4.1.3 oligopoly Flashcards
What is an oligopoly?
A market where very few firms dominate, exerting significant control over prices and output.
When is a market an oligopoly?
When the top 5 firms in the market account for more than 60% of market share.
What are some characteristics of an oligopoly? [5]
- High barriers to entry
- Interdependence
- Stable prices
- Collusion
- Non-price competition
What is concentration ratio?
The combined market share of the top few firms in a market.
What is collusive behaviour?
When firms agree to work together on something, for example choosing to set a price or fix the quantity of output they produce to minimise competitive pressure they face.
What does collusion lead to? [3]
- Lower consumer surplus
- Higher prices
- Greater profits for firms colluding
Why do firms in an oligopoly have a strong incentive to collude?
They can maximise their own benefits and restrict their output, causing market price to increase. This deters new entrants and is anti-competitive.
When is collusion more likely to happen? [5]
When there are only a few firms, they face similar costs, there are high entry barriers, it is not easy to be caught, there is an ineffective competition policy.
What is non-collusive behaviour?
When firms are competing.
When is non-collusive behaviour more likely to occur? [4]
When there are several firms, one firm has significant cost advantage, products are homogeneous and the market is saturated.
What are the two types of collusion?
- Overt
- Tacit
What is overt collusion?
When a formal agreement is made between firms. It is illegal in EU, US and several other countries.
When does overt collusion work best?
When there are only a few dominant firms, so one does not refuse.
What is a real life example of overt collusion?
It is suspected that fuel companies partake in overt collusion. Could be by price fixing.
What is tacit collusion?
When there is no formal agreement but collusion is implied.
What is an example of tacit collusion?
The UK supermarket industry, where firms are competing in a price war.
What is a cartel?
A group of two or more firms which have agreed to control prices, limit output, or prevent the entrance of new firms into the market.
What is a famous example of a cartel?
OPEC, which fixed their output of oil. This was possible cine they controlled over 70% of supply of oil in the world.
What do cartels lead to? [2]
- Higher prices for consumers
- Restricted outputs
What is price leadership?
When one firm changes their prices, and other firms follow.
When does price leadership usually occur?
When the dominant firm in the market changes prices, and other firms are forced into doing so too otherwise they risk losing their market share.
Why does price leadership explain why there is price stability in an oligopoly?
As other firms risk losing market share if they do not follow the price change.
What is a price war?
A type of price competition, which involves firms constantly cutting their prices below that of its competitors. Their competitors then lower their prices to match.
What is game theory?
Related to the concept of interdependence between firms in an oligopoly, and is used to predict the outcome of a decision made by one firm, when it has incomplete information about the other firm. It can be explained using the Prisoner’s dilemma.
What is the Prisoner’s dilemma?
A model based around 2 prisoners who have the choice to either confess or deny a crime.
The 2 are not allowed to communicate but can consider what the other prisoner is likely to choose, this relates to characteristic of uncertainty in an oligopoly.
What is the dominant strategy in the Prisoner’s Dilemma?
The option which is best, regardless of what the other person chooses. This is for both prisoners to confess, since this gives the minimum number of years that they both have to spend in prison.
What is the Nash equilibrium?
A concept in game theory which describes the optimal strategy for all players, whilst taking into account what opponents have chosen.
Why is the Nash equilibrium unstable?
As there is an incentive to cheat and take the upper hand, such as confessing in the prisoner’s dilemma whilst you know the other will deny.
What are the advantages of an oligopoly? [4]
- Can earn significant supernormal profit. Might invest which can make the market more dynamically efficient in the long run and yield positive externalities
- Higher profits could be a source of government revenue
- Industry standards could improve, especially true in the pharmaceutical industry as firms can collaborate on technology and improve it, saves on duplicate R&D
- Can exploit economies of scale, so have lower average costs of production
What are the disadvantages of an oligopoly? [3]
- Basic model suggests higher prices and profits and inefficiency may result in misallocation of resources compared to competitive markets
- If firms collude there is loss of consumer welfare
- Collusion could reinforce monopoly power of existing firms and make it hard for new firms to enter. Absence of competition means efficiency falls and average cost of production increases
When does price discrimination occur?
When different prices are charged to different groups of consumers for the same good or service.
What is first degree price discrimination?
When each consumer is charged a different price.
For example a lawyer might charge a high income family more than a low income family.
What is second degree price discrimination?
When prices are different according to the volume purchased.
What is third degree price discrimination?
When different groups of consumers are charged a different price for the same good or service.
For example, the higher price at peak times on trains, than off-peak times.
What are the costs to consumers of price discrimination? [2]
- Results in loss of consumer surplus since P > MC, there is a loss of allocative efficiency
- Strengthens the monopoly power of firms which could result in higher prices in long run for consumers
What are the benefits of price discrimination to consumers? [2]
- Could benefit from net welfare gain as result of cross subsidisation, if they receive a lower price
- Some who were previously excluded by high prices might now be able to benefit from the good. This can sometimes yield positive externalities
What are the costs of price discrimination to producers? [2]
- Firm could face investigation by the Competition and Markets Authority if it is used as a predatory pricing method
- Might cost the firm to divide the market, which limits the benefits they could gain
What are the benefits of price discrimination to producers? [3]
- Make better use of spare capacity
- Higher supernormal profits could stimulate investment
- If more profits are made in one market, a different market making losses could be cross subsidised, especially if it yields social benefits. This will limit or prevent job losses which may result from closure of the loss-making market
