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what are most markets?
imperfectly competitive
what are concentrated markets?
most markets are this
dominated by few suppliers
what is market conduct?
how oligopolistic firms behave in order to achieve their objectives
what two key characteristics of its market structure must an industry have to be called ‘oligopolistic’?
supply in the industry must be concentrated in the hands of relatively few firms
firms must be interdependent
supply in the industry must be concentrated in the hands of relatively few firms
e.g. an industry where the three largest firms produce 80% of output would be oligopolistic.
note that alongside a few very large producers there may also be a much larger number of very small firms, so an industry with 100 firms, where the three largest firms produced 80% of the output, would still be classed as oligopolistic.
firms must be interdependent
the actions of one large firm will directly affect another large firm.
in perfect competition, firms are independent.
if one farmer decides, for instance, to grow more wheat, that will have no impact on price or sales of other farmers in the industry.
in oligopoly, if one large firm decides to pursue policies to increase sales, this is likely to be at the expense of other firms in the industry.
one firm is likely to sell more only by taking away sales from other firms.
interdependence → firms will face uncertainty.
they don't know how other firms will react if they change their competitive strategy, such as changing their price or their mix of products.
what other characteristics are economists interested in of oligopolistic markets?
are there barriers to entry in the market?
are products differentiated?
barriers to entry
assume oligopolistic markets have high barriers to entry and exit
product differentiation
if so, then each firm sells slightly different products.
e.g., car manufacturers all sell cars but each produces unique models of car which normally cannot be bought from another manufacturer.
however, in some highly concentrated oligopolistic markets where firms are interdependent, they sell identical, homogeneous products.
non-collusive/competitive oligopoly
occurs when oligopolistic firms may compete against themselves
what is the disadvantage of non-collusive oligopoly?
but there is a strong incentive for oligopolistic firms to collude → they make agreements amongst themselves so as to restrict competition and maximise their own benefits.
when is collusive oligopoly said to exist?
when oligopolistic firms collude
benefits of collusion
by restricting output → higher prices and higher profits
when does overt/formal collusion exist?
firms make agreements amongst themselves to limit competition.
e.g., two firms in a market may share out new contract work between themselves or agree not to sell in certain geographical areas.
they may come to a price agreement where they fix prices for their products.
when does a cartel exist?
when there is a wide-ranging agreement amongst several firms in a market
type of overt collusion
firms typically agree to limit their output in order to raise prices.
production limits need to be agreed.
regular meetings to discuss issues and problems are another feature of cartels.
what is the most famous cartel today?
not made up of firms but of countries
OPEC (Organization of the Petroleum Exporting Countries)
a group of oil-producing countries that today sell less than half of world output of oil but have more than half of the world's known oil reserves.
OPEC attempts to manipulate the world price of oil by restricting supply.
countries are given production quotas that are renegotiated every six months at OPEC meetings.
what conditions must apply for a cartel to function effectively?
an agreement has to be reached.
likely to be easiest in oligopolistic industries where only a few firms dominate the market
the larger the number of firms, the greater the possibility that at least one key participant will refuse to collude.
is also likely to be easiest in stable, mature industries where no single firm has recently been able to gain advantage by pursuing aggressive competitive strategies.
e.g., collusion is far more likely in a mature industry like steel manufacturing or cement making than in a rapidly changing industry like the computer industry.
cheating has to be prevented.
once an agreement is made and profitability in the industry is raised, it would pay an individual firm to cheat so long as no other firms do the same
e.g., it would pay a small cartel producer with 10% of the market to expand production to 12% by slightly undercutting the cartel price.
the profit it would lose by the small cut in price on the 10% is more than offset by the gain in profit on the sale of the extra 2%.
however, if every producer does this, the market price will quickly fall to the free market level and all firms will lose the privilege of earning abnormal profit.
potential competition must be restricted.
abnormal profits will encourage not only existing firms in the industry to expand output but also new firms to enter the industry.
firms already in the industry which don't join the cartel may be happy to follow the policies of the cartel in order to earn abnormal profits themselves.
to prevent this, cartel firms could agree to drive other firms which compete too aggressively out of the market.
cartel firms could also agree to increase barriers to entry to the industry.
what happens when a distinction is made between overt and covert collusion?
both become types of formal collusion
what is overt collusion?
occurs when the collusion is open for everyone to see
e.g. OPEC
why do firms wanting to create a cartel or collude in some other way have to collude covertly, or in secret?
collusion is illegal in most countries including EU countries and the USA
covert collusion
designed to be hidden from legal authorities
most used formal collusion
tacit or informed collusion
exists when there is still collusion but firms do not make any formal agreements about cooperating together.
instead, firms monitor each other's behaviour closely. Unwritten rules are developed which become custom and practice, defining ways in which firms may or may not compete
price leadership
form of tacit collusion
when one firm in the market sets a price that other firms in the market follow.
the price leader is often the largest firm (dominant firm) in the market and the price followers, the smaller firms in the market.
the firms in the industry effectively collude to maximise their profits.
the price leader sets a price that allows it to earn abnormal profit but at the same time also allows price followers to earn a higher profit than would be the case if competition broke out in the market.
what other forms can tacit collusion take?
e.g. an unwritten rule in a market may be that firms do not try to take away existing customers from other firms.
or there may be an understanding that advertising expenditure should be kept low.
game theory
considers what would be the outcomes if two or more players were interdependent and made certain choices.
prisoner’s dilemma
Two individuals have committed a crime together and have been arrested.
They are kept in separate cells.
Each prisoner knows that there is enough evidence to convict them on a related minor charge for which they can expect to serve six months in jail.
However, they have been arrested for a more serious offence.
The police offer each prisoner a deal.
If they confess and implicate their fellow prisoner, they will get a reduced suspended sentence, which means they don't have to go to jail.
But their fellow prisoner will get five years in jail.
However, if both confess, then they will both get two years in jail.
If they could get together and collude, they would choose to plead their innocence and both would get six months on the minor charge.
But in isolation, neither trusts the other.
So they both choose to plead guilty and both get two years in jail.
In an oligopolistic market, there are a few interdependent dominant firms.
Typically, if they can collude, they can raise prices and their profits at the expense of customers.
But they need to be able to trust each other.
payoff matrix
in game theory, shows the outcomes of a game for the players given different possible strategies.
duopoly
an industry where there are only two firms
types of price competition
price wars
predatory pricing
limit pricing
price wars
typically occur in markets where non- price competition is weak.
e.g., goods may only be weakly branded.
consumers may be highly price conscious and advertising may fail to persuade them that one firm's product is better than another.
also occur in markets were firms find it difficult to collude either formally or tacitly.
price wars tend to drive prices down to levels where firms are frequently making losses.
in the short run, firms stay in the market because they are at least covering their variable costs of production and making some contribution to fixed costs. In the long run, prices must rise perhaps because supply falls as firms leave the market or because demand rises.
predatory pricing
occurs when anestablished firm in a market is threatened by a new entrant.
the established firm responds by setting such a low price that the new entrant cannot make a profit.
the aim of the established firm is to drive the new entrant out of the market.
once this is achieved, the existing firm then puts its prices back up to their previous levels.
predatory pricing can also be used by one firm in a market against another firm.
if the one firm judges that the other firm is gaining too much of a competitive advantage and gaining market share, it may defend its share by cutting prices.
this may take away market share from the other firm or even force it out of the market.
limit pricing
occurs when firms set a low enough price (the limit price) to deter new entrants from coming into the market.
e.g., assume that there is tacit collusion in a market with four firms.
they all charge around £10 for a good that they make.
if £10 is a very high price and allows the firms to earn high levels of abnormal profit, then new entrants are likely to come into the market.
by charging a lower price, they can gain market share and still make at least normal profit.
it would be better for existing firms to charge a lower price than £10.
the price has to be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market.
the limit price will be greater the higher the barriers to entry to the market.
this is because the higher the barriers to entry, the less likely it is that a new entrant will come into the industry.
e.g., there might be large initial costs that could not be recovered if the new entrant left the industry (i.e. there are high sunk costs).
if sunk costs are high, a firm is unlikely to risk entering the industry unless there are large profits to be made.
types of non-price competition
in a perfectly competitive market, firms producing homogeneous goods compete solely on price.
in the short run, factors such as delivery dates might assume some importance, but in the long term price is all that matters.
in an imperfectly competitive market (i.e. monopolistic competition or oligopoly), price is often not the most important factor in the competitive process.
firms decide upon a marketing mix - a mixture of elements which form a coherent strategy designed to sell their products to their market.
the marketing mix is often summarised in the '4 Ps'.
firms produce a product which appeals to their customers.
the product may or may not be differentiated from rivals' products.
a price needs to be set but this could be above or below the price of competing products depending upon the pricing strategy to be used.
e.g., a high price will be set if the product is sold as a high-quality product.
a low price will be set if the firm wishes to sell large quantities of a standard product.
promotion (advertising and sales promotion) is essential to inform buyers in the market that the good is on sale and to change their perceptions of a product in a favourable manner.
a good distribution system is essential to get the product to the right place at the right time for the customer.
brands
many markets are dominated by brands.
a branded good is one which is produced by a particular firm and which appears to possess unique characteristics.
these may be real characteristics, such as a unique formulation or a unique design.
e.g. Mars bar or a Rolls Royce car are unique products, but often more important than the real characteristics are the imagined characteristics of the product in the mind of the buyer.
this image is likely to have been created by advertising and promotion, so it is possible for the same baked beans or the same breakfast cereal to be packaged differently and sold on the same supermarket shelves at different prices.
often the higher-priced, branded product will sell far better than the lower-priced, unbranded product despite the fact that the product itself is the same.
