3.4.4 Oligopoly

Question 1

Oligopoly

Answer 1

Oligopoly is where there are a few firms that dominate the market and have the majority of market share, although this does not mean there won’t be other firms in the market.

Question 2

Characteristics of oligopolies

Answer 2

1) Differentiated products
2) High concentration ratio
3) Interdependent
4) Barriers to entry

Question 3

Differentiated products (oligopolies)

Answer 3

Products are not identical and have recognisable differences between them

Question 4

High concentration ratio (oligopolies)

Answer 4

Supply in the industry must be concentrated in the hands of a relatively small number of firms.

Question 5

Interdependent (oligopolies)

Answer 5

Actions of one firm will directly affect another.

Question 6

N-firm concentration ratios

Answer 6

The concentration of supply in the industry can be indicated by the concentration ratio which measures the percentage of the total market that a particular number of firms have .

Question 7

3 firm concentration ratio

Answer 7

Shows the percentage of the total market held by the three biggest firms, whilst the 4 firm ratio shows the percentage by the four biggest firms and so on.
- 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
(The method used will depend on the information in the question.)

Question 8

Collusion

Answer 8

When firms make collective agreements that reduce competition. When firms don’t collude, this is a competitive oligopoly.
- The UK energy market is an oligopoly that is suspected of collusion.

Question 9

Reasons for collusive behaviour

Answer 9

• If firms compete, they know lowering prices to gain new customers is likely to cause other firms to lower their prices. However, if they work together, they could maximise industry profits​.
• Collusion ​reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits.

Question 10

Reasons for non-collusive behaviour

Answer 10

• Firms may decide to be a non-collusive oligopoly since collusion is illegal ​and due to the ​risks of collusion​, such as other firms breaking the cartel (a cartel is a form of collusion between suppliers. A cartel occurs when two or more firms (usually within an oligopoly) enter into agreements to restrict the market supply and thereby fix the price of a product in a particular industry) or prices being set where they don’t want it.
• A firm with a ​strong business model and something that ​sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors.

Question 11

When does collusion between firms work best?

Answer 11

When:
- there are a few firms which are all well known to each other
- the firms are not secretive about costs and production methods and the costs and production methods are similar
- they produce similar products
- there is a dominant firm which the others are happy to follow
- the market is relatively stable; and there are high barriers to entry

Question 12

Collusive oligopolies

Answer 12

When firms engage in collusion, they may agree on prices, market share or advertising expenditure.

Question 13

Overt and tacit collusion

Answer 13

There are two main types of collusion:
- Overt collusion is when firms come to a formal agreement
- Tacit collusion means there is no formal agreement

Question 14

Cartel

Answer 14

A formal collusive agreement is called a cartel, ​which is a group of firms who enter into agreement to mutually set prices.
- The rules will be laid out in a ​formal document which may be legally enforced and fines will be charged for firms who break these rules.

Question 15

How cartels operate

Answer 15

There are two ways a cartel could operate: ​
1) Agree on a price for the goods and then compete freely using non-price competition to maximise their market share
2) Agree to divide up the market ​according to the present market share of each business

Question 16

Cartels evaluation

Answer 16

No firm is likely to set their prices/output at the level they would not ideally choose and there is ​constant temptation to break the cartel​.
- The more successful the cartel, the greater the incentive to break it; it is important for firms to be the first to break it and not the firm who is left to deal with the after effects.

Question 17

Tacit collusion

Answer 17

Since collusion is illegal, firms may be involved in tacit collusion such as price leadership and barometric firm.
Other examples could be unwritten rules about keeping advertising low or not trying to take each other’s customers.

Question 18

Price leadership

Answer 18

Where firm has advantages due to its size or costs and becomes the dominant firm. Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war. As a result, the dominant firm will decide the price and allow the other firms to supply as much as they wish at this price.

Question 19

Barometric firm price leadership

Answer 19

Where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader.

Question 20

Non-collusive oligopoly

Answer 20

The behaviour of a firm under non-collusive oligopoly will depend on how it thinks other firms will react to its policies. ​
- Game theory ​can be used to examine the best strategy a firm can adopt for each assumption about its rivals.

Question 21

Game theory

Answer 21

Game theory explores the ​reactions of one player to changes in strategy by another player. The aim is to examine the best strategy a firm can adopt for each assumption about its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets. The easiest way of demonstrating this is where ​duopoly exists in the market, so there are two identical firms.

Question 22

Game theory strategies

Answer 22

There are two strategies the firm could take: a maximin policy or a maximax. The maximin policy involves firms working out the strategy where the worst possible outcome is the least bad. Alternatively, the ​maximax policy involves firms working out the policy with the best possible outcome.
- If the maximin and maximax strategies end up with the same solution, this is called the ​dominant ​strategy. However, ​dominant strategies aren’t that common in real life​ and the best strategy for a firm tends to depend on what the other firm does.

Question 23

Nash equilibrium

Answer 23

In some cases, there is a ​Nash Equilibrium where neither player is able to improve their position and has optimised their outcome based on the other players expected decision. They have no incentive to change behaviour, unless someone else changes theirs.

Question 24

Prisoner’s dilemma

Answer 24

One common example of game theory is the prisoner’s dilemma. In the situation, two people are questioned over their involvement in a crime and are kept apart so they can’t communicate. The dominant strategy in this situation is to confess: it’s the greatest reward (3 months rather than a year) and the least bad (3 years rather than 10 years). However, if the prisoners could collude or had confidence in one another, the best option would be to deny the crime; this is the Nash equilibrium.

Question 25

Types of price competition

Answer 25

Price wars
Predatory prices
Limit pricing

Question 26

Price wars

Answer 26

Occur in markets where ​non-price competition is weak​; where goods have weak brands and consumers are price conscious. They also occur when it is ​difficult to collude.
A price war will drive prices down to ​levels where firms are frequently making losses. In the short term, firms will continue to produce if their AVC is below AR but in the long run, they will ​leave the market and prices will have to rise since supply falls.
- It lowers industry profits
Example: Supermarkets are one example of an industry using heavy price wars, with firms
desperately trying to offer lower prices than their rivals.

Question 27

Predatory pricing

Answer 27

Occurs when an ​established firm is threatened by a new entrant or if one firm feels that another 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 so will be ​driven out the market. The existing firm is then able to ​put their price back up.
Eval/counter argument: This is ​illegal and only works when one firm is large enough to be able to have low prices and ​sustain losses​.

Question 28

Limit pricing

Answer 28

In order to prevent new entrants​, firms will set prices low (the limit price). The price needs 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 greater the barriers to entry, the higher the limit price. It is mainly used in
contestable markets.
Eval: The drawback of this is that it means firms cannot make profits as high as they would be otherwise be able to.

Question 29

Types of non-price competition

Answer 29

An oligopolistic market tends to have a ​lot of non-price competition due to the fact that prices are relatively stable. They spend a long time and a lot of money on ​advertising and promotions​, for example the ​Tesco club-card or the computers for schools scheme​. ​The soft drink market is one good example of a market with high levels of non-price competition.
- Advertising
- Loyalty cards
- Branding
- Quality
- Customer service
- Product development

Question 30

Advertisement

Answer 30

This creates an awareness of the company/product and can persuade a customer to purchase the product. If advertising is successful, it can increase sales and market share for a business which in the long run can increase profits. Advertising can also make the demand for a product/service more inelastic.

Question 31

Loyalty cards

Answer 31

These encourage repeat purchases by rewarding customers for their loyalty. They also provide firms with lots of data on consumers’ buying habits, which the firm can use to increase sales.

Question 32

Branding

Answer 32

A successful brand can help increase loyalty and repeat purchases for a business. People will trust the brand and the quality it represents so will more likely keep buying from them. An established brand should find it easier to release new products.

Question 33

Quality

Answer 33

A firm that is known for good quality may be able to charge higher prices, and is likely to have strong brand loyalty. They are likely to have good reputation and benefit from positive recommendations.

Question 34

Customer service

Answer 34

This will encourage loyalty amongst customers and give the business a more positive reputation.

Question 35

Product development

Answer 35

A business that invests in product development will have a competitive advantage over rivals. If they’re the first firm to release a new product, they would see an increase in sales and this is likely to help with branding.

Question 36

Non-price competition evaluation

Answer 36

The problem with these methods is that they are often ​expensive ​and so firms need the money before they are able to undertake the competition. Similarly, only large firms will be able to do large scale advertising, research and development etc.. There is ​no guarantee that it will be successful.

Question 37

Efficiency (oligopolies)

Answer 37

● Firms will be ​statically inefficient​, since they are not productively or allocative
efficient.
● They are likely to be ​dynamically efficient. ​They make supernormal profits, so have the funds to invest, and they have an incentive to invest, due to competition. However, some may just share its profits with its shareholders or decide not to invest. It will depend on the market.
● They will be able to exploit ​economies of scale​, lowering costs.