9.7 Oligopoly

Question 1

What are the six characteristics of an oligopoly?

Answer 1

The six characteristics of an oligopoly are: 1) a few large firms dominating the market with a high concentration ratio, 2) differentiated goods and services produced, making firms price makers, 3) high barriers to entry and exit for firms, 4) interdependence among firms in making decisions, 5) non-price competition in the form of advertising, branding, and product quality, and 6) an unknown objective for oligopolists as they fight for market share in a race to monopoly power.

Question 2

What is the concentration ratio in oligopoly?

Answer 2

The concentration ratio in oligopoly is high, with a few firms dominating the market and taking approximately 70% of the market share.

Question 3

How are goods and services produced in oligopoly?

Answer 3

In oligopoly, the goods and services produced are differentiated, which makes each firm a price maker with the ability to set prices given the unique nature of the product sold.

Question 4

What are the barriers to entry and exit in oligopoly?

Answer 4

In oligopoly, there are high barriers to entry and exit, meaning that entry and exit is difficult and potentially expensive. These barriers can include high start-up costs, sunk costs, economies of scale, and brand loyalty.

Question 5

How does interdependence affect oligopoly?

Answer 5

There is interdependence in oligopoly where firms make decisions based on the expected reactions of rivals. Oligopoly is a fight for market share in a race to monopoly power, hence firms must think carefully about the likely moves of rivals before making their own decision. This is why price competition is unlikely, and prices tend to be ‘sticky’ or ‘rigid’ in oligopoly.

Question 6

What is non-price competition in oligopoly?

Answer 6

Due to price rigidity, there is a lot of non-price competition in the form of advertising, branding, and product/service quality. By developing brand loyalty, firms are more likely to sustain increases in market share and get ahead of rivals.

Question 7

Evaluation 2: Why is the objective of oligopolists unknown?

Answer 7

The objective of oligopolists is unknown because each firm does whatever it can to get ahead of rivals to attain monopoly power. The specific objective that is most likely to get them there will be used, but this can vary depending on the market and specific market conditions.

Question 8

What is the kinked demand curve model in oligopoly?

Answer 8

The kinked demand curve model provides two ways to understand firm behaviour and why prices tend to be sticky in oligopoly. At a stable price of P1 at the kink, firms do not want to change their price. Raising their price from P1 to p2 will take them onto the price elastic part of the demand curve where the proportionate decrease in quantity demanded from Q1 to Q2 is greater than the increase in price. Total revenue and market share will decrease as rival firms will react by keeping their prices fixed at P1. Furthermore, firms do not want to reduce their price from P1 to P3 as this will take them onto the price inelastic portion of the demand curve. Demand will increase but proportionately less than the price decrease, resulting in a loss of total revenue and no long-term change in market share. This is because rival firms will react by matching the price reduction or undercutting further culminating in a ferocious price war between suppliers benefitting consumers but not producers

Question 9

What is the vertical discontinuity of the marginal revenue curve in oligopoly?

Answer 9

The corresponding marginal revenue curve of a kinked demand curve possesses a vertical discontinuity. If costs of production increase in this vertical gap from MC1 to MC2, for example, due to a rise in raw material prices or an increase in wages, a profit-maximizing oligopoly producing at MC=MR will continue to produce at output level Q1 and price of P1. Hence, firms perhaps do not need to change their price from P1.

Question 10

Game Theory

Answer 10

Game theory can also help explain the behaviour of oligopolists. Take the following prisoner’s dilemma game and payoff matrix for example
Two firms in oligopoly can either charge £19 or £20 for a product, always making the decision that maximises their payoff (the yearly profits in the cells). Decisions are based on the reactions of rivals.
For example if firm A charged £20 or £19, firm B should always charge £19 to maximise profits. If firm B charged £20 or £19, firm A should always charge £19. There clearly is a dominant strategy here for both firms to charge £19 with long term profits being made of f15million a year, an equilibrium that can be sustained over time. Interdependence and leads both firms to always take the lower price option to avoid the sting of being undercut themselves. This is the Nash Equilibrium further explaining a reason for price rigidity in oligopoly despite this not being the most profitable outcome for both firms.

Question 11

Game Theory - Collusion

Answer 11

4) If both firms are able to organise a situation whereby £20 is charged, greater profits can be made of £25million each. This is a cartel agreement or collusive oligopoly where firms join together to fix prices or quantities essentially becoming a monopoly in the market. The payoff matrix above also explains why collusion is unlikely to hold given the very strong incentive for a firm in a cartel to cheat on the agreement and lower the price charged to making higher profits of £30million. This will not last however as the rival will lower prices straight away resulting in the Nash Equilibrium of £19 being charged by both companies with a f15million profit share.

Question 12

How does game theory help explain the behaviour of oligopolists?

Answer 12

Basically interdependence leads both firms to always take the lower price option to avoid the sting of being undercut themselves. This is the Nash Equilibrium, further explaining a reason for price rigidity in oligopoly despite this not being the most profitable outcome for both firms.

Question 13

What is a cartel agreement in oligopoly?

Answer 13

A cartel agreement or collusive oligopoly is when firms join together to fix prices or quantities, essentially becoming a monopoly in the market. If both firms are able to organize a situation whereby £20 is charged, greater profits can be made of £25 million each. However, the payoff matrix also explains why collusion is unlikely to hold given the very strong incentive for a firm in a cartel to cheat on the agreement and lower the price charged to make higher profits of £30 million. This will not last, however, as the rival will lower prices straight away resulting in the Nash Equilibrium of £19 being charged by both companies with a £15 million profit share.

Question 14

What is the potential outcome of price competition among firms in oligopoly?

Answer 14

Firms can compete on price despite the rationale of the kinked demand model. The aim of price reduction is to try and maximize market share in the long run by sacrificing profits in the short run. The end result will be a ferocious price war benefiting consumers with higher consumer surplus while harming producer revenue and profitability.

Question 15

What is the potential outcome of non-price competition among firms in oligopoly?

Answer 15

Firms can compete on non-price factors by strengthening advertising, developing brand loyalty, and improving product and service quality. This again is in the interests of consumers and can lead to market share gains by producers if successful.

Question 16

What is diseconomies of scale in a cartel?

Answer 16

Cartels can be productively inefficient if they become too large and suffer from diseconomies of scale. This occurs when output takes place where average costs are rising due to problems with communication, coordination, and/or motivation, where productivity is reduced due to the excessive size of the firm. As a consequence, consumers suffer from higher prices and lower consumer surplus than if the monopolist was smaller and benefiting from lower average costs.

Question 17

What is overt collusion in oligopoly?

Answer 17

Firms can break interdependence by colluding and forming a cartel. A formal agreement to fix prices or quantities is overt collusion where the cartel acts as a monopolist, generating outcomes that are against the public interest. Such behavior is illegal.

Question 18

What is tacit collusion or ‘price leadership’ in oligopoly?

Answer 18

Firms can break interdependence by engaging in tacit collusion or ‘price leadership’. This is where an informal agreement is made between firms not to engage in a price war or for firms to follow price changes made by the dominant firm in the industry. This prevents price competition going against the public interest but is harder to prove than overt collusion.

Question 19

What is allocative inefficiency in a cartel?

Answer 19

Cartels produce outcomes that are allocatively inefficient. This is because they exploit consumers by charging prices greater than marginal cost at the profit-maximizing level of output, Q1. At this point of production, resources are not allocated according to consumer demand, with consumers getting a lower quantity than they desire. Consumer choice is restricted, and prices are high, reducing consumer surplus in the market. The quality of the product being sold may suffer too given the lack of competitive forces to meet the needs and wants of the consumer.

Question 20

How does a cartel cause a welfare loss to society?

Answer 20

The diagram comparing cartel and competitive outcomes shows that cartels exploit consumers by charging excessively high prices (price beyond marginal cost), resulting in a deadweight loss of both consumer and producer surplus indicated by the triangle. Cartels charge higher prices than the competitive price taken at allocative efficiency where demand meets supply. Quantity in the market is below the social optimum, indicating a misallocation of resources, allocative inefficiency, and a welfare loss to society.

Question 21

Why are cartels productively inefficient?

Answer 21

Cartels are productively inefficient because they do not produce at the minimum point on the average cost curve, choosing instead to voluntarily forgo some economies of scale. Output could be increased further with lower average costs, but as this does not correspond with profit maximization, where MR=MC, productive inefficiency prevails. As a consequence, consumers suffer from higher prices and lower consumer surplus than if all economies of scale were exploited.

Question 22

What is X inefficiency in a cartel?

Answer 22

Cartels can be X inefficient. This is because they can become complacent and lazy in the production process, allowing waste (cost in excess of average cost) to creep in at quantity Qcart. As a consequence, consumers suffer from higher prices and lower consumer surplus than if all waste, excess cost, was eradicated.

Question 23

How can cartels be dynamically efficient?

Answer 23

Cartels can be dynamically efficient as supernormal profit is being made in the long run. Such profit can then be reinvested back into the company in the form of technology advances, innovative new products, and R&D. This is beneficial for consumers who will receive brand new, better quality products over time, perhaps able to purchase products that do not yet exist. Prices could be lower over time if technology advances reduce costs for businesses, which are then passed on to consumers. The choice available to consumers would increase too. For the cartel, new product development can maintain monopoly power, especially if such products are patentable, and better technology can allow a reduction of costs of production, increasing the profit-making potential of the firm even more over time.

Question 24

How can cartels promote allocative efficiency?

Answer 24

2) Even though cartels are productively inefficient, they may still be exploiting greater economies of scale than smaller competitive firms who produce lower levels of output given the ferocity of the competition. Costs of production can therefore be lower for cartels compared to competitive firms resulting in lower prices charged and higher quantities produced, actually promoting outcomes that benefit society.

Question 25

How can competitive oligopolists be productively efficient?

Answer 25

Competitive oligopolists can also be productively efficient, where production takes place at the lowest point of the average cost curve. This means all possible economies of scale are being exploited, as firms cannot increase output and lower their average costs any further. These lower average costs can translate into lower prices for the consumer, increasing their consumer surplus. Competitive oligopolists do this to benefit from lower average costs, which can lead to higher levels of supernormal profit over time and increases in market share if economies of scale benefits translate into lower prices than rivals.

Question 26

How can competitive oligopolists promote dynamic efficiency?

Answer 26

Competitive oligopolists behave competitively and can promote dynamic efficiency by getting ahead of rivals who are not meeting consumer wants and needs, thus increasing their market share. Over time, this can result in higher profits for the business.

Question 27

What makes it easier for firms to organise agreements to fix prices or quantities to make supernormal profits in an oligopoly?

Answer 27

If there are a small number of firms in the industry, it makes it easier for firms to organise agreements to fix prices or quantities to make supernormal profits. It is also easier for firms to stay in contact with one another reducing the risk of cheating.

Question 28

Why is it easier to facilitate and maintain cartel arrangements over time in an oligopoly with firms having similar costs?

Answer 28

If firms have similar costs to each other, it is easier to agree on a price or quantity to fix, thus making cartel arrangements simpler to facilitate and maintain over time.

Question 29

How do high entry barriers into an industry affect cartels?

Answer 29

If entry barriers into the industry are high, the supernormal profits made by cartels can be sustained in the long term, increasing the incentives for firms to get together and fix prices or quantities.

Question 30

How does ineffective competition policy promote anti-competitive practices in an oligopoly?

Answer 30

If competition policy is ineffective, perhaps with weak regulatory bodies in a given industry where cartel agreements can be formed, firms will believe they won’t be caught engaging in illegal anti-competitive practices, promoting such activity.

Question 31

Why is strong consumer brand loyalty towards a firm beneficial for collusive agreements in an oligopoly?

Answer 31

If consumer brand loyalty is strong towards a given firm, cheating on a collusive pact by reducing prices is not in the best interest of firms, as there is no guarantee consumers will switch consumption to the firm that has cheated. Collusive agreements are therefore more likely to last in the long term.

Question 32

evaluation: What is the impact of strong consumer inertia on collusive agreements in an oligopoly?

Answer 32

If there is strong consumer inertia in the industry when switching suppliers, cheating on a collusive pact by reducing prices is not in the best interest of firms, as there is no guarantee consumers will switch consumption to the firm that has cheated. Collusive agreements are therefore more likely to last in the long term.

Question 33

How does highly differentiated goods benefit cartels in an oligopoly?

Answer 33

If the goods being produced by firms are highly differentiated, it allows a cartel to set high prices much more easily and still expect strong consumer demand, increasing the level of supernormal profit made over time.

Question 34

What kind of market conditions are more likely to lead to cartel agreements being made or lasting over time in an oligopoly?

Answer 34

Collusive agreements are more likely to be made in oligopolistic markets that are calm and without price volatility. Whereas markets that are saturated and unstable with lots of price movements and fierce competition are unlikely to lead to cartel agreements being made or lasting over time.