Question

In oligopoly we have a "few" firms and hence we do not reap all the benefits of perfect competition. The other side of the coin is an industry in which there are an excessive number of sellers. Explain the consequences of this situation

Short answer

An industry with an excessive number of sellers, also known as a highly fragmented market, can lead to lower prices due to intense competition. However, it also results in market inefficiency, as resources may not be optimally allocated, and firms may struggle to differentiate their products. Furthermore, the inability to achieve economies of scale can lead to higher costs and prices for consumers. Additionally, smaller firms may be less inclined to innovate due to limited resources and concerns about competitors copying their work, slowing overall industry progress. Lastly, lower and more volatile profits can create market instability, with smaller firms struggling to survive, potentially resulting in market consolidation over time.

Step-by-step solution

Introduction: Excessive number of sellers

An industry with an excessive number of sellers is referred to as a highly fragmented market. This market structure is characterized by having a large number of small firms, each with a negligible market share. In this type of market, firms engage in intense competition, which often leads to several consequences.

Consequence 1: Lower prices

When there are an excessive number of sellers in a market, increased competition often leads to lower prices. Each firm tries to attract customers by offering their products or services at a lower price than their competitors. As a result, consumers typically benefit from more competitive prices.

Consequence 2: Market inefficiency

An excessive number of sellers can lead to market inefficiency, as resources may not be optimally allocated. In a highly fragmented market, there may be redundancies and an overabundance of firms offering similar products or services. This can lead to a waste of resources and, in some cases, make it difficult for consumers to differentiate between products.

Consequence 3: Reduced economies of scale

In a market with an excessive number of sellers, firms are often too small to achieve economies of scale. Economies of scale occur when a firm's cost per unit of output decrease as its output increases. When firms are unable to take advantage of economies of scale, they may be less efficient, which can lead to higher costs and ultimately higher prices for consumers.

Consequence 4: Lack of innovation

In an industry with a high degree of fragmentation, firms may be less inclined to innovate. Smaller firms may lack the resources to invest in research and development or may worry that their innovations could easily be copied by competitors. This lack of innovation can slow the overall progress in the industry.

Consequence 5: Market instability

In markets with excessive competition, profits are usually lower and more volatile. This can lead to market instability, as smaller firms may struggle to survive in such a competitive environment. Over time, this may result in market consolidation, as larger, more stable firms acquire or drive out smaller competitors. In conclusion, while an industry with an excessive number of sellers can lead to increased competition and lower prices, it can also have several negative consequences, including market inefficiency, reduced economies of scale, a lack of innovation, and market instability.

Key concepts

Oligopoly

Oligopoly is a market structure characterized by only a "few" firms dominating the market. These firms hold significant market power, which means they influence prices and other market outcomes. Unlike perfect competition, where many firms are price takers, an oligopoly allows its few dominant firms to be price setters. This occurs because each firm's actions can significantly impact its competitors. Therefore, firms in an oligopoly are interdependent and often make strategic decisions by considering the potential reactions of the few other players in the market.

One key feature of oligopolies is barriers to entry. High barriers protect the dominant firms from new competitors entering the market. These barriers can include things like significant start-up costs, access to essential technologies, or control of critical resources. As a result, consumers may face fewer choices and potentially higher prices compared to more competitive market structures.

• Interdependence among firms
• Barriers to entry
• Potential for collusion or cooperation

Perfect Competition

Perfect competition is a hypothetical market structure used as a benchmark to assess other market compositions. It features many buyers and sellers, all produce identical products with no single firm able to influence market prices. In a perfectly competitive market, every participant is a price taker. This means they accept the market price, set by supply and demand, without having any power to change it.

These markets have several characteristics that promote efficient resource allocation. Firms enter and exit the market freely based on their performance, ensuring that only the most efficient producers survive long-term. Consumers benefit from lower prices and high-quality products, as outdated or inefficient practices lead to losses for those unable to compete.

While perfect competition may not exist fully in reality, it serves as a model illustrating the effects of intense competition:

• Free entry and exit
• Identical products
• No single price maker

Fragmented Market

A fragmented market occurs when there are a large number of small firms, each with only a minor share of the market. In this scenario, no single firm has significant power to influence market conditions, making it the opposite of a concentrated market structure like oligopoly. This high degree of competition can lead to intense rivalries among firms, often reducing profit margins as companies compete aggressively for customers.

Fragmented markets can sometimes benefit consumers through lower prices and increased choices. However, they can also lead to market inefficiencies because many smaller firms fail to optimize resource use. These firms often struggle to achieve economies of scale, meaning they can't take advantage of reduced costs per unit through larger production volumes.

• High number of small firms
• Low individual market power
• Potential market inefficiency

Economies of Scale

Economies of scale refer to the cost advantage experienced by firms when they increase the level of production. This principle holds that as businesses grow in size, their unit costs generally decrease. Larger firms can spread fixed costs over a more substantial number of goods, negotiate better terms with suppliers, and use more efficient production techniques.

Economies of scale can be particularly vital in competitive markets. They allow companies to lower prices and strengthen their position relative to smaller, less efficient competitors. On the flip side, in fragmented markets with many small players, reaching these efficiencies can be challenging. The inability to leverage economies of scale often leads to inefficiencies and higher per-unit costs, which can hurt both the firms and their customers.

• Cost decreases with increased production
• Efficiency through scale
• Impact on market competitiveness

Market Inefficiency

Market inefficiency arises when resources are not used in the most economically optimal way. In fragmented markets, where many small firms compete, inefficiency might occur due to the over-proliferation of similar products, leading to wastages and redundant operations. This scenario means businesses may not fully utilize available resources, leading to higher costs and reduced overall market performance.

Often, inefficiencies beget challenges such as difficulty in product differentiation, as many firms offer similar products without significant innovation. Moreover, inefficient markets can cause volatility and instability because numerous small entities may struggle to sustain operations in the face of aggressive competition, sometimes leading to market consolidation.

Understanding and identifying market inefficiency is essential for improving economic productivity:

• Resource misallocation
• Wastage and redundancy
• Volatility and instability risks