3.4.4 Oligopoly

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 the feature of price rigidity in depth in an oligopolistic market ( using game boy as an example)

Ooo okay so in an oligopolistic market there are 3 dominant gaming console companies, which means firms are interdependent. this means that if gamebox were to increase its prices other firms would keep their prices the same leading to a loss in profit for gamebox as consumers would go to rival firms due to similar products being sold. if gamebox were to decrease their prices other firms would do so customers do not flock to gamebox, which also reduces profit for gamebox. this increases the incentive for firms to keep prices rigid, as increasing or decreasing prices in an oligopolistic market leads to a loss in profit, which profit maximising firms such as gamebox do not want

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

Explain game theory and prisoners dilemma

So firms in an oligopolistic market face an almost identical situation to that of the prisoners dilemma. This is where firms do not know whether rival firms will increase, decrease prices or keep them the same, which can be represented with the game theory diagram. This represents firms' behaviour and interdependence in alot more detail compared to the kinked demand curve theory. So game theory is where firms a and b can set a high price which has greater snp, a low and high price which leads to the firm setting a low price having greater snp, or both setting a low price leading to reasonable snp for both firms. this is also called the nash equilibrium. now game theory and the prisoners dilemma are really useful because the help to explain the key features of an oligopoly which are price rigidity and the incentive to collude to set high prices to increase joint welfare due to increase snp, and the incentive to break collusive agreements or to engage in price wars for short term increases in snp.

What is Nash equilibrium?

The Nash Equilibrium occurs when both firms set low prices, because neither firm has any incentive to change its strategy. If one firm raises its price, the other will take advantage and make more supernormal profit, so the first firm would be worse off. If both firms raise their prices, they might lose customers to competitors. So, they both settle for the low price to avoid these risks.

Even though this Nash Equilibrium is stable (both firms keep their prices the same), it’s not the optimal outcome. If the firms colluded (worked together to set high prices), they could achieve higher profits. However, the fear of the other firm undercutting leads to a stable, but less profitable outcome.

This also leads to price rigidity because changing prices is risky for both firms. As a result, firms often compete on non-price factors like branding or quality instead of adjusting prices.

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