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Pazhanisamy, R.
Working Paper Limit Pricing Oligopoly Market: Evidence from Tamilnadu Politics
Suggested Citation: Pazhanisamy, R. (2019) : Limit Pricing Oligopoly Market: Evidence from Tamilnadu Politics, ZBW – Leibniz Information Centre for Economics, Kiel, Hamburg
This Version is available at: http://hdl.handle.net/10419/
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Limit Pricing Oligopoly Market Evidence from Tamilnadu Politics
R.Pazhanisamy
Assistant Professor of Economics
SET- Global Campus, Jain University- Bangalore, India
(E-Mail: pazhani.swamy@jainuniversity.ac.in)
ABSTRACT
Limit pricing oligopoly market is a hypothetical market explained with various hypotheses in the literature which has limited scope for the real world economic evidence and its application which leads the impact of the operation of such market is mostly unknown among the policymakers and academics. The available literature evidences are mostly neglected to explore the scope of such markets conditions and failed to direct appropriate policies.
In India among most of the national level parties and in the states levels there are two only have been surviving over the long periods. This trigger the intuition to inquire into answer the questions a) why the political market is appears to be an oligopolistic market? b) How it maintain the limit pricing policy to deter the entry of new? c) How the share the market? d) Are they collusive oligopolistic or non collusive? e) Are they price leadership oligopolist or not? f) How could they operate in the long run while some of them closed it even within the short run? Since there are very limited attempts only are available to answers this question. This calls for an enquiry by incorporating the micro economics theory with the political system. This paper is attempted to fill this gap in research.
Key Words: Limit Pricing Oligopoly, Oligopolitics, Breaking the Oligopoly Politics, Collusive and Non Collusive Politics, Entry Prevention in Politics
JEL Classifications: D01, D03, D43, D72, G18, H30, Q12, P
REVIEW OF LITERATURE
Andrew Sweeting, James W. and Robertsy Chris Gedge (2016) have studied about the dynamic limit pricing with an application to the airline industry and developed a dynamic limit pricing model where an incumbent repeatedly signals information relevant to a potential entrant's expected profitability. The model is tractable, with a unique equilibrium under refinement. The researchers shows that model provides a plausible explanation for why incumbent airlines cut prices dramatically on routes threatened with entry by southwest airlines by providing new evidence that incumbents sought to deter entry, showing that other suggested explanations are inconsistent with the data, and demonstrating that our model can predict the size of cuts observed in the data when we parameterize it to capture the main features of these routes.
Based on the Gini coefficient, Franco Modigliani 1958 suggest in his new developments on the oligopoly front that concentration had tend to increase the appreciation of the limit pricing over a period. Bhagwati, J. N., (1970) in his paper titled oligopoly theory, entry prevention and growth he highlighted about the various options of entry prevention price available to the established firms and justify how the firm will set the limit price to achieve maximum profit even in the short run.
Christopher Gedge, James W. Roberts and Andrew Sweeting (2014) has applied the limit pricing theory of oligopoly in the airline industry and the potential and actual entry on the distribution of the airline prices. By mathematically constructing the incumbent market by carrier and by constructing the market size, they have developed theoretical and empirical frameworks for analyzing a classic form of strategic behavior of entry deterrence by setting a low price.
Curwen P.J. (1976) in his contribution titled the role of entry in oligopoly: the theory of the firm he argued that the literature on entry has become very extensive over the years. Although the question of entry-preventing behavior was first raised by Kaldor, the main discussion arose out of the basic prediction of the model of monopolistic competition that firms would earn only normal profits in the long run, and that each firm would be operating with excess capacity. Harrod argued that firms would forgo some potential profit in the short run by setting a price lower level that which would maximize their profits in order to discourage new entrants into the industry. Subsequently, the discussion of the role of entry has largely evolved into an
attempt to provide answer to the question as to whether it is more profitable for a firm to maximize short-run profits in the knowledge that this will attract new entrants and hence erode the firm‟s market share in the long run, or for a firm to deter entry by holding down prices in the short run in the expectation that it will be able to retain a substantial share of the market over time.
Dale K. Osborne (1964) has argued about the role of entry in oligopoly theory and highlighted about the various types of barrier to entry. Pashigian, B. (1968) work titled limit price and the market share of the leading firm provides the detailed explanation of why the market share of the leading firm did not decline. He also noted that it may be more profitable in some cases to set the limit price and accept the entry and justifies how Bain and Modigliani have largely ignored the discrepancy between the limit price and the competitive price. David B Baron (1973) has investigated the effect of potential entry and barriers to entry on the price and profitability of the firm and proved the concept that the potentials to the entry will attract the new firms.
Eichner, A. (1974) studies about the determination of the mark-up under oligopoly and discussed bout the various cost conditions of the oligopolies by providing an extended micro economics theory of the oligopolistic firm with time horizon differentiating from the traditional micro economic theory.
Fisher, F. (1959) in his work titled new developments on the oligopoly front: cournot and the Bain-Sylos analysis reviewed the model presented by Modigliani and tested the importance implication of Sylos postulate. Frank Bass Ernan Haruvy Ashutosh Prasad(2006) in thier variable pricing in oligopoly market they stressed about how the oligopoly market as Price variability affects consumer sensitivity to price and product differences. This conclusion arises from two streams of literature. However, slight differences in behavioral specifications in the literatures were found to cause diametrically opposite pricing implications for firms. In the “payoff sensitivity” specification, as variability increases, consumer attention to quality and price differences falls. Hence, lower-quality, lower-priced firms can compete better.
George, K. (1968) analyzed bout the concentration, barriers to entry and rates of return. Using the leading companies in the industries and their concentration ratios he explained about the barrier to entry possibilities and the process involves in the setting of limit pricing.
deregulation will lead to overall high fare and high frequency combinations in areas of heavy demand with areas of low demand which left unserved. Secondly the deregulation will lead to distinct qualities being offered in different fares. In particular, high frequencies will be offered at high fares for those with high values of time, whilst low frequencies with low fares will be offered for those with low values of time.
Robert E. Hall (2008) has researched into the potential competition, limit pricing, and price elevation from exclusionary conduct and found that the implications of the modern analysis of limit pricing are ambiguous on this point. Modern dynamic models of potential competition recognize that incumbent firms may employ strategies that trade off some reduction in prices before entry to deter entry and thereby avoid the larger reduction in price that would occur upon entry of a rival. As a result, antitrust law should strategies that involve reductions in price relative to more static monopoly outcomes and be allowed even though they allow incumbent monopolists to sustain their market power for longer periods of time.
Salary Andrade De Sa and Julien Doubanes (2014) have studied about the limit pricing and the ineffectiveness of the carbon tax and interpreted the limit price more broadly than the entry price of a substitute that offers drastic substitution possibilities. Sometimes the backstop substitute needs to be developed and the falling limit price induced by the strategic oil producer, which destroys the oil demand after some lag.
Shepherd, W. (1973) in his work revealed ideas on the entry as a substitute for regulation reveals that how the entry of new firms can be conceptualized as the substitutes for the regulation of the market where the usual regulatory norms fails. He argued in favour of the new entry as it clears market imperfection through the competitions.
Susmita Chatterjee, Srobonti Chattopadhyay, Rittwik Chatterjee and Debabrata Dutta (2017) have studied about the public firm in mixed oligopolistic structure through theoretical exposition and found that the choice problem of a public sector firm is subject to additional on straints, vis a vis private firms. Profit maximization without constraint always produces better result than constrained maximization. State owned firm cannot charge a high price, so as to maximise profit. The social welfare maximization obligation restricts the profit. This is known as the problem of multiple objectives and sub optimal performance.
Sylos-Labini, P(1962) has explained about the oligopoly and technical progress through his limit pricing oligopoly model and suggest that the entry prevention price
is sometime may not be profitable in the short run and would be profitable in the long run.
Summing up the available theoretical and empirical literature it is found that there are very few attempts only made in respect to the application and the implication of the limit pricing theory which stimulates an intuition to inquire into finding the real world evidence and applications of the theory of limit pricing oligopoly in the market? With this backdrop this paper is attempted to fill this gap in research by interconnecting the economics theory of limit pricing oligopoly with the ongoing politics of Tamilnadu.
CORE IDEA OF THE THEORY
Limit Pricing is a pricing strategy the monopolist may use to stop entry. If a monopolist set its profit maximizing price (where MR=MC) the level of supernormal profit would be so high and will attracts new firms into the market. Limit pricing involves reducing the price sufficiently to deter entry. It leads to less profit than possible in short-term, but it can enable the firm to retain its monopoly position in long-term with high profitability.
For limit pricing to be effective, the monopolist needs to decrease the price to the point where a new firm will not be able to make any profit by entering the market. By discouraging entry, the incumbent firm is guaranteed an „easy life‟ and guaranteed high profits.
A large multinational may be willing to enter a market – even if it is unprofitable in the short-term. The large multinational can use its reserves and profit elsewhere to substitutes a loss of making entry. Rather than limit pricing, a firm may set the profit maximizing price, but then react when a new firm enters. Limit pricing will be more effective in industries with substantial economies of scale.
Integrating the Limit Pricing Theory of Oligopoly and Politics: A Theoretical Framework:
Bain formulated his „limit-price‟ theory in an article published in 1949, several years before his major work Barriers to New Competition which was published in 1956. His aim in his early article was to explain why firms over a long period of time were keeping their price at a level of demand where the elasticity was below unity, that is, they did not charge the price which would maximize their revenue.
- The entrants react on the basis of the current price they expect the price charged by the established firms to continue in the post-entry period.
- The established firms are aware of the threat of potential entry.
- The established firms can estimate correctly the limit price.
MODEL 1: BAINS THEORY ANT ITS RELEVANCE TO TAMILNADU POLITICS
The idea of the application of the bains model of limit pricing oligopoly to tamilnadu politics can be classified into the two sections as follows.
Case: 1: If there is No Collusion with the New
Assume that the market demand is DABD‟ with the corresponding marginal revenue is Dabm (Figure. 1). Assume further that the limit price (PL) is correctly calculated (and known both to the existing firms and to the potential entrants). Given PL, only the part AD‟ of the demand curve and the section am of the MR are certain for the firms. The part to the left of A, that is, DA is uncertain, because the behavior of the entrant is not known. Whether the firms will charge the PL or not depends on the profitability of alternatives open to them, given their costs.
Assume the LAC (which is uniquely determined by the addition of the LMC = LAC of the collusive oligopolist) is LAC 1. In this case two alternatives are possible. Either to charge the PL and realize the profit PLAdPc1 with certainty or to charge the monopoly price, that is, the price that corresponds to the intersection of LAC 1 = MC 1 with the MR. This price will be higher than PL (given LAC 1 ), but its precise level is uncertain post- entry. Thus the profits in the second alternative are uncertain and must be risk- discounted. The firm will compare the certain profits from charging PL with the heavily risk-discounted profits from the second „gamble‟ alternative, and will choose the price (PL or PM) that yields the greatest total profits. Given the entry-preventing price PC (^) l is defined, the alternatives choices are available to the established viz 1. To charge a price equal to PL and prevent entry 2. To charge a price below PL and prevent entry (this will be adopted if PM < PL). 3. To charge a price above PL and take the risks associated with the ensuing entry. It will choose the alternative which maximizes profit.
Case: 2: If Collusion Takes Place between Established and New Political Parties
With collusion assumed to take place between the established firms and the entrant the model would be even easier, however with collusion the whole D curve shifts to the left by the share which is allocated to the new entrant at each price. The new DD” curve is known with certainty at all its points, as a consequence of the collusion, and so is the corresponding m” which is revealed in the Figure. 2.
Assumptions:
- The market demand is given and has unitary elasticity. The product is homogeneous and will be sold at a unique equilibrium price. Every have their own method of doing politics called their technology.
- The technology consists of three types of plant small with a tiny capacity and a medium-size with a capacity of medium output and a large-size plant with a capacity of relatively bigger market share. Each firm can expand by multiples of its initial plant size only. There are economies of scale cost decreases as the size of the plant increases three cost lines corresponding to the sizes of the party.
- The price is set by the price leader who is the largest firm, with the lowest cost at a level low enough to prevent entry. The smaller firms are price-takers. Each one individually cannot affect the price. But collectively they may put pressure on the leader by regulating their output. The largest firm must set a price that is acceptable to all the firms in the market as well as preventing entry if the collusion takes place on the basis of the price leadership by low cost or dominant.
This is what happened in the state politics of Tamilnadu for the past few decades. Both the Dravida Munnetra Kazhagam-DMK and the Anna Dravida Munnetra Kazhagam- ADMK have been setting the entry prevention price by making collusion with the potential entrants like VCK, DMDK, PMK, and other small when ever political challenges arises. Since these small sized and other newly farmed parties like Makkal Neethi Maiyam and other are unknown about their market share they accept the collusion with the existing parties and accept very minimum numbers of seat offered by the existing ruling parties and face the elections.
It is to be noted that the new entrants cannot survive in the long run even if they own political power due to the limited financial allocation offered for them from the ruling parties. As a result they have to go in collaboration with the existing ruling parties. If they tend to become a new competition to the already existing parties they would never allow it and kick them out of the market by isolating and using the entry prevention price. For example offering of free products for all the households like TV, Grinder, Mixy, cattles like Goat and cow has not only detained the entry of the new in the state and also it prevent even the existing experienced like DMK to stay away from the market.
- There is a normal rate of profit in each industry.
- The leader is assumed to know the cost structure of all plant sizes, and the market demand.
- The entrant is assumed to come into the industry with the smallest plant size and have no capacity to adjust with loss.
- The established firms and the entrant behave according to Sylos‟s postulate which describes that the established expect that the potential entrant will not come into the market if he thinks that the price of post-entry will fall below his LAC and the new political entrant expects that the established firms will never change the policies in the post-entry period.
In addition to this assumptions specified in the theory the following additional and realistic assumptions are also to be required to understand the implications.
- For the sake of analysis there are assumed as the firms since they design and implement the public welfare policies. The markets for the supply of these products are of oligopolist since it has a few participation where as on the demand side it is perfectly competitive market with durable goods.
- Consumers of the political products and services or the nature of public are not rational but act upon the rational expectation hypothesis.
- Are designing the products and services to the public and receive the administrative power over the country for the long run as their rewards or revenue in addition to the influences.
LIMIT PRICING PRICE DETERMINATION OF POLITICS
The market share of the is measured through the seat they owned in the loc Saba and in the central Rajya Saba assembly in the form of number of members of the parliaments and the number of the (MPs and MLAs) that a have. More the number of MPs and MLAs more would be the political power and market share and vice versa. Similarly more the power they can compete independently in all assemblies and vice versa. It is said that the price is set by the largest, most efficient who are having high market share and it will set the equilibrium price which must be acceptable by all the firms in the industry, and should be at a level that prevent entry of new into the system. If the costs
at the level XLp + Xs = X and the price will fall to the minimum acceptable price of the entrant, that is, to a level just below Ps.
The LP is indirectly determined by the total output that the established firms will sell in the market. Given that in the long run price cannot fall below the cost of the least efficient firm, and that the entrant can enter only with the smallest least- efficient plant size, the leader can determine the output X at which all established firms use their plants up to capacity. He next determines the total quantity that the firms will sell in the industry XLp so as to prevent entry.
XL is such that if the entrant comes into the market with the minimum viable size, Xs, the total post-entry output (XLp + Xs) will just exceed X, and hence will drive price down to a level just below the AC of the entrant. Given XLp, the limit price LP is determined from the market-demand curve DD. The entrant will be deterred from entering the market because they know that if they enter they will cause the price to fall below his AC. Any output larger than XLp is entry-preventing. It should be clear that in Sylos‟s model all firms earn abnormal profits, which are increasing with plant size and there is an upper and a lower limit of the entry-preventing price and the equilibrium price cannot be higher than LP not lower than Ps.
In Sylos’s model the Determinants of the Entry-Preventing Price are:
(1). There is a negative relationship between the absolute size of the market and the limit price. The larger the market sizes the lower the entry prevention price. If there is a
dynamic increase in the demand, denoted by a shift to the right of the industry-demand curve, the effect on the price and the structure of the industry depends on the size and the rate of increase.
If the increase in demand is considerable and occurs rapidly, the existing firms will have to set lower price initially, in anticipation of the developments on the demand side, and build up additional capacity to meet the demand. If it failed build up capacity fast enough to keep up with the rate of growth in demand, and then entry from new firms or already established firms in other industries will take place.
If the growth of demand is slow, the existing firms will most probably be able to meet the increased demand by making appropriate reserve capacity the price will not be reduced.
(2). the elasticity of market demand is also negatively related to the limit price. The more elasticity of the demand is, the lower the price that established firms can charge without attracting entry. The detection of changes in the elasticity is almost impossibly difficult in practice, and the established firms will most probably not count (and plan ahead) on such uncertain changes in it. Thus if it change substantially, new large firms (established elsewhere) will enter into the market, since the existing firms will not be able to cope with such change, and the price will fall.
(3). the prices of factors of production, which, together with the technology, determine the total average cost of the political parties. Changes in factor prices affect all the firms in the industry in the same way. Thus an increase in factor prices will lead to an increase in the costs and the limit price in the industry. Similarly a reduction in factor prices will lead to a decrease in the limit price
DIFFERENTIATED OLIGOPOLITICS
Sylos extended his analysis to the case of differentiated oligopoly. Sylos argues that when the products are differentiated the entry-barriers will be stronger than in the case of homogeneous oligopoly due to marketing economies of scale. It seems to accept that advertising unit costs and possibly the cost of raw materials per unit of output are likely to fall as the scale of output increases. Hence the overall cost difference between the smaller and larger parties will be greater as compared to the homogeneous oligopoly case. Product differentiation, therefore, will reinforce the scale-barrier. Sylos‟s analysis of differentiated oligopoly lacks the rigors of his model of homogeneous oligopoly. He
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