3.4.4 Oligopoly Flashcards
Characteristics of Oligopoly
> Oligopoly is where there are a few firms that dominate the market and have the majority of market share. There are still small firms in the market.
There are 4 key characteristics of oligopoly;
> High concentration ratio - the majority of supply in the industry must be concentrated in the hands of relatively few firms.
> Interdependence of firms - firms are interdependent, so the actions of one firm will directly affect another.
> Barriers to entry - they have high barriers to entry and exit.
> Product Differentiation - products are generally differentiated.
Calculation of n-firm concentration ratios and their significance:
> The concentration ratio is the combined market share of the top few firms in a market.
The higher the concentration ratio, the less competitive the market, since fewer firms are supplying most of the market.
It is worked out by adding the percentages of market share for the firms or using the formula: (total sales of n firms/total size of market) x 100.
Collusion:
Collusion is when firms make collective agreements that reduce competition and maximise their own benefits.
When firms don’t collude this is a competitive oligopoly. The firms compete.
Collusive behavior:
> When firms compete, they know that lowering prices to gain customers is likely to cause other firms to lower their prices. But, if they work together they could maximise industry profits.
Collusion reduces the uncertainty that firms face and reduces the fear of competitive price cutting or advertising.
Collusion leads to a lower consumer surplus, higher prices and greater profits for firms. So firms in an oligopoly have a strong incentive to collude.
Collusive behaviour is more likely to happen when: there are a few firms which are well-known to each other, the firms aren’t secretive about costs/production methods, they produce similar products, there are high barriers to entry, it is hard to be caught, there is ineffective competition policy.
Non-collusive behaviour:
> Firms may decide to be non-collusive since collusion is illegal and it has risks, like firms breaking the agreement.
A firm with a strong business model and something that sets it apart will not ant to collude if they feel that they can increase market share or charge higher prices than competitors.
More likely yo occur when: there are several firms, products are homogenous, and the market is saturated.
Overt + Tacit Collusion
> Overt collusion is when firms come to a formal agreement to limit competition.
Tacit Collusion exists when there is still collusion but firms do not make any formal agreements about cooperating together.
Cartels
> A cartel exists when a group of firms make an agreement.
In cartels firms typically agree to limit their output in order to raise prices.
Cartels can lead to a loss of consumer welfare, because they can cause higher prices for consumers and output is reduced.
A problem with cartels is that no firm will want to set their price/output at a level that they wouldn’t ideally choose, and there is constant temptation to break the cartel rules.
Conditions for a successful cartel:
> An agreement must be reached. Easier in markets with few dominant firm, because the more firms there are, the more likely it is that one will not agree.
Cheating must be prevented. It would benefit an individual firm to cheat and set a lower price, but would then push the price down to the market level if every firm did it.
Potential competition must be restricted. Abnormal profits will encourage firms to join the industry and encourage existing firms to increase output. To prevent this cartel firms may agree to drive out other firms that compete too aggressively or increase barriers to entry.
Price Leadership
When one firm in the market sets a price that other firms in the market follow.
The price leader is often the largest firm in the market.
Other firms will follow this dominant firm because they would be fearful of taking them on in a price war.
Game Theory
> Game theory is related to the concept of interdependence between firms in an oligopoly. It’s used to predict the outcome of a decision made by one firm when it has incomplete info about the other.
It can be explained by the prisoners dilemma. The consequences of ones decision depend on what the other chooses.
(Diagram sheet 4)
The firms don’t know what the other will do, relating to the uncertainty in an oligopoly.
If collusion exists then they would decide to raise price and their profits at the expense of customers. However they need to trust eachother. Of collusion brings the safest/best outcome then there is an incentive to collude.
The Nash equilibrium is a concept in game theory that describes the optimal strategy for all players, whilst taking into account what others have chosen. They can’t improve their position given the choice of the other.
However if they collude and both agree to keep prices the same, each has an incentive to cheat and therefore raise prices, making the Nash equilibrium unstable.
Types of Price Competition:
> Price Wars
- where several firms repeatedly lower their prices to outcompete other firms. The objective may be to gain or defend market share.
- Typically occurs in markets where non-price competition is weak or where consumers are highly price conscious, and advertising is ineffective. Also occur in markets where it is difficult to collude.
- They tend to drive prices down to a point where firms are frequently making losses. In the short term firms may continue to produce if their AVC curve is below their AR curve. But in the long run they will leave the market and prices will rise since supply has fallen.
Predatory Pricing
- Occurs when a an established firm is threatened by a new entrant or if they feel another firm is gaining too much market share.
- The established firm will set such a low price that other firms are unable to make a profit and will be driven out of the market. The established firm can then put their price back up.
- The firm must be large enough to sustain losses.
Limit Pricing
- In order to prevent new entrants, firms will set prices low (the limit price). The price must be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market.
- The greater the barriers to entry the higher the limit price.
- Drawback is that firms can not make profits as high as they would otherwise be able to.
Types of non-price competition:
> Oligopolistic markets tend to have lots of non-price competition due to the fact that prices are relatively stable. They spend lots of time and money on branding and advertising. Hopes to increase sales and market share.
The issue with these methods is that they are often expensive so firms need a lot of money to fund it. Only large firms can afford to do large-scale advertising, research and development, etc. And there is no guarantee that non-price competition will be successful.
Types
- Advertising - creates awareness for the company/product and ideally persuades customers to purchase.
- Loyalty cards - encourage repeat purchases by rewarding customers for loyalty.
- Branding - successful branding can help increase loyalty and repeat purchases. Will make product launches more successful
- Quality - a firm known for quality may be able to charge a higher price and is likely to have strong brand loyalty.
- Customer service - encourage customer loyalty and give firms a positive reputation.
- Product development - can give a competitive advantage. If successful can see increase in sales.
Efficiency
> Statically inefficient since they are not productively and allocatively efficient.
Likely to be dynamically efficient. They make supernormal profit so have the funds to invest, and the incentive to invest due to competition. Some might just share the profits with shareholders.
