4.1.5.5 Oligopoly (Paper 1)

Question 1

Define oligopoly

Answer 1

A market structure dominated by a small number of powerful firms

Question 2

Characteristics of an oligopoly

Answer 2

1) Few firms dominate the market - high concentration ratio
2) Differentiated goods - firms are price makers
3) High barriers to entry/exit
4) INTERDEPENDENCE - price rigidity
5) Non-price competition
6) Profit max. not sole objective

Question 3

Define concentration ratio

Answer 3

• A measurement of how concentrated a market is - the total market share held by the largest firms in a market

Question 4

How can oligopolies be define in two different ways?

Answer 4

• In terms of market structure

- In terms of market conduct

Question 5

Define collusion

Answer 5

• Occurs when firms work together to determine price and/or output
• Reduces uncertainty that may exist among firms in the industry regarding pricing and output decisions of rivals

Question 6

Define cartel

Answer 6

• A collusive agreement among a group of oligopoly firms to fix prices and/or output between themselves

Question 7

Famous example of a cartel

Answer 7

The Organisation of the Petroleum Exporting Countries (OPEC):
- 15 countries - including Venezuela, Angola, Qatar

Question 8

Define tacit collusion

Answer 8

• A collusive relationship between firms without any formal agreement having been made

Question 9

Define overt collusion

Answer 9

• A collusive relationship between firms involving an open agreement

Question 10

What happens when collusive agreements are made?

Answer 10

• Consumers are essentially presented with an effective monopoly and the associated benefits and drawbacks
• Collusive agreements allow inefficient firms to survive

Question 11

Kinked demand curve

Answer 11

• Illustration of the interdependence and uncertainty facing firms in this form of imperfect competition (oligopoly) and why oligopolistic markets tend to have stable prices and non-price methods of competition

Question 12

Define interdependence

Answer 12

• How firms in competitive oligopoly are affected by rival firms’ pricing and output decisions

Question 13

Explain the kinked demand curve theory

Answer 13

• If individual firm produces at Q1 - selling at P1 - perceives its demand curve as being relatively elastic if it raises its price and inelastic if it cuts its price (because the firms expects rival firms not to follow a price rise but to follow a price cut)
• If firm raises price - and rivals don’t follow suit - will lose some, not all, market share - will lead to a small expansion of market size but no rise in market share for the firm
• Price rise and cut perceived as being likely to reduce revenue and subsequent profit for the firm - therefore, each firm understands its best strategy to be holding at price P1 and Quantity Q1

Question 14

How can price stability in oligopoly be explained further with the MR curve?

Answer 14

• It’s understood that the MR curve is twice as steep as the AR curves - and below the ruling market price P1
• The kinked D = AR curve gives rise to discontinuous MR curve - so the individual firm can be in profit-maximising equilibrium where MC = MR for a range of MC curves

Question 15

Methods of non-price competition

Answer 15

• Production differentiation - e.g., marketing, packaging, advertising and branding
• Customer service - e.g., point of sale and after-sales service
• Loyalty products - e.g., loyalty cards, warranties and guarantees

Question 16

Advantages of oligopoly (for consumers)

Answer 16

• Competitive oligopoly can lead to price wars which increase consumer surplus
• Battle for market share - higher levels of R&D which can improve dynamic efficiency
• Dominant firms can exploit EoS - leads to lower AC and lower prices in the long run
• High SNP can be taxed - source of revenue for govt to help fund public services

Question 17

Price wars

Answer 17

• Don’t necessarily benefit all consumers

- Some long term risks for consumers from aggressive price wars

Question 18

Disadvantages of oligopoly (for consumers)

Answer 18

• Cartel behaviour (price fixing collusion, for example) - leads to higher prices, causing a loss of AE and hurting low-income households
• High concentration ratio - limits consumer choice - and B2E may deter innovative smaller firms from profitable entry
• Persuasive advertising - can manipulate preferences - and distort the allocation of the price mechanism
• Many transnational oligopolies - successfully avoid taxes (through shadow pricing) - leaves a govt with less money

Question 19

How can oligopolistic markets vary?

Answer 19

• Can be very different in relation to, for example, the number of firms, degree of product differentiation and ease of entry