2011

Arvind Gupta (Roll Number: ePGP-03-103

Indian Institute of Management Kozhikode

1/17/2011

Oligopolistic Competition: Telecom Industry

Ol i g o p o l i s t i c c o m p e t i t i o n - i n t r o d u c t i o n

Introduction

Oligopoly is a common market form. As a quantitative description of oligopoly, the four-firm concentration

ratio is often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such

collusion, this is known as a cartel

Main Assumptions of Oligopolistic Competition

Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue

equals marginal costs

Ability to set price: Oligopolies are price setters rather than price takers.

Entry and exit: Barriers to entry are high. The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms

Number of firms: "Few" – a "handful" of sellers. There are so few firms that the actions of one firm can influence the actions of the other firms.

Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits.

Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles).

Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic actors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and

demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price cost and product quality.

Interdependence: The distinctive feature of an oligopoly is interdependence.

Evaluation: The Realism of Oligopolistic Competition as a Model

There is no single model describing the operation of an oligopolistic market.[6] The variety and complexity of the models is due to the fact that you can have two to 102 firms competing on the basis of price,

quantity, technological innovations, marketing, advertising and reputation. Fortunately, there are a series of simplified models that attempt to describe market behavior under certain circumstances. Some of the better-known models are the dominant firm model, the Cournot-Nash model, the Bertrand model and the kinked demand model

Dominant firm model

In some markets there is a single firm that controls a dominant share of the market and a group of smaller firms. The dominant firm sets prices which are simply taken by the smaller firms in determining their profit maximizing levels of production

Cournot-Nash model

The Cournot-Nash model is the simplest oligopoly model. The models assumes that there are two “equally positioned firms”; the firms compete on the basis of quantity rather than price and each firm makes an

“output decision assuming that the other firm’s behavior is fixed

Bertrand model

The Bertrand model is essentially the Cournot-Nash model except the strategic variable is price rather than quantity.

Kinked demand curve model

According to this model, each firm faces a demand curve kinked at the existing price.The conjectural assumptions of the model are; if the firm raises its price above the current existing price, competitors will

not follow and the acting firm will lose market share and second if a firm lowers prices below the existing price then their competitors will follow to retain their market share and the firm's output will increase only marginally.

Case Study on Telecom Industry (Near to Perfect Competition)

Major Companies:

TELECOM IN INDIA:

The telecom services have been recognized the world-over as an important tool for socio-economic

development for a nation. It is one of the prime support services needed for rapid growth and modernization

of various sectors of the economy. Indian telecommunication sector has undergone a major process of

transformation through significant policy reforms, particularly beginning with the announcement of NTP

1994 and was subsequently re-emphasized and carried forward under NTP 1999. Driven by various policy

initiatives, the Indian telecom sector witnessed a complete transformation in the last decade. It has

achieved a phenomenal growth during the last few years and is poised to take a big leap in the future also.

Status of Telecom Sector

The Indian Telecommunications network with 621 million connections (as on March 2010) is the third

largest in the world. The sector is growing at a speed of 45% during the recent years. This rapid growth is

possible due to various proactive and positive decisions of the Government and contribution of both by the

public and the private sectors. The rapid strides in the telecom sector have been facilitated by liberal

policies of the Government that provides easy market access for telecom equipment and a fair regulatory

framework for offering telecom services to the Indian consumers at affordable prices. Presently, all the

telecom services have been opened for private participation.

Evolution of Telecom Industry in India:

1. The process of liberalization in the country began in the right earnest with the announcement of the New Economic Policy in July 1991. Telecom equipment manufacturing was delicensed in 1991 and value added services were declared open to the private sector in 1992, following which radio paging, cellular mobile and other value added services were opened gradually to the private sector.

2. In 1994, the Government announced the National Telecom Policy which defined certain important

objectives, including availability of telephone on demand, provision of world class services at reasonable prices etc

3. The entry of private service providers brought with it the inevitable need for independent regulation.

The Telecom Regulatory Authority of India (TRAI) was, thus, established with effect from 20th

February 1997 by an Act of Parliament, called the Telecom Regulatory Authority of India Act, 1997,

to regulate telecom services, including fixation/revision of tariffs for telecom services which were

earlier vested in the Central Government.

4. The most important milestone and instrument of telecom reforms in India is the New Telecom Policy 1999 (NTP 99). The New Telecom Policy, 1999 (NTP-99) was approved on 26th March 1999, to become effective from 1st April 1999

5. In the field of international telephony, India had agreed under the GATS to review its opening up in 2004. However, open competition in this sector was allowed with effect from April 2002 itself. There is now no limit on the number of service providers in this sector

6. Another major step was to set up the Universal Service Obligation Fund with effect from April 1,

2002. An administrator was appointed for this purpose. Subsequently, the Indian Telegraph

(Amendment) Act, 2003 giving statutory status to the Universal Service Obligation Fund (USOF) was passed by both Houses of Parliament in December 2003

7. Recognizing the potential of ubiquitous Broadband service in growth of GDP and enhancement in

quality of life through societal applications including tele-education, tele-medicine, e-governance, entertainment as well as employment generation by way of high-speed access to information and web based communication; Government has announced Broadband Policy in October 2004

8. The Indian Telecom Sector has witnessed major changes in the tariff structure. The

Telecommunication Tariff Order (TTO) 1999, issued by regulator (TRAI), had begun the process of

tariff balancing with a view to bring them closer to the costs. This supplemented by Calling Party

Pay (CPP), reduction in ADC and the increased competition, has resulted in a dramatic fall in the

tariffs. ADC has been abolished for all calls w.e.f. 1st October 2008.

Growth of Telecom Industry:

The number of telephones has increased from 54.63 million as on 31.03.2003 to 621.28 million as

on 31.03.2010. Wireless subscribers increased from 13.3 million as on 31.03.2003 to 584.32

million as on 31.03.2010. Whereas, the fixed line subscribers decreased from 41.33 million in

31.03.2003 to 36.95 million in 31.03.2010. The broadband subscribers grew from a meager 0.18

million to 8.76 million as on 31.03.2010.

Tele-density in the country increased from 5.11% in 2003 to 52.74 % in March 2010. In the rural

area teledensity increased from 1.49% in Mar 2003 to 24.31% in March 2010 and in the urban

areas it is increased from 14.32% in Mar 2003 to119.45% in March 2010.This indicates a rising

trend of Indian telecom subscribers.

Apart from the 200.77million fixed and WLL connections on March 2010 provided in the rural

areas, 570000 uncovered VPTs have been provided as on March 2010. Thus, 96% of the villages

in India have been covered by the VPTs. More than 3 lakh PCOs are also providing community

access in the rural areas.

Opportunities in Telecom Industry

India offers an unprecedented opportunity for telecom service operators, infrastructure vendors,

manufacturers and associated services companies. A host of factors are contributing to enlarged

opportunities for growth and investment in telecom sector:

· An expanding Indian economy with increased focus on the services sector

· Population mix moving favorably towards a younger age profile

· Urbanization with increasing incomes

Investors can look to capture the gains of the Indian telecom boom and diversify their operations outside

developed economies that are marked by saturated telecom markets and lower GDP growth rates.

Network expansion

800 million connections by the year 2012.

Rural telephony

200 million rural subscribers by 2012

Reduce urban-rural digital divide from present 25:1 to 5:1 by 2010.

Broadband

Broadband on demand is every village by 2012

Manufacturing

Making India a hub for telecom manufacturing by facilitating more and more telecom specific

SEZs.

Achieving exports of 10 billion during 11th Five year plan.

Research & Development

Pre-eminence of India as a technology solution provider.

Comprehensive security infrastructure for telecom network.

Tested infrastructure for enabling interoperability in Next Generation Network.

International Bandwidth

Facilitating availability of adequate international bandwidth at competitive prices to drive ITES

sector at faster growth.

ECONOMIC INDICATORS

CONCENTRATION RATIO:

In Economics the concentration ratio of an industry is used as an indicator of the relative size of firms in relation to the industry as a whole. This may also assist in determining the market form of the industry. One commonly used concentration ratio is the four-firm concentration ratio, which consists of the market share, as a percentage, of the four largest firms in the industry. In general, the N-firm concentration ratio is the

Percentage of market output generated by the N largest firms in the industry. Market forms can often be classified by their concentration ratio. Listed, in ascending firm size, they are:

Perfect competition with a very low concentration ratio

Monopolistic competition below 40% for the four-firm

Oligopoly above 40% for the four-firm measurement

Monopoly with a near-100% four-firm measurement

We are considering 5 telecom companies to calculate concentration ratio:

Conclusion:

The top four companies constitute almost 85. 39% of the market, thus showing a high concentration ratio; this implies the industry is dominated by top 5 players thus it shows a oligopolistic market.

H INDEX:

The Herfindahl-Hirschman index is the sum of the squared market shares of the 50 largest firms in the industry.

H = M12 + M2

2 + M32 + ... + M50

2

Where Mi is the market share of an individual firm.

Suppose there are a total of four firms in a specific industry. Three firms have a 20% share each and one

has a 40% market share, H = 202 + 202 + 202 + 402 = 2800.

The advantages of the Herfindahl index is that it reflects more firms in the industry and it gives greater weight to the companies with larger market share.

Properties of the Herfindahl index:

It is always smaller than 10,000. (In a monopoly the HHI is 10,000)

One can classify the competition structure of a market according to this ratio. o An H below 1,000 indicates a competitive market. o An H of 1,000 to 1,800 indicates moderate competitive. o An H above 1,800 indicates uncompetitive.

S No Company Name % Market Share

1 Bharti Airtel 22.11

2 Vodaofone India 17.25

3 Idea Cellular 11.02

4 Aircel 6.18

5 Tata Teleservices Ltd 11.2

6 Reliance Communication 17.63

Total 85.39

If all firms have an equal share, H = N x (1/N)2 = 1/N. Note that the reciprocal of the index shows the number of firms in the industry.

When the firms have unequal firms in the industry, the reciprocal of the index indicates the

"equivalent" number of firms in the industry. Using the above example, the market structure is equivalent to having 10,000/2,800 = 3.57 firms of the same size.

In the telecom industry let us calculate the H Index:

Since H Index is 1382.3 indicates moderate competitive atmosphere where it had been dominant by 6 players which constitutes about more than 85% of the market share. This concludes and gives more appropriate answer that Telecom industry in oligopolistic market as it satisfies the condition for the same

as below:

Major there are Few Sellers (Listed Above as 6 of them having major market share) They mostly provide identical products with some modification in services It is difficult to enter the market as it requires huge investment and volume is the major

chunk for profit earning

S No Company Name % Market Share Square of Market Share

1 Bharti Airtel 22.11 488.8521

2 Vodaofone India 17.25 297.5625

3 Idea Cellular 11.02 121.4404

4 Aircel 6.18 38.1924

5 Tata Teleservices Ltd 11.2 125.44

6 Reliance Communication 17.63 310.8169

Total Herfindahl index 1382.3043

SYNOPSIS OF THE DEMAND AND SUPPLY

SITUATION: This part provides a simple picture of the demand and supply situation in India to illustrate some of the

conditions prevailing in the market. The main points that emerge here are: Excess demand in the form of network congestion implies that the customers are not on the

aggregate demand curve for the telecom service in question. Also, it is not clear which price will

bring the customers to the desired demand curve. Hence, it would not be appropriate or easy to rely on pricing or mark-up based on demand.

The fluctuations in prices are unlikely to affect overall demand, except in areas where the supply constraint does not apply.This supply constraint does not apply.

Since supply rather than demand is the main constraint, it would be useful to focus on increasing the supply of the network. This can now be feasible due to increased deregulation and increased FDI in the industry.

Such a focus on investment is even more meaningful in a situation with excess demand in the form

of a waiting list for connections, and where considerable additional demand is anticipated to arise in the future. For instance, in the next five years, the anticipated demand will be more than double the current network size.

Since there is likely to be such a major increase in demand, and it is not yet clear when the supply

will increase enough to meet this demand, determining the demand curve is not an easy task. Even if supply increases enough to cater to the additional demand, the fact that demand is

increasing at a rapid pace implies that the determination of the extent and nature of demand will not be an easy task. This will be further complicated by the new products that are emerging in the

market.

The Figure below shows a simplified picture of the demand and cost situation relevant to telecom pricing. DD is the demand curve for a basic telecom service, MC is the marginal cost curve, and AC is the average

cost curve. For simplification, marginal costs are shown to be the same for each unit of output. Since fixed costs do not change with a change in the output level, the average total costs (comprising average fixed and marginal costs) will be above marginal costs, but declining.

In the Figure above, the level of output Q0 is the level at which price is equal to marginal cost (i.e., the point of intersection of the demand curve and the marginal cost curve). It is evident that the price does not cover costs at that level because the average cost is above the price level. The Ramsey rule suggests the extent

to which the price should be increased to obtain the revenue that would cover costs and provide an adequate return. The Ramsey rule requires that the prices be those given by the demand curve, i.e. there should not be any constraint for the customer to be operating on the demand curve. In the Indian situation, however, there is likely to be a capacity constraint and thus the customers are

unlikely to be on the demand curve. The capacity constraint in India arises for two reasons. One, the subscribers linked up to the network face congestion and are thus not able to make as many completed calls as they desire. Second, the existing network does not satisfy the demand of all those wanting to be linked up to the network. The first type of constraint (i.e. congestion) implies that the supply constraint

shown by SS is the operating schedule for the subscribers.

EXCESS DEMAND AND CONGESTION:

MC is the marginal cost curve and DD is the demand curve. The congestion in the network due to a

capacity constraint is reflected by the vertical line SS. The output Q1 corresponding to the vertical line shows the supply beyond which the volume of traffic cannot be increased (Technically, with increasing congestion, the vertical line could move to the left, thus showing decreasing capability of the network with a rise in congestion).

The fact that there is congestion is diagrammatically illustrated by the fact that the actual demand for the product is more than the capacity. With congestion, the customer is somewhere on the vertical line SS and not on the demand curve. The excess demand is shown by the horizontal distance between the vertical line SS and the demand curve. Therefore, the actual price is somewhere lower than P1.

For a proper implementation of the Ramsey rule, the point of reference from where the movement for mark-up has to occur is the point where the demand curve intersects the marginal cost curve, i.e. point R in the diagram above. In a situation with congestion, the starting point itself is away from the Ramsey reference point, and the position of this starting point is dictated by the available capacity. Furthermore, the position of

this capacity constraint for different types of services (or demand) might be different, and it is highly unlikely that these constraints are positioned in such a way that the Ramsey rule for mark-up could be satisfied for different services.

The fact that the price is above marginal cost means that some mark-up already exists. Any change in the mark-up (due to a change in price) will not affect the level of demand as long as the customers face a capacity constraint, i.e. as long as they are on the vertical line SS above. Thus, in effect, the elasticity of

demand for each service with a capacity constraint is the same, i.e. it is equal to zero on SS.

OVERALL EXCESS DEMAND:

The fact that there is overall excess demand due to congestion does not mean that such congestion operates everywhere. Thus, the situation would comprise those who do not face any supply constraints and others who face a supply constraint in certain parts of the country. This is shown by the two demand curves above, D1D1 and D2D2. Only D2D2 is subject to a supply constraint, and thus a change in price will affect

the overall level of demand of those in situations D1D1 and not of those in situation D2D2. However, the presence of a supply constraint does reduce the elasticity (or responsiveness) of the overall demand for the telecom service.

EXCESS DEMAND FOR TELEPHONE CONNECTIONS: There is considerable excess demand for telephone connections in India, and this demand is expected to rise sharply in the near future. The Department of Telecommunications has estimated that in the next five

years, demand for telephones is likely to more than double. While capacity extension will continue to try to cater to this demand, this situation adds to the difficulty created by the abovementioned capacity constraint in using the demand situation in India to assess the telecom price or the mark-up.

In the Figure above, an expansion of capacity is shown by a rightward shift of the vertical line S1S1 to SS.

This capacity expansion results in meeting the excess demand of those who were on the waiting list. The waiting list is shown by the difference between the demand curves D1D1 to D2D2. To this must be added the increase in demand over time.Adding these would give us the new demand curve as D4D4. The effect of these changes on the excess demand situation (or on congestion) would depend on the extent of the

change in capacity and the extent of prevailing excess demand and the increase in demand over time. If those demanding a link-up with the network are not provided the link-up, then the actual demand at D3D3 will be to the left of D4D4. The difference between D3D3 and D4D4 shows the demand in waiting. Moreover, if there continues to be congestion for those linked up to the network, we are again in the same

situation as the one discussed earlier, i.e. the consumer is likely to be on the supply constraint and not on the demand curve.

Even if the customer is not subject to the supply constraint, it may not be feasible to apply the Ramsey rule as long as the desired price is to the right side of the supply constraint. Moreover, when the link to the

network is increasing as rapidly as 20 per cent per annum, and excess demand still continues to prevail, it is very difficult to estimate demand characteristics accurately or to use the demand curve for pricing telecom.

WHEN THE PRICES DECLINE: With a capacity constraint, the decline in price would take place without any change in the level of existing

demand. On the other hand, if there isno capacity constraint, then the fall in price would take place along the demand curve. In this case, the short-term effect on revenue would depend on the elasticity of demand. However, if the price decline increases demand to such an extent that the capacity constraint becomes binding again, then the elasticity of demand becomes irrelevant in calculating the change in revenue. This

is shown in the diagram below. The starting point is price P1, and two different demand curves are considered, with different elasticities of demand. At price P2, the supply constraint becomes binding for demand curve D1D1, and at price P3 it becomes binding for demand curve D2D2. At prices lower than P3, the comparison of the old and the new levels of revenue does not depend on the elasticities of the demand

curves.

Conclusion:

With the overall discussion in the previous slides it indicates that Telecom Industry is the oligopolistic Market and it is having the huge potential to grow further. 6 firms as indicated constitute 85% of the market share in the current scenario. There is one word that telecom companies are hearing a lot these days-

“Volumes”. As of today, the trend seems favourable toward the continued growth of the telecom industry. The target of 800 million telephone connections by the year 2012 is very much achievable. Even with 500 million telephone connections, the tele-density of the country is only about 52% percent. It has been noted that mobile telephony is growing at an annual rate of over 90 percent. Also, on an average over eight

million subscribers are being added every month. Besides the basic telephone service, there is a huge potential for different Value Added Services (VAS). In fact, the real potential for telecom service growth is still lying untapped.

BIBLIOGRAPHY

www.trai.gov.in

www.coai.com

www.dot.gov.in

Google search engine