3.3.3.5 - oligopoly

assumptions of oligopoly

-small number of large firms

-high barriers to entry/exit

-differentiated or homogenous products

-mutual interdependence

-firms are price MAKERS

barriers to entry - EOS

EOS is very large in oligopolies, and a few firms operating at lowest AC can satisfy consumer demand. therefore, new firms are likely to produce less and have much higher AC.

barriers to entry - limit pricing

when firms set a low enough price to discourage new entrants - they can do this because they are still able to make normal profit even by charging a lower price.

barriers to entry - patents

a patent is an exclusive right to an invention.

patents can prevent competitors from making a product for a given number of years after its invention.

firms can charge high prices to gain greater profits when they are protected from competition by patents.

barriers to entry - branding

large firms can place high entry barriers through high spending on advertising/marketing.

consumers associate a certain type of good with the firm's product, creating brand loyalty and therefore making it difficult for new firms to enter & compete.

barriers to entry - sunk costs

costs that cannot be recovered if a firm leaves the industry, eg. advertising costs, cost of redundancy, selling inventory/land/capital. also acts as a barrier to exit.

barriers to entry - legal

law may give firms privileges, eg. exclusive rights to the production of a product, making it possible for the oligopolists to maintain dominant market position

interdependence of firms - game theory

game theory states that, if firms can collude, they will raise prices and profits together at the expense of customers (nash equilibrium).

however, they need to be able to trust each other in knowing that the other will not undercut them by keeping prices low to attract more customers.

interdependence of firms - reasons for collusive behaviour

firms in an oligopoly have an incentive to collude as they can fix output at a level that would maximise profit. by restricting output, they can gain supernormal profit.

it overcomes the uncertainty of other firms' market behaviour.

they can avoid price wars that would decrease profits by colluding.

formal collusion & price agreements

overt/covert agreements to limit competition, like sharing contract work or agreeing not to sell in certain areas. they may come to a price agreement, where they fix prices for their products.

formal collusion is illegal in many countries, so firms wanting to collude have to hide it from authorities.

tacit collusion & price leadership

when firms do not make any formal agreements but monitor each other's behaviour and develop unwritten rules that become custom among them.

can be seen in price leadership, where the dominant/largest firm sets a price that the smaller firms follow. price leader makes abnormal profit, and allows the followers to gain more profits than they would have in a competitive market.

interdependence of firms - cartels (& conditions of cartels)

method of formal collusion where firms agree to limit output so they can raise prices. regular meetings are common. several conditions must apply for a cartel to work:

- agreement: easier in smaller, more mature industries rather than larger ones that are rapidly changing, as it is more likely for at least one main firm to refuse

- preventing cheating: once a collusive agreement is set, it would be easy for a firm to cheat by selling slightly below the cartel price/supplying more than agreed quota. however, if all firms do this, the price will decrease to free market level and nobody will earn abnormal profit.

- restricting competition: supernormal profit will encourage new entrants, so the cartel may agree to increase barriers to entry. incumbent firms not in the cartel can follow cartel rules to earn abnormal profit themselves.

interdependence of firms - price wars

occur when non-price competition is weak, firms are interdependent & competing with each other. drive prices down to levels where the firms are making losses.

in the short run, firms stay in the market as they are meeting AVC. in the long run, prices rise as demand rises or supply falls due to firms leaving the market.

costs/benefits of collusion to producers

BENEFITS

- charge a higher price, leads to higher profits

- markets will be less competitive, firms spend less on advertising and so reduce costs

COSTS

- firms cannot increase sales as much as they want under collusive agreement, restricts ability to increase market share

- sales revenue will be lower due to quota

- EV: prices will still be higher than without collusion, so profit may still be higher than without collusion

costs/benefits of collusion to consumers

BENEFITS

- see more market stability as firms less likely to leave

- consumer confidence will rise

COSTS

- higher prices, less output to purchase

- restricted competition = less market choice, consumer preferences are less important to firms

costs/benefits of collusion to workers

BENEFITS

- stable output of products, less likely to lose jobs from firm going bankrupt

- abnormal profits can fund possible wage increase

COSTS

- restricts movement of labour due to fewer firms in the market

costs/benefits of collusion to the government

BENEFITS

- higher tax revenue from higher firm profits

COSTS

- less competition leads to firm inefficiency, unlikely to be productively/allocatively efficient

price competition - predatory pricing

when a firm sets an artificially low price to drive away competition, usually at a loss and below the other firm's cost of production.

short run P < AC, long run P increases due to reduced competition

non-price competition - advertising/branding

builds a strong image through branding, encourages consumer loyalty as they feel reassured about the quality of products. makes it more difficult for new firms to enter the market.

non-price competition - quality

a firm that is known for good quality may be able to charge higher prices by standing out, and is likely to have strong brand loyalty.

they are likely to have a good reputation and benefit from positive recommendations.

non-price competition - endorsement

firms pay famous people to use their products/feature in advertising, encouraging consumers to have faith that the brand is good quality, leading to brand loyalty and higher sales

non-price competition - product placement

develops consumer awareness of brands in target market by featuring them indirectly in the media

non-price competition - after-sales service

some firms offer after-sales service so consumers prefer to buy from them rather than a firm only offering the required guarantee by law, encouraging customer loyalty and word of mouth promotion

ensures firm's position in oligopoly by retaining customer base and attracting new customers

costs/benefits of non-price competition - firms

BENEFITS

- if PED elastic, higher revenue because loss in revenue from lower prices are made up by higher proportionate increase in sales

- non price comp. increases sales & sales revenue by attracting customers

COSTS

- non price comp adds to firms' costs, reducing profitability

costs/benefits of non-price competition - consumers

BENEFITS

- lower prices (but possibly not same product quality)

- reassures consumers the goods they buy are reliable and good quality

COSTS

- prices remain high if there is only non-price competition, reduces consumer surplus

costs/benefits of non-price competition - employees

BENEFITS

- higher sales make jobs more secure

COSTS

- if firms earn less revenue due to price competition, costs are reduced by lower wages which impacts workers negatively

- particularly if there are only few firms in market as mobility of labour is reduced

costs/benefits of non-price competition - suppliers

BENEFITS

increases sales if firms' goods do well due to lower price

COSTS

- may be pressure on suppliers to reduce prices for oligopolists or make goods of a certain quality which would increase costs for supplier as they would need to use more specialist manufacturing