3.4.4 Oligopoly

Question 1

Oligopoly

Answer 1

An oligopoly is an industry dominated by a few large firms (high concentration ratios) and interdependence of firms
- For example, an industry with a five-firm concentration ratio of greater than 50% is considered an oligopoly.

Question 2

Characteristics of oligopoly

Answer 2

• high barriers to entry and exit
• high concentration ratio
• interdependence of firms and strong incentive to collude (actions of one firms affects another)
• product differentiation

Question 3

Calculation of n-firms concentration ratios and their significance

Question 4

Collusive behaviour

Answer 4

• occurs if firms agree to work together on something.
• E.g might choose to set a price or fix the quantity of output they produce = minimises the competitive pressure they face.

Question 5

Reasons for collusive behaviour

Answer 5

• Firms in an oligopoly have a strong incentive since can maximise their own benefits & restrict their output, = the market price to increase = deters new entrants and is anti-competitive.
• Moreover, there should be consumer inertia. All of these factors make the market stable.

Question 6

Overt collusion

Answer 6

• when a formal agreement is made between firms.
• It works best when there are only a few dominant firms, so one does not refuse.
• It is illegal in the EU, US and several other countries.

Question 7

Tacit collusion

Answer 7

when there is no formal agreement, but collusion is implied.
- forms of tacit collusion is price leadership,

Question 8

High concentration

Answer 8

a few large firms dominate
- high market share of some firms

Question 9

Costs of collusion

Answer 9

• loss of consumer welfare
• fall in efficiency
• increases barriers to entry

Question 10

Costs of collusion (loss of consumer welfare)

Answer 10

Since prices are raised and output is reduced

Question 11

Costs of collusion (fall in efficiency)

Answer 11

the absence of competition means efficiency falls
- this increases the average cost of production

Question 12

Costs of collusion (increases barriers to entry)

Answer 12

It reinforces the monopoly power of existing firms and makes it hard for new firms to enter

Question 13

Benefits of collusion

Answer 13

• improve in industry standards
• excess profits
• exploit economies of scale

Question 14

Benefits of collusion (improve industry standards)

Answer 14

Industry standards could improve. This is especially true in the pharmaceutical industry and for car safety technology.
This is because firms can collaborate on technology and improve it.

Question 15

Benefits of collusion (excess profits)

Answer 15

Excess profits could be used for investment, which might improve efficiency in the long run.
Alternatively, they might be used on dividends.

Question 16

Benefits of collusion (exploit economies of scale)

Answer 16

By increasing their size, firms can exploit economies of scale, which will lead to lower prices.

Question 17

Cartels

Answer 17

A formal agreement between firms to limit competition in the market by controlling prices, limit output, or prevent the entrance of new firms into the market.
- A famous example of a cartel is OPEC, which fixed their output of oil. This was possible since they
controlled over 70% of the supply of oil in the world. This reduces uncertainty for
firms, which would otherwise exist without a cartel.

Question 18

Impact of cartels

Answer 18

Cartels can lead to higher prices for consumers and restricted outputs. Some cartels
might involve dividing the market up, so firms agree not to compete in each other’s
markets.

Question 19

Price leadership

Answer 19

occurs when one firm changes their prices, and other firms follow.
- This firm is usually the dominant firm in the market/has best knowledge of prevailing market conditions
- Other firms are often forced into changing their prices too, otherwise they risk losing their market share.
This explains why there is price stability in an oligopoly; other firms risk losing market
share if they do not follow the price change.

Question 20

Dominant strategy

Answer 20

• the option which is best, regardless of what the other person chooses.
• This is for both prisoners to confess, since this gives the minimum number of years that they have to spend in prison. It is the most likely outcome.

Question 21

Nash Equilibrium

Answer 21

a concept in game theory which describes the optimal strategy
for all players, whilst taking into account what opponents have chosen. They cannot
improve their position given the choice of the other.

Question 22

Instability of nash equilibrium

Answer 22

However, even if both prisoners agree to deny, each one has an incentive to cheat and therefore confess, since this could reduce their potential sentence from 2 years to 1 year. This makes the Nash equilibrium unstable.

Question 23

Types of pricing strategies/price competition

Answer 23

• Price wars
• Predatory pricing
• Limit pricing

Question 24

Types of price competition (price wars)

Answer 24

Occurs in markets where non-price competition is weak (goods may be weakly branded)
- involves firms constantly cutting their prices below that of its competitors
- Their competitors then lower their prices to match. Further price cuts by one firm will lead to more and more firms cutting their prices.
- e.g the UK supermarket industry

Question 25

Types of pricing strategies/price competition (predatory pricing)

Answer 25

https://www.tutor2u.net/economics/reference/exam-answer-predatory-pricing
- Predatory pricing is illegal
- Firms price their g/s below their avc to drive out rivals firms out of the market to achieve market dominance in long run
- In the short run = them making losses but in long run, once firms leave, the remaining firms raise their prices slowly above previous competitive levels to regain their losses from where P < AVC

Question 26

Types of price competition (limit pricing)

Answer 26

This is not necessarily illegal.
- price is set below the AC of potential rivals to prevent new competitors entering the market
- It ensures the price of a good is below that which a new firm entering the market would be able to sustain.
- Potential firms are therefore unable to compete with existing

Question 27

Types of non-price competition

Answer 27

• advertising and branding
• brand proliferation
• loyalty schemes
• innovation leading to new product development

Question 28

Highly concentrated market

Answer 28

• high market share of some firms where a few large firms dominate
• uncompetitive
• Firms can set prices control output
• Interdependent (1)
• High barriers to entry/exit (1) low contestability (1)

Question 29

Types of pricing strategies/price competition (predatory pricing) evaluation

Answer 29

It won’t work with brand loyalty
- predatory pricing is anti-competitive and therefore potentially illegal
- May lead to fines up to 10% of worldwide turnover
- depends on whether rivals are small and financially weak. If they also have a diverse portfolio of product/operate in a number of markets or have large cash reserves in the bank,they may respond by slashing their own price below AVC

Question 30

How is a firm able to make a loss and still survive (predatory pricing)

Answer 30

In the short run, cross-subsidisation of losses (multi-product firms)

Question 31

Predatory pricing example

Answer 31

In 2005 Tesco was accused of predatory pricing by the Association of Convenience Stores. They are opening small grocery outlets to serve a local community. Independent grocery stores have traditionally served this market (equivalent of 40% discount).
- designed to force small grocers out of the market

Question 32

Types of price competition (limit pricing) evaluation

Answer 32

• considering how the low profits of existing firms might dissatisfy shareholders, since they receive lower dividends
• opportunity cost = lowered quality, lowered spending on R&D
• can lead to price wars if there are lots of firms in the market

Question 33

Incumbent

Answer 33

Established firm

Question 34

Predatory pricing example

Answer 34

• In 1994, Darlington Bus Wars case
• Stagecoach offered free bus travel to try and drive the Darlington Bus Company out of business.
• DBC was driven out leaving monopoly power left in the market
• Over the next decade, bus use in area fell by almost 40%
• Societal harm: consumers only benefiting from free rides in the short term before having to endure higher prices in long term = less bus more cars =more pollution

Question 35

Sunk cost

Answer 35

Costs which aren’t recuperable

Question 36

Brand proliferation (non price strategies)

Answer 36

• branding = aim to increase the loyalty to a brand = makes demand for a good more price inelastic

Question 37

Advertising and branding (non price strategies)

Answer 37

• More well known = influence consumer preference
• ## goods appears to have unique characteristics (real or imagined)

Question 38

Advertising and branding/loyalty schemes evaluation

Answer 38

• will increase AC and is a sunk cost
• may be time lags
• PED

Question 39

Innovation evaluation (non price strategies)

Answer 39

• will increase AC and is a sunk cost
• may be time lags
• very uncertain
• PED

Question 40

Innovation (non price strategy)

Answer 40

• quality of service/goods
• e.g more available delivery times, keep shops open for longer

Question 41

Loyalty schemes (non price strategies)

Answer 41

• special offers, loyalty cards, free gifts = attract consumers = increase demand

Question 42

Non price strategy graph

Answer 42

• increase in demand is shift in curve
• change in PED is rotation of demand curve

Question 43

Collusive oligopoly

Answer 43

A market with a high concentration ratio where a few interdependent firms cooperate, either formally or tacitly, to restrict competition

Question 44

Concentrated market

Answer 44

A market where most of the out is produced by a few firms and where therefore the concentration ratio is high

Question 45

Examples of over collusion

Answer 45

• e.g it is often suspected that fuel companies partake in overt collusion. This could be in the form of price fixing,

Question 46

Why might firms participate in over collusion?

Answer 46

maximises their joint profits, cuts the cost of competition, such as by preventing firms using wasteful advertising, and reduces uncertainty.

Question 47

Result of collusive behaviour

Answer 47

Collusion = lower consumer surplus, higher prices and greater profits for the
firms colluding.

Question 48

When is collusion likely to happen?

Answer 48

• Collusion is more likely to happen where there are only a few firms, they face similar costs, there are high entry barriers = it is not easy to be caught and there is an ineffective competition policy.

Question 49

How might collusion work against consumer & society’s interest?

Answer 49

• firms collude to raise prices = reduce consumer surplus = reduce welfare= regressive also less competition = less dynamic efficiency
• = pharmaceuticals = improve drugs

Question 50

What did the UK competition & markets say about collusion?

Answer 50

collusion can result in “reductions of output, efficiency, innovation and choice, all of which are harmful to consumers.”

Question 51

Example of of oligopolies reducing consumer

Answer 51

Apple, who were sued by consumers for price-fixing with publishers to force consumers to over pay for e-books.

Question 52

Evaluation of collusion leading to reduced consumer surplus

Answer 52

• tacit collusion includes firms who monitor what other firms sell to ensure that they are matching the cheapest price in geographic area
• may also result in driving down of price as firms seek to match improvement in cost efficiencies made by other firms
• (e.g mobile phone contracts where it is easy to compare prices)

Question 53

Evaluation of collusion helping develop drugs

Answer 53

• depends on othe factors
• e.g majority of collusion that takes place isn’t firm working together
• benefits that come from firms working together are dependent on those firms passing those cost savings onto consumers (might spend on dividends)
• benefits likely small compared due to regulators

Question 54

Example of firms colluding but it not benefiting consumers

Answer 54

in 2017, US firms spent more money on share buy-backs than they did on research and development.

Question 55

What will the extent of impact of collusion on consumers depend on?

Answer 55

• depends fundamentally on how long the oligopoly is able to carry on collusion (game theory) - Nash equilibrium
• Assuming the following pay offs in a cartel such as OPEC, where states agree to collude to reduce production levels and benefit from a higher price:

Question 56

Example of anti-competitive behaviour (drugs)

Answer 56

• Aug 2015
• Pfizer and Flynn Pharm charged ‘excessive and unfair prices’ for an anti-epilspegy drugs inflating the annual NHS drugs bill by tens of millions of pounds

Question 57

Impact of high level of advertising spending in oligopoly

Answer 57

• Traditional & digital advertising are common features of non-price competition between businesses in an oligopolistic market.
• In part this is because of the interdependent nature of decision-making in this market structure.
• Firms have to consider what their rivals are choosing to do, and game theory suggests that the Nash equilibrium might be for firms to spend heavily on advertising if rivals are doing likewise to prevent a loss of market share, sales revenue and, ultimately, operating profits. But to what extent is a high level of advertising beneficial for consumers and society as a whole?

Question 58

Example of collusive industry

Answer 58

Mobile phone network

Question 59

Why might a firm in an oligopolistic market prefer to engage in non-price competition rather than price competition?

Answer 59

The demand for the good is likely to be inelastic in relation to a price rise

Question 60

Aims of business collusion

Answer 60

• businesses in a cartel recognise their mutual interdependence & act together (to maximise joint profits)
• collusion lowers the costs of competition (e.g wasteful marketing wars which can run into millions of pounds)
• collusion reduces uncertainty in a market & higher profits = producer surplus