the firm benefits, which would not have been possible if independently functioning. Among the benefits are lower transaction costs, capturing upstream and downstream profit margins, reduction in uncertainty (i.e. there is always supply assurance), expansion of core competence and the ability to gain a considerable part of the market share. These benefits are supported by the existence of taxes and regulations of market transactions, economies of scale, and similarities between the integrated activities (Greaver 1999). According to Buzzel (1983), he argued that operating in an integrated basis results in the benefits being offset by costs and risks, among which he noted capital requirement, reduced flexibility, and loss of specialization.

Firms enjoying monopoly power would act to defend their market through entry barriers, which is a potential free – rider problem. Unless, the barriers to entry can be effectively coordinated, it would be difficult to derive a means of calculating above competitive profits. Given the unlikelihood associated with gaining monopoly profit without the expense of extra resource, it would be profitable to utilise extra resources to deter entry. Tullock (1967) and Posner (1975), as cited in Cowling and Waterson (2003), maintained that if the existence of competition for market power is granted by some authority and that the practice acquire real resource costs, it is possible that all the gains due on monopolistic tendencies may be frittered away in the struggle to obtain it. These resource costs may be in the form of excessive generation of advertising goodwill stock; involvement is excess production capacity and excessive costs on Research and Development by engaging in product differentiation. It was also believed that the efforts to acquire patent protection, tariff protection and other forms of unwarranted state treatment contribute significantly to welfare loss meted out by monopolies. So, Cowling and Muell