3.4.4 Oligopoly Flashcards
1
Q
Characteristics of an oligopoly
A
- a few large firms dominate the market (can still be lots of firms in the industry)
- branded/differentiated products
- barriers to entry
- interdependence between competing firms
- uncertainty above how firms will behave
- supernormal profit in the long run
2
Q
What is concentration ratio?
A
- reveals what percentage of the total market share a specific number of firms have
- concentration ratio is very high in an oligopoly
3
Q
What does it mean if a concentration ratio gets more concentrated?
A
Bigger firms are increasing their market share
4
Q
How do you show the concentration ratio?
A
number of firms: combined market share
5
Q
How will the concentration ratio be influenced?
A
- barriers to entry in an industry = higher concentration ratio
- entering the industry is difficult due to existing dominance of relatively few firms = high start up costs
- leaving the industry is difficult due to the high level of sunk costs (costs that can’t be retrieved)
6
Q
Examples of barriers to entry?
A
- high capital costs (costs of machinery)
- strong brand loyalty e.g. Nike or adidas
- sunk costs - e.g. advertising
- economies of scale - benefits of large scale production requires new entrants to have high start up costs
7
Q
What is collusive behaviour?
A
- the collaboration of firms to increase prices together to a fixed amount, instead of being price competitive
- this is illegal
8
Q
Reasons for collusion
A
- few firms/competitors —> makes it easier to collaborate on prices/output + to understand other competitors’ actions
- similar costs —> firms face identical costs being in the same industry = don’t have an incentive to trigger a price war which would decrease profit
- high barriers to entry —> makes it unlikely new entrants will emerge + disrupt
- brandy loyalty —> reduces incentive to be price competitive
9
Q
What is non-collusive behaviour?
A
Firms are competing on price + non-price factors
10
Q
What are the two types of collusion?
A
- overt = explicitly agree to limit competition or raise prices
- tacit = avoid formal agreements but closely montior each other’s behaviour (following the
lead of the largest firm)
11
Q
What is an example of overt collusion?
A
- a cartel is the most restrictive form of collusion + is illegal in most countries
- the aim of a cartel is joint profit maximisation by fixing prices above what would be a competitive market price
- members have to keep output to agreed limit so not to exceed profit maximising output for the cartel
12
Q
Consequences of overt collusion
A
- high prices for consumers
- less output in the market
- poor quality products and/or customer service
- less investment in innovation
13
Q
How does overt collusion occur?
A
- price fixing = competitor agree a fixed price for all their competing products + usually higher then price equilibrium
- setting output quotas which limit supply + naturally rises prices
- agreements to block new firms from entering the industry
- agreement to pay suppliers the same price = driving down prices in the supply chain
14
Q
Example of tacit collusion?
A
- price leadership
- firms may have an implicit understanding about each others pricing or output behaviour, without any direct communication or agreement
15
Q
How does tacit collusion occur?
A
- when firms monitor the price of the largest firm in the industry + then adjust their prices to match
- it is difficult for regulators to prove that collusion has occurred
- similar consequences for consumers + benefits to firms as overt collusion but not to the same degree
16
Q
What is game theory?
A
- considers how firms form a strategy on whether to collude or not in order to achieve an outcome that is to their benefit
- collision aims to achieve joint profit maximisation as it leads to the greater good rather than the pursuit of individual gain
17
Q
How do firms use game theory?
A
- when making decisions to raise or lower prices
- when make decisions about new advertising + branding initiatives
- when making decisions about investment in product innovation
18
Q
Game theory in an oligopoly
A
- firms may seek to joint profit maximise by price fixing
- this serves to reduce uncertainty as oligopoly is characterised by uncertainty + interdependence = the behaviour of one firm affects the other
19
Q
When is collusion more likely?
A
- the managers of the firms trust one another = don’t think one will cheat
- there is less chance being caught by competition authorities (CMA)
- firms have similar cost structure - so there is no point competing on price
- high barriers to entry = new firms can’t enter + undercut
20
Q
Explain a game theory grid
A
- if both firms agree to collude, they are better offer in terms of joint profit maximisation (top left corner)
- however, if one cheats (sets a lower price) + the other doesn’t = the cheater benefits (top right + bottom left MUST BE MIRRORED)
- if they both cheat = they are both worse off than if they collude (bottom right)
21
Q
Why is there an incentive to cheat in collusion?
A
- because collusion is tacit since it’s illegal in the UK
- this means there is no written down contract
- if a firm cheats they will gain greater profits then if they colluded
- however, if the other firm follows by lowering the price (both cheat), both firms end up worse off compared to collusion
22
Q
Disadvantages of collusion
A
- one firms may act as a whistleblower = inform the regulatory of collusion
- whistleblowers get a lower penalty
- those found guilty may be fined + suffer damage to reputation
23
Q
Why might cartels collapse?
A
- incentive for firms to increase output beyond agreed limit = increases firms individual profit
- game theory = incentive to cheat to steal profits
- firms are most likely to cheat if it is less likely they will get caught
24
Q
What are the types of price competition?
A
- price wars
- predatory pricing
- limit pricing
25
What is a price war?
- when the price leader lowers its price
- the price leader has a cost advantage + can sustain lower prices for a longer period than revival = experience a fall in current profits
- they may pursue this strategy to drive a rival or rivals out of the market
- if successful they are left with a more dominant market position
26
Why can a price war be risky?
- the firm is unlikely to known exactly the cost structure of other firms
- rival firms may be able to sustain a fall in profits longer than expected
27
What is entry limit pricing?
- lower price below profit maximisations up to the point of normal profit (AC=AR) = deters entry
- firms may set price below average cost of new entrant = the prospect of losses prevent entry
28
Entry limit pricing in different markets
- no barriers to entry
- entry limit pricing in such market means setting price equal to average costs = only normal profit is made
- when there is barriers to entry there is still scope for supernormal prints while still deterring entry (but still likely to be below profit maximising price price)
29
Difficulties of limit pricing?
- established firms may not have accurate info about the cost conditions of potential entrants in stable periods = difficult to set effective limit price
- if there are a few firms in the market, then they may have to agree on sharing the market in such a way as to keep the price at the entry level = difficult to do in practice
- rapidly changing demand + cost conditions makes it difficult for firms to calculate limit price
- new firms may have developed new products/processes = improves their ability to enter market
30
What is predatory pricing?
- when a firm charges a price below it’s short run marginal costs = set below shirt run AVC
31
What is predatory pricing used for?
- designed to force competitors out of the market
- if a firm believes it can sustain a very low price for longer rivals, it might charge such price on a temporary basis
- when the rival firm has been forced out the market, the remaining firm can raise the price + take advantage of monopoly position
32
When is predatory pricing suitable?
- it is an attractive strategy when the market is segment e.g. a dominant firm can discipline a rival firm in a local market by decreasing the price below costs without disturbing the price it charges elsewhere in the market
- effective if the exact cost structure of the dominant firm is not known by rivals so that if the firm cuts prices aggressively the other firm doesn’t think it can sustain cutting prices longer
33
Limitations of predatory pricing
- the rival firm may shut down their capacity + restart once prices have risen = dependent on shut down + starting again costs (e.g. very high for coal mining)
- the dominant firm may make excessive losses
- as one firms leaves the market, another may enter after prices rise
- such practise is anti-competitive behaviour + is outlawed by UK completion law
34
What is ‘hit and run’?
- when firms enter the industry, make quick profit + then leave
- this can only happen when the market is highly contestable = low/no barriers to entry + low sunk costs
35
Responses to a ‘hit and run’?
- firms may employ limit pricing or predatory pricing to face possible hit + run
- limit pricing deters the possibility of hit and run
- predatory pricing may be used to drive competitors out of they have already entered
36
Types of non-price competition
- advertising
- sales promotion
37
Impact of advertising
- advertising allows consumers to familiarise themselves with the product or service = uncertainty reduced
- informs consumers about new products on the market + aims to persuade consumers to buy it
- the act of informing consumers = more consumer choice through product differentiation
38
Influence of advertising on diagram
- if successful = shifts the demand curve to the right (or AR curve)
- advertising expenditure increases the costs to the firm = shifts ATC upwards
- the net effect will depend on the particular way advertising changes the position + shape of the cost + revenue curves
- **advertising can lead to higher prices/lower output OR lower prices/higher output**
39
Example of an industry with lots of advertising
- car manufacturers
- they produce a range of models
- advertising is prominent in the car industry as manufacturers aim to to highlight product differentiation
- people with higher incomes also look to update their car regularly - often every 2/3 years
40
What markets is advertising prominent?
- monopolistic
- oligopoly
- a significant amount of advertising expenditure in these markets where there is product differentiation + repeat purchases
41
Examples of sale promotion policies
- reward loyalty cards to encourage repeat purchases e.g. tescos club card
- buy one get one free - can be dangerous e.g. McDonald’s once did this with Big Macs + couldn’t meet demand
- free gift offer
- sponsorship
