LS13 + LS14 - Oligopoly And Contestability Flashcards
Characteristics of oligopoly e
- high barriers to entry & exit (high startup costs eg. expensive planes, high level of sunk costs if firms leave market eg. car product development, market research, tech)
- high concentration ratio (few large dominant firms so lower levels of comp)
- interdependence of firms (firms need to consider reaction of competitors when changing prices, firms often follow each other so overall revenue will fall = prices often rigid. Oligopoly = fight for MS in a race to monopoly power hence firms must think carefully about moves of rivals before making their own decision. Price comp is unlikely as higher prices than rivals will reduce MS and reducing prices lower than rivals will result in a price war. For this reason prices tend to ‘sticky’ or ‘rigid’ in oligopoly.)
- product differentiation (high degree so firms have ability to set price = downward sloping demand curves, compete through non-price factors eg. advertising, brand loyalty)
- firms profit maximise (MC=MR)
Eg. UK Supermarkets, airline industry, car manufacturers
Oligopoly
Small number of large firms
High barriers to entry - economies of scale make it hard for new firms starting on a small scale to compete due to high costs, legal barriers such as patents, control of natural resources, aggressive tactics such as advertising
High start up costs
Products may be differentiated or homogenous
Mutual interdependence - decisions made by one firm effect others in the industry
Concentration ratio
- measures percentage of total market a particular number of firms have (eg. 3 firm concentration ratio shows percentage of total market held by 3 biggest firms)
- higher concentration ratio in oligopoly = lower levels of comp in market
= (total sales of n firms / total size of market) x 100. Or by adding market share of top n
Oligopoly strategic behaviour
Based on plans of action that take rivals actions and reactions into account
Result of mutual interdependence
Oligopoly conflicting incentives
Incentive to collude - agreeemnt between firms to limit competition between them, usually by fixing price and lowering quantity - collusion reduces uncertainty from not knowing how rivals will act –> maximise profits for all firms
Incentive to compete - each firm faces incentive to compete with rivals in aim to capture part of their market shares and profits –> increasing own profit at expense of rivals
Oligopoly game theory
Game theory - analysis of behaviour of decision makers who are dependent of one another, using strategic behaviour to anticipate the behaviour of their rivals
Prisoners dilemma - decision makers who use strategic thinking to guess rivals moves to maximise profits may end up being collectively worse off = Nash equilibrium
Conflict between pursuit of self interest and collective firm interest - both firms could be better off by cooperating, but by trying to make itself better off, they both end up worse off by cheating
Collusive oligopoly
Agreement in setting price/output –> gives all parties involved a unfair advantage over rest of the market - allows them to boost profits and reduce uncertainty
Illegal in most countries - works to limit competition
May be formal or informal
Open/formal collusion
Cartel - formal agreement between firms in an industry to take actions to limit competition - formal collusion
Limit competition, increase monopoly power and boost profits
* Limiting and fixing quantity sold
* Fixing prices,
* Setting restrictions on non price competition such as advertising,
* Dividing market according to geographical or other factors
* Agreeing to set up barriers to entry
OPEC - 13 oil producing countries, periodically try to raise oil prices by limiting output
Difficulties with collusion
Incentive to cheat - a firm that cheats can improve its own market share and profits at the expense of other firms - this results in risk of cartel collapsing, Nash equilibrium
Cost differences between firms - each firm faces different cost and revenue curves - hard to set a price as firms with higher AC curves make lower profits, but firms with lower AC curves make higher profits; different demand curves due to brand loyalty, advertising - more differentiation, bigger gap in demand curves –> difficulties in agreeing upon a price
Number of firms - larger number of firms - harder to reach agreement over price and output, due to differing views - agreement and compromise more difficult
Price war - firm cheating on cartel agreement might result in price war - firms continue to undercut one another - lower prices and lower profits overall
Recessions - sales fall, profits reduced, firms have stornger incetive to cheat and lower prices
Entry into industry - large profits attarct new entrants - drive down price setting power of cartels - reduced profits
Lack of dominant firm - firm with highest market power assumes leadership position - leads negotiations towards agreement
Oligpoly pros and cons
PROS:
Cartels can be dynamically efficient as supernormal profit is being made in l/r. such profit can be reinvested back into company in the form of technology advances, innovative new products and R&D. This is beneficial for consumers who will receives brand-new, better-quality products over times. Prices could be lower over time if tech advances reduces costs for businesses – passed onto consumers. Inc in choice
For the cartel new product development can maintain monopoly power esp. if such products are patentable and better tech can allow a reduction of costs of production inc price making potential of firm over time
Even though cartels are productively inefficient, may still be exploiting greater E.O.S than smaller competitive firms who produce lower levels of output given the ferocity of competition. Costs of production can be lower for cartels compared to competitive firms resulting in lower prices charged and higher quantities produced, actually promoting outcomes the benefit society.
If oligopolists behave competitively, outcomes could be like those attained in competitive market structures Allocative efficiency - achieved with prices close to or equal to marginal cost. Resources are allocated according to consumer demand. Given that firms in oligopoly can compete significantly on both price non-price factors, consumer choice is high and prices are low increasing CS in the market. The quality of the product being sold is excellent too given the drive to meet the needs and wants of the Consumer. Competitive oligopolists do this to benefit by getting ahead of rivals who are not meeting consumer wants and needs thus increasing their market share. Overtime this can result in higher profits for the business
Competitive oligopolists can also be productively efficient where production takes place at the lowest point of the AC curve- all possible economies of scale are being exploited as it cannot increase output and lower their average costs any further. These lower average costs can translate into lower prices for the consumer increasing their CS.
CONS:
Cartels produce outcomes that are allocatively inefficient= exploit consumers by charging prices greater than marginal cost at the profit maximising 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 CS in 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.
Cartels are productively inefficient- 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 maximisation, where MR=MC, productive inefficiency prevails. As a consequence consumers suffer from higher prices and lower CS than if all economies of scale were exploited
Cartels can be x-inefficient- complacent and lazy in the production process allowing waste to creep in at quantity Qcart- consumers= higher prices and lower CS than if excess cost was eradicated
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 excess size of firm. Consumers suffer from higher prices and lower consumer surplus than if the monopolist was smaller and benefiting from lower average costs.
Tacit/informal collusion
Cooperation understood between the cooperating firms without a formal agreement
Objectives to coordinate prices, avoid competitive price cutting, limit comp, reduce uncertainties and increase profits
Tacit collusion attempts to bypass the obstacles created by the illegality of formal collusion
Examples:
- price leadership (dominant firm sets a price and initiates any price changes, remaining firms become price takers, accepting price established by leader. Price changes tend to be infrequent, only when major demand or cost changes occur). PROBLEMS - STILL INCENTIVE TO CHEAT, MAY BE ILLEGAL DEPENDING ON HOW IT IS PRACTICED, SOME FIRMS MAY FOLLOW SOME WILL NOT MEANING LEADER RISKS LOSING SALES AND MARKET SHARE IF IT INITIATES A PRICE INCREASE THAT IS NOT FOLLOWED
- limit pricing, where firms informally agree to set a price that is lower than the profit maximising prices thus earning less than the highest possible profits and so discouraging new firms from entering the industry
Contestable markets
Sunk costs refer to costs that a firm incurs in setting up a business and which cannot be recovered if the firm exits the market
Contestability - advertising
Incumbent firms are more likely to spend more on advertising, building brand loyalty
Makes it difficult for new entrants to grow and become established
Reduces contestability
Counted as sunk costs - cannot be recovered if firm fails
Contestability - research and development
Some industries undertake heavy R&D programs (pharma industry)
Contributes to rising fixed costs - new entrants will have to spend heavily on R&D if they wish to keep up with incumbents
Makes market less contestable
