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What is the definition of an oligopoly?
The industry is dominated by a few (3-5) suppliers
What are the 5 characteristics of an oligopoly?
Few large sellers
High barriers to entry due to high sunk costs
Differentiated goods ( similar goods slightly different)
Interdependence- one firm’s actions will directly affect another firm
Short run profit maximisers
What is the definition of a market concentration ratio?
The percentage share of the market of a given number of firms
Why are concentration ratios useful to understand the degree of competition within an industry?
An industry where there is a high few firm concentration ratio has limited competition because there are few dominant firms in the market
What are the 3 criticisms over the usefulness of concentration ratios?
Difficult to define the market
Doesn’t take into account the size of different firms in the market
Explain the criticism of ‘difficult to define the market’
To be able to reach a meaningful conclusion about a firm’s market power using concentration ratios, need to be confident in determining what defines a firm as being in that market.
eg. 3 firms concentration of the sun the mirror and express would be different if you did or did not include the financial times
Explain the criticism ‘ doesn’t take into account the size of different firms in the market’
Two industries might have four firm concentration ratios of 80% but the way firms operate would be very different if the market concentration was split 50% 10% 20% 10% in one industry and 20% 20% 20% 20% in another industry
What is the Kinked Demand curve theory?
Because firms are interdependent, we would expect firms to respond when another firm changes its price. The kinked demand curve theory assumes that the way firms respond to another firm changing price depends on whether the price is increased or decreased. There will be an asymmetrical reaction to a change in price
How will other firms respond if the firm decides to reduce its price?
They will further reduce their prices to match with the original firm. They will do this in order to prevent their market share being eroded.
What impact does a reduction of price have for the firm which initially reduce its price?
Demand will not increase by much at all as other firms have cut their prices as well. This means demand is inelastic
Draw the kinked demand curve.
How will other firms respond if one firm decides to increase its price?
Other firms will not increase their price, knowing they can steal market share from their rival by keeping their prices the same
What impact does this have on the demand for the firm which initially increased its price?
The initial firm will lose a lot of demand to its rivals. Demand will be elastic, a small increase in price will lead to a significant reduction in QD.
Due to the average revenue curve being kinked, the marginal revenue curve is discontinuous which means that…
There will be a significant jump in marginal revenue between a small increase in price and a small decrease in price because of how sensitive a firm’s revenue will be to changes in its price due to fierce competition which exists in the industry
What happens to total revenue, when demand is inelastic, for price increase and decrease
(increase) Total revenue=( greater increase )Price (smaller decrease) Quantity demanded
(Decrease in) total revenue = (greater decrease in) price x (smaller increase in) qd
Draw a diagram displaying the average and marginal revenue curves in an oligopoly
Where will output be set on an oligopoly diagram and what is its level of profit?
Output set at where MC=MR
Supernormal profit is made due to high barriers to entry for other firms
Illustrate the market equilibrium for an oligopoly
What are the 4 features of an oligopoly (expected to know in detail)?
Collusion
Price Wars
Price Rigidity
Non-price competition
Define collusion.
Where firms make agreements between each other over prices and/or output to maximise joint welfare
Why will firms in an oligopolistic market collude?
They know that if they compete on price they will lose out on revenue thus want to avoid price wars at all costs. Colluding to restrict competition and keeping prices high allows all firms to earn higher profits.
What is the definition of overt collusion?
A formal agreement between firms
Explain overt collusion.
Where firms formally agree on how to act collectively. They are sometimes known as a cartel. This is illegal and anti-competitive behaviour
Define a cartel.
Where several suppliers are colluding together
Who does not like overt collusion and why?
The Competition and Market Authorities (CMA). This is because overt collusion avoids competition and increases prices which does not maximise consumer welfare
What are 2 examples of overt collusion?
When British Airways and Virgin Atlantic colluded to keep prices high, regulators noticed and started investigation. Virgin Atlantic whistleblew to the CMA and gained full immunity (protection from fines) and British Airways lost £270 million due to fines.
OPEC Oil cartel, example of countries colluding not firms. Have gotten away with collusion.
What is tacit collusion?
An unspoken agreement between firms to collude
Explain tacit collusion.
Informal agreements are reached to avoid being caught by regulators
One form of tacit collusion could be price leadership, where all firms follow the pricing strategy of one firm, often the most dominant firm in the market
What is an example of tacit collusion?
Asda and Tesco match each other for baked beans, milk and cereal
What are the 2 conditions for when collusion is most likely to hold?
Firms have similar costs so won’t have a natural advantage they can use to outcompete other firms
All firms in the industry are colluding together, meaning they do not have to respond to another firm outside the collusive agreement
What are the 3 types of price competiton?
Price Wars
Predatory Pricing
Limit Pricing
Define price wars and provide an example
When firms try to undercut each other with lower prices to steal other firms consumers.
Tesco and Asda have taken part in price wars, they cut baked beans down to 3p
Define predatory pricing and explain it.
Reduce prices under average variable costs to force out competition.
The short run shut down point is where AVC=AR
If prices are below average variable costs, then they are below the short run shut down point forcing firms out of the market as they cannot compete.
In the short run, the initial firm will make a loss but in the long run they will get rid of competition, increase prices again and take over the market
This is illegal, can only work with firms which can sustain the loss
Define and explain Limit pricing.
An incumbent firm sets prices low enough to limit new firms from entering the market.
The incumbent firm benefits from economies of scale, can reduce price, limits new firms from entering as they cannot compete.
Small new firms, do not benefit from economies of scale, higher prices, little sale, make no profit, stay out of market
Why does collusion break down and how does this lead to a price war?
Firms may be tempted to break collusive agreement and lower prices in order to steal market share from other firms and increase their SNP.
Price war will occur as if one firm reduces their price other firms have to respond with a reduction in price to avoid losing market share
Explain why an increase in marginal cost is unlikely to cause prices to increase?
Discontinuous portion of the MR curve, small rise in costs will be absorbed by the oligopolist in the form of reduced SNP. Firms would rather do this than risk disturbing equilibrium that has been reached
Define game theory.
Game theory explores the reactions of one player to changes in strategy by another player
What is Nash equilibrium?
where neither player is able to improve their position and has optimised their outcome based on the other player's expected decision. They have no incentive to change behaviour, unless someone else changes theirs.
Is an oligopoly productive, allocative, dynamic and X efficient?
Production (AC=MC) No, firms restrict output to keep prices high
Allocative (AR=MC) No, Firms collude to keep prices above the allocatively efficient levels
Dynamic Yes, Large SNP exist to invest in non price competition
X No, prices and output stay the same even if firms have different costs, X inefficiency may develop
Are these features for consumer welfare present
Low prices?
High quality products?
High levels of choice?
No, Firms collude to set high prices. But consumers do benefit from price wars if collusion breaks down
Yes, compete on non price factors, high snp= higher quality goods to increase brand loyalty
? Many firms to choose from but dominant firms produce similar products which makes firms interdependent, consumers do not have significant choice
What is the first advantage and disadvantage of an oligopoly?
If collusion breaks down consumers benefit from price wars
However, consumers will be exploited and charged high prices as a result of collusion
What is the second advantage and disadvantage of an oligopoly?
Likely to be significant innovation as firms enjoy market power through non price competition
However, there is productive and allocative inefficiency due to collusion
What are the 4 non price-competition factors?
Advertising
Loyalty cards eg tesco clubcard
Branding
Quality
