3.4.4 oligopoly Flashcards
What are the characteristics of an oligopoly?
- high barriers to entry and exit
- high concentration ratio
- interdependence of firms
- product differentiation
What is strategic interdependence?
One firm’s output and pricing decisions are influenced by the likely behaviour of competitors. There are few sellers, so each firm is likely to be aware of the actions of others. This leads to high risk of collusive behaviour.
What is the X-firm concentration ratio?
Measures the percentage market share of the largest X-firms in the industry. If the top “x” firms have a high market share, the industry is said to be highly concentrated - common in oligopolies.
What percentage of the market share do the top firms in an oligopoly typically have?
The leading five firms in an oligopoly usually account for 60% of the market share.
What is the kinked demand curve?
Used for non-collusive oligopolies, models firm’s pricing behaviours
What does the kinked demand curve assume?
- firms sell homogenous products, or close substitutes
- firms compete on price
- firms have predictable patterns of behaviour, they copy each other’s behaviours
How does the kinked demand curve show the price rigidity in an oligopoly?
If they raise prices above P, demand becomes price elastic as consumers switch to substitutes. If they lower price below P, demand becomes price inelastic as firms follow and cause a price war, so there is little gain in quantity demanded.
Why is MR discontinuous in the kinked demand curve model?
When demand is price elastic, a fall in price leads to a larger than proportionate increase in quantity demanded, increasing TR so MR is positive. When demand is price inelastic, a fall in price leads to a less than proportionate increase in quantity demanded, decreasing TR so MR must be negative.
How does a change in costs alter the price and output in an oligopolistic firm (kinked demand curve model)?
A change in a firm’s costs will have little impact on the price and output. If they are aiming to profit maximise, they operate where MR = MC. Even if costs change slightly, they would have to alter significantly to alter the point of profit maximisation.
What are the advantages of the kinked demand curve model?
- explains the real-world observation that prices in an oligopoly are relatively stable over time
- can be used to explain how price wars can occur
- suitable for use in a small number of oligopolistic markets where products are homogenous
What are the disadvantages of the kinked demand curve model?
- not a particularly dynamic model eg. can’t explain how a new stable price may be achieved after firms lower or raise prices
- doesn’t consider the likelihood of collusion
- not relevant in oligopolistic markets that sell differentiated products
What is an oligopoly?
When a few firms dominate a market. The actions of firms can have a significant effect on the actions of others - interdependence.
What is predatory pricing?
Occurs when firms undercut their competitors to force them out of the market. Anti-competitive practice. The predator sets price below the AVC of the target firm to discourage them from entering the market, then they increase prices to make abnormal profit. The AVC of predator should be lower than the predatory price.
What is limit pricing?
Firms select the highest price possible without encouraging entry. If competitors entered the market, extra supply would drive prices down to a level where they couldn’t survive. The existing firm usually sets prices equal to the LRAC of the possible entrant to the market. The existing firm should be able to make normal profit but PEs would make a loss if they entered the market.
What is collusion?
When firms work together to set high prices and restrict output. Agreements are made to reduce competition
What are the disadvantages of collusive behaviour?
- damages consumer welfare = higher prices, loss of allocative efficiency, regressive impact
- absence of competition hits efficiency = X-inefficiency leads to higher unit costs, less incentive to innovate (lower dynamic efficiency)
- reinforces monopoly power of the cartel = higher barriers to entry, reduced contestability
What are the benefits of collusion?
- general industry standards bring social benefits due to pharmaceutical research, improved safety and technology
- fairer prices for producer cooperatives in low and middle income countries = competes more effectively with powerful corporations who hold monopsony power, reduced rates of extreme poverty
- profits can be used for R+D, increasing dynamic efficiency, higher wages for employees = increased consumption
- businesses in a cartel recognise their interdependence and act together to maximise joint profits
- reduced uncertainty = higher profits increases producer surplus and shareholder dividends
What is a duopoly?
A market dominated by two leading firms with significant market power.
What is firm behaviour like for oligopolies with homogenous goods?
- very stable prices
- occasional price wars
- risk of collusion/cartels
- can be analysed with kinked demand curve or game theory
What is firm behaviour like for oligopolies with differentiated goods?
- strong non-price competition
- may be different prices
- collusion is less likely
- analyse through game theory
What are some legal forms of collusion?
- when respective agreements “contribute to improving the production or distribution of goods or promoting technical progress in a market”
- development of improved industry standards of production and safety which benefit the consumer eg. joint industry standards in Europe for mobile phone chargers
- information sharing designed to give better information to consumers
- research joint ventures and agreements which seek to promote innovative and inventive behaviour in a market.
What is open/overt collusion (cartel)?
Spoken, open or traceable (firms have actively agreed to collude). There is often a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in the industry. Price fixing is an attempt by suppliers to control supply and prices at a level close to the level expected from a monopoly. To collude, producers need some control over market supply and strong pricing power. Rules are laid out in a formal document which is legally enforced.
What are the conditions when price-fixing cartels are likely to occur?
- industry regulators are ineffective, regulatory failure
- penalties for collusion are low relative to the gain in profits
- few firms in the market and price inelastic demand = higher prices leads to higher revenues
- participating firms have high percentage of total sales, allowing them to control market supply
- firms can communicate well and trust each other, similar strategic objectives
- products are standardised and output in the cartel is easily measurable so that supply can be controlled
- brands are strong so that consumers won’t switch demand when collusion raises prices
- there are no strong barriers preventing consumers from switching to alternative products
What does the Competition and Markets Authority (CMA) say about collusion?
The CMA believes that cartels are damaging to economic efficiency and welfare. They are a major barrier to competition and lead to significantly increased prices and reduced output, efficiency, innovation and choice. This can be harmful to consumers.
