3.4.4 Oligopoly

Question 1

What is an oligopoly?

Answer 1

• An oligopoly is an imperfectly competitive industry where there is a high level of market concentration.
• Oligopoly is best defined by the actual conduct (or day-to-day behaviour) of firms within a market

Question 2

What are the key assumptions of an oligopoly?

Answer 2

i) A market dominated by a few large firms each with a significant / large market share
ii) High market concentration ratio
iii) Each firm supplies branded products, which may or may not be properly differentiated
* Petrol retailers sell identical products (petrol / diesel has to be the same at every retailer)…but they
try to attract consumers by making other products available to buy (e.g. sweets, milk, newspapers)
and also compete on location
* Some oligopoly markets sell products that are more noticeable differentiated e.g. coffee shops, banks

iv) High barriers to entry and exit
v) Interdependent strategic decisions by firms (this is the crucial aspect of modelling oligopoly)

Question 3

Explain the meaning of strategic interdependence.

Answer 3

• Strategic interdependence means that one firm’s output and price decisions are influenced by the likely
  behaviour of competitors/rivals
• Because there are few sellers, each firm is likely to be aware of the actions of the others
• Decisions of one firm influence, and are influenced by, the decisions of other firms
• This causes oligopolistic industries to be at risk of tacit or explicit collusion which can lead to allegations of
  anti-competitive behaviour
• In oligopoly, there is always a high level of uncertainty

Question 4

What is the market share?

Answer 4

proportion of total revenue in a market accounted for by a brand, product or company.

Question 5

What is the concentration ratio?

Answer 5

The concentration ratio measures the combined market share of the top ‘n’ firms in the industry.

Question 6

What is non collusive behaviour?

Answer 6

Non-collusive behaviour effectively means that firms do not work together, and instead they compete with each other, either in terms of price competition and/or non-price competition.

Question 7

What are objectives that businesses may have in an oligopoly?

Answer 7

• Maintaining a satisfactory rate of profitability
• Protecting market share
• Growing their user base
• Reacting to the decisions of rival firms

Question 8

What does non price competition focus on?

Answer 8

• Quality of product
• Design, look and feel
• Environmental impact (many consumers want information on the ethical sourcing of raw materials)
• After sales services / availability and cost of replacement parts
• Other marketing factors such as branding and advertising

Question 9

What is collusion?

Answer 9

Businesses working together to agree to jointly set prices high and/or restrict output

Question 10

What are types of collusion?

Answer 10

• Horizontal – between firms at the same stage of production
• Vertical – between businesses at different stages of production
• Explicit v tacit collusion (i.e. open v quiet collusion)

Question 11

What are the key aims of business collusion in an oligopoly?

Answer 11

1. Businesses in a cartel recognise their interdependence and act together – the aim is to maximise joint profits
2. Collusion lowers the costs of competition e.g. wasteful marketing wars which can run into millions of pounds
3. Collusion reduces uncertainty – and higher profits increases producer surplus / shareholder value – leading
   to higher share prices

Question 12

What are legal forms of business collusion according to the EU?

Answer 12

1. Practices are not prohibited if the respective agreements “contribute to improving the production or
   distribution of goods or to promoting technical progress in a market.”
2. Development of improved industry standards of production and safety which benefit the consumer – a good
   example is joint industry standards in Europe for mobile phone chargers
3. Information sharing designed to give better information to consumers
4. Research joint ventures and know-how agreements which seek to promote innovative and inventive
   behaviour in a market. The EU has introduced R&D Block Exemption Regulation for this situation..

Question 13

What is Overt (formal) collusion?

Answer 13

Overt means spoken, open or traceable i.e. firms have actively agreed to collude to achieve joint-profit maximisation within a market or prevent price
and revenue instability in an industry.

Question 14

List conditions by which collusion through price fixing may be easier to achieve

Answer 14

1. Industry regulators are ineffective – this is an example of regulatory failure
2. Penalties for collusion are low relative to gain in profits - fines therefore do not act as a proper deterrent
3. Few firms in the market and price inelastic demand (PED < 1) – higher prices then lead to increased revenues
4. Participating firms have a high percentage of total sales – this allows them to control market supply
5. Firms can communicate well and trust each other – this is helped by having similar strategic objectives
6. Products are standardised and output within the cartel is easily measurable so that supply can be controlled
7. Brands are strong so that consumers will not switch demand when collusion raises prices
8. There are other strong barriers that prevent consumers from switching to other products / alternatives

Question 15

Why do many price fixing cartels eventually break down?

Answer 15

• Enforcement problems:
  o The cartel aims to restrict production to maximize total profits.
  o But each individual seller finds it profitable to expand their production.
  o Other firms who are not members of the cartel may take a free ride by selling under the cartel price
• Falling market demand – for example during a recession – which creates excess capacity in the industry and
  this then puts downward pressure on profits and cash-flow in the cartel
• The successful entry of non-cartel firms into an industry undermines a cartel’s control of the market
• The exposure of price-fixing by whistle-blowing firms – i.e. firms engaged in a cartel that pass on information
  to the competition authorities in the hope of more lenient treatment from the regulatory competition
  authorities

Question 16

What does the CMA think about cartels?

Answer 16

They think that “cartels are a major barrier to competition and can lead to significantly increased prices and reductions of output, efficiency, innovation and choice, all of which are harmful to consumers.”

Question 17

What are the penalties for UK businesses guilty of being in price fixing cartels etc?

Answer 17

1. Businesses in breach of competition law can face fines of up to ten per cent of their worldwide turnover.
2. Those convicted of a cartel offence can face up to five years of imprisonment, unlimited fines, director
   disqualification for a period of up to fifteen years and potential confiscation of their assets.

Question 18

Explain the costs of collusive behaviour

Answer 18

• Damages consumer welfare:
  o Higher prices / lost consumer surplus
  o Loss of allocative efficiency
  o Hits lower income families – i.e. has a regressive impact
• Absence of competition hits efficiency:
  o X-inefficiencies leads to higher unit costs
  o Less incentive to innovate / loss of dynamic efficiency
  o Output quotas penalise firms who want to expand
• Reinforces the cartel’s monopoly power:
  o Harder for new businesses to enter the market – this reduces market contestability

Question 19

Explain the potential benefits from collusion?

Answer 19

• General industry standards can bring social benefits from:
  o Pharmaceutical research
  o Improved car safety technology
• Fairer prices for producer cooperatives in lower and middle-income developing countries:
  o Competing more effectively with powerful corporations who have monopsony power
  o This may help in reducing rates of extreme income poverty
• Profits have value – how are they used?:
  o Research and development – leading to dynamic efficiency
  o Higher wages for employees – increased consumption

Question 20

What is game theory?

Answer 20

Game theory is the study of how people and businesses behave in strategic situations (i.e. when they consider
the effect of other people’s responses to their own actions).

Question 21

What is a cooperative outcome?

Answer 21

An equilibrium in a game where the players agree to cooperate

Question 22

What is a dominant strategy?

Answer 22

A dominant strategy is one where a single strategy is best for a player regardless of what
strategy other players in the game decide to use

Question 23

What is the Nash equilibrium?

Answer 23

Any situation where all participants in a game are pursuing their best possible strategy
given the strategies of all of the other participants

Question 24

What is tacit colliusion?

Answer 24

Where firms undertake actions that are likely to minimize a competitive response, e.g.
avoiding price-cutting or not attacking each other’s market OR
Firms may end up raising prices but without ever having discussed it or reached a formal
collusive agreement

Question 25

What is whistleblowing?

Answer 25

When one or more agents in a collusive agreement report it to the authorities

Question 26

What is the general idea of the Prisoner’s Dilemma?

Answer 26

• The Prisoner’s Dilemma is a game that illustrates why it is difficult to cooperate, even when in the best interest
  of both parties.
• Both players are assumed to select their own dominant strategies for personal gain.
• Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they
  could both agree to select an alternative (non-dominant) strategy.

Question 27

Explain how to interpret this matrix

Answer 27

• Put yourself in the shoes of Prisoner A
• Assume that Prisoner B has decided to Confess to the crime
• In this case, Prisoner A would get 3 years in prison if she also confesses or 10 years if she denies it – the
  rational choice here would be to Confess
• Now suppose that Prisoner B has decided to Deny the crime
• In this case, Prisoner A would get 1 year in prison if she confesses or 2 years if she denies it – the rational
  choice here would again be to Confess
• In other words, Prisoner A has a dominant strategy – whatever Prisoner B chooses to do, it is always better
  for Prisoner B to Confess
• The example above is a ‘symmetric payoff matrix’ i.e. the payoffs are identical, given identical
  choices/strategies, for each Prisoner
• This means that Prisoner B’s dominant strategy is also to always Confess
• The two dominant strategies ‘intersect’ so that the Nash Equilibrium is for both Prisoners to Confess – this
  gives them 3 years in prison each
• However, if they had been able to cooperate, it would have been better for them both to deny the crime and
  receive just 2 years in prison…although this risks 1 of them ‘cheating’ on the agreement to get themselves
  down to just 1 year in prison
• When both prisoners follow narrowly-defined self-interest, both actually end up making themselves worse off

Question 28

Explain this matrix

Answer 28

• Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B opts for a low
  output, Firm A wins £12m and Firm B wins £4m.
• In this game, the reward to both firms choosing to limit supply and thereby keep the price relatively high is
  that they each earn £10m. But choosing to defect from this strategy and increase output can cause a rise in
  market supply, lower prices and lower profits - £5m each if both choose to do so.
• A dominant strategy is one that is best irrespective of the other player’s choice. In this case the dominant
  strategy is competition between the firms.
• The Prisoner’s Dilemma can help to explain the breakdown of price-fixing agreements between producers –
  this is because there is an incentive to ‘cheat’ because of the potential for higher profits. This can lead to the
  outbreak of price wars among suppliers, the breakdown of other joint ventures between producers and also
  the collapse of free-trade agreements between countries when one or more countries decides that
  protectionist strategies are in their own best interest.
• The key point is that game theory provides an insight into the interdependent decision-making that lies at the heart of the interaction between businesses in a competitive market.

Question 29

Evaluate the relevance of game theory

Answer 29

• Game theory becomes relevant to analysing business decision making when there are relatively few firms
• Standard game theory assumes rational agents are looking to maximise their own self-interest
• More complex game theory reveals that people / businesses can develop co-operative and/or collaborative
  behaviours e.g. the rise of joint ventures / altruism
• However, Game theory can over-simplify complex decisions, and when there are
  more than two rival firms in a market the degree of complexity increases. Many firms fall back on rules of
  thumb when making decisions on price, advertising budgets, production levels and much else beside

Question 30

Who are the winners of price wars?

Answer 30

• Regular consumers who will see an increase in consumer surplus
• Managers – sales revenues will increase if demand is price elastic (i.e. PED>1) which might lead to higher sales
  bonuses

Question 31

Who are the losers of price wars?

Answer 31

• Shareholders – if a prolonged price wars leads to lower profits
• Suppliers – who may get squeezed if a firm uses monopsony power to lower the prices of their supplies – for
  example, farmers have complained that supermarket price wars have led to delays in them getting payment
• Smaller firms - who may not be able to absorb possible losses from an intense price war
• The government - if lower profits causes a decline in corporation tax revenues

Question 32

What are examples of price competition?

Answer 32

Question 33

What is breakeven price?

Answer 33

P=AC

Question 34

What is limit pricing?

Answer 34

Limit pricing is pricing by a firm to deter entry or the expansion of fringe firms. The
limit price is below the short run profit maximising price but above the competitive
level

Question 35

What is predatory pricing?

Answer 35

Predatory pricing is a deliberate strategy of driving competitors out of the market by
setting low prices or selling below average variable cost.

Question 36

Explain how a firm may use limit pricing (exam question)

Answer 36

Limit pricing is defined as pricing by the incumbent firm(s) to deter the entry or the expansion of fringe firms. Limit
pricing is a pricing strategy designed as a barrier to entry in order to protect a firm’s monopoly power & supernormal
profit. The limit price is below the normal profit maximising price but above the competitive level. This is shown in my
analysis diagram. The monopolist is charging a price lower than the estimated AC for a rival. They are willing to sacrifice
profits in the short run to prevent entry. As a result, the potential rival firm may decide that the risks of entering the
industry are too high – they may make a sizeable loss and might not have the resources to sustain those losses until
they can reach a competitive level of average cost through scale economies. If limit pricing is successful, then a market
is likely to remain highly concentrated in the hands of one or a small number of dominant, businesses who can continue
to earn supernormal profit with P>AC.