3.4.4 Oligopoly

Question 1

How to calculate n-firm concentration ratio?

Answer 1

• Market share of n largest firms in an industry
• Can be calculated on basis of shares in output or shares in employment

e.g. three-firm CR = market share of 3 largest firms in industry

Question 2

Drawbacks of calculating concentration ratio on basis of shares in employment?

Answer 2

Largest firms in industry may be more capital-intensive in their production methods = share of employment in industry < share of output

Question 3

Oligopoly market definition?

Answer 3

A market with just a few sellers where the firms are interdependent

Question 4

Characteristics of oligopoly market?

Answer 4

• Few large firms
• High barriers to entry
• Products can be differentiated or homogenous
• Mutual interdependence between firms

Question 5

High barriers to entry characteristic for oligopoly market?

Answer 5

Economies of scale - makes it difficult for new firms to compete due to high costs (e.g. aircraft industry, patents, control of natural resources)

High start-up costs - enormous sums spent on product differentiation and advertising by existing firms = difficult for new firms to match such expenditures

Question 6

Mutual interdependence characteristic for oligopoly market?

Answer 6

• Decisions by one firm affect other firms in industry so interdependent
• Firms are keenly aware of actions of rivals
• Leads to strategic behaviour and conflicting incentives

Question 7

Strategic behaviour in oligopoly market?

Answer 7

Plans of action that takes into account rivals’ possible courses of action

Question 8

Conflicting incentives in oligopoly market?

Answer 8

• Firms in oligopoly face incentives that conflict with each other
• Incentive to collude
• Incentive to compete

Question 9

Incentive to collude in oligopoly market?

Answer 9

• Refers to an agreement between firms to limit competition by fixing price and lowering Q produced
• Reduces uncertainties, maximises profits

Collusion is illegal and gets fined by CMA (apart from OPEC)

Question 10

Incentive to compete in oligopoly market?

Answer 10

Firms face incentive to compete with rivals to capture portion of rivals’ market shares and profits

Question 11

Prisoner’s dilemma?

Answer 11

Shows how two rational decision-makers use strategic behaviours to maximise profits by guessing their rival’s behaviour but may end up being collectively worse off

Final position = Nash equilibrium

Question 12

What does that Nash equilibrium show?

Answer 12

Conflict between pursuit of self-interest and collective firm interest

Firms could be better off by cooperating, trying to make themselves better off ends up making them and rival worse off

Question 13

Open collusion in oligopoly markets?

Answer 13

Cartel is a formal agreement between firms in an industry

Key objective is to limit competition, increase monopoly power and increase profits

Question 14

Examples of open collusion?

Answer 14

OPEC
* Each member country assigned a quota - restricted quantity = higher price of oil = higher profits

Question 15

What factors make it difficult for a cartel to be established and maintained?

Answer 15

• Incentive to cheat
• Cost differences between firms (different cost curves means price difficult to set)
• Number of firms (larger the number = more difficult to arrive at an agreement)
• Possibility of a price war
• Recessions
• Potential entry into the industry (needs high barriers)
• The industry lacks a dominant firm (e.g. Saudi Arabia in OPEC)

Question 16

Tacit collusion definition?

Examples of types?

Answer 16

Implicit cooperation between firms that is informal

Price leadership, limit pricing

Question 17

Objectives of tacit collusion?

Answer 17

Same as open

Coordinates prices, avoids price wars, limits comp., reduces uncertainties = increased profits

Question 18

Price leadership?

Answer 18

Type of tacit collusion
Dominant firm sets a price and initiates any price changes - remaining firms are price takers

e.g. US steel

Question 19

Obstacles to price leadership?

Answer 19

• Cost differences between firms
• Not all firms may follow the leader
• Firms still face incentive to cheat
• High industry profits = attracts new firms = price leadership agreement endangered
• May not be legal

Question 20

Limit pricing?

Disadvantage for firms?

Answer 20

Informal agreement to set price lower than profit-maximising = less profit = discourages new firms from joining industry

(Have to sacrifice profit)