LS13 - Oligopoly

Question 1

What are the characteristics of oligopoly?

Answer 1

• Dominated by a small number of large sellers (firms)
• High concentration ratio
• Most likely differentiated products
• Barriers to entry or exit
• Firms are price makers - they can influence the market price because products are not identical; demand to the firm slopes downwards to the right and MR is twice as steep as AR
• Supernormal profit is possible in the long run

Question 2

What is a concentration ratio?

Answer 2

The concentration ratio measures the combined market share of a leading cluster of businesses in a clearly defined market e.g. the five-firm concentration ratio is the sum of the market shares of the largest five firms as a %. (If the 5-firm CR is 60%+ this indicates an oligopoly)

Question 3

Describe the independence levels of firms within an oligopoly

Answer 3

Firm in oligopoly are interdependent. They have to consider how the action of one firm affects other firms. A firm’s decision to change price, output, how it competes…can impact quickly on other firms. Firms try to anticipate their rivals’ decisions; there is uncertainty

Question 4

What are the two kinds of oligopoly?

Answer 4

Competitive oligopoly – the firms compete

Collusive oligopoly – the firms act as a monopoly and make agreements together on pricing and output

Question 5

Describe some characteristics of a competitive oligopoly

Answer 5

• Price war
• Stable/sticky/rigid prices & non-price competition

Question 6

Describe some characteristics of a collusive oligopoly

Answer 6

• Tacit/informal; unspoken, hard to detect; may be due to price leadership, usually illegal; firms can face considerable consequences if caught
• Overt/formal/cartel;

Question 7

In a competitive oligopoly who might gain from a price war?

Answer 7

Consumers: lower prices, higher consumer surplus

Surviving firms: gain market share and increase longer term profit and ALSO may be able to use their monopsony power to depress the prices they pay to suppliers to cut costs and stop profit falling

Question 8

In a competitive oligopoly who might lose from a price war?

Answer 8

Consumers: loss of choice if firm is forced to leave

Firms: lose profit in the short run

Firms: weakest firms may have to leave

Shareholders: may lose profit

Suppliers: may lose profit if they cannot charge such high prices

Question 9

Aside from competing using price, how may firms compete in a competitive oligopoly?

Answer 9

Oligopolistic firms may decide not to compete using price, but instead use non- price competition methods such as product differentiation, advertising and marketing, product innovation, loyalty schemes, customer service, special offers, free gifts etc.

The kinked demand curve shows why prices may not adjust when the firm’s costs change.

Question 10

What are the two different kinds of collusion in a collusive oligopoly?

Answer 10

Overt collusion: where firms openly fixed prices, output, etc

Tacit collusion: behind the scenes agreement , unspoken and usually illegal

Question 11

What is price leadership?

Answer 11

firms adjust their prices in line with the actions of the market leader

Question 12

What is a risk of tacit collusion?

Answer 12

Collusion is usually illegal and can result in big fines and prison sentences.
Whistleblowing: a firm involved in cartel behaviour has an incentive to reveal the anti-competitive pracitces; it may avoid fines imposed on other firms

Question 13

What are the conditions required in an oligopoly for a cartel to be effective?

Answer 13

• Fewer, larger firms involved makes it easy to make an agreement
• High barriers to entry so cartel price cannot be undercut
• Strong branding so consumers stick with goods when price is high
• Easy to monitor each firms’ output to ensure adherence to quotas
• Easier if firms have similar cost structures (a very efficient firm could be
reluctant to join a cartel)
• Demand is price inelastic; setting a high cartel price does not impact
demand much
• Easier if there is a dominant firm leading the group
• Weak industry regulators and competition authorities

Question 14

Why is cartel behaviour often unstable? (Lots of disagreements/cheating)

Answer 14

• There is an incentive for a firm to ‘cheat’ (and increase output, which would bring the cartel price down) if there is no credible threat or risk
• Supernormal profits may attract new firms if barriers to entry are not high enough destabilising the agreement
• If market demand falls, there may be over-capacity putting downward pressure on the price
• Regulatory and competition authorities use the law to break them up
• There is an incentive to whistle-blow

Question 15

What are some costs of collusive behaviour?

Answer 15

Damages consumer welfare (higher price)
Absence of competition reduces efficiency
Reinforces monopoly power

Question 16

What are some benefits of collusive behaviour?

Answer 16

Industry standards can increase some social welfare
Could help offset monopsony power by suppliers in cooperatives
Profits may be used to improve dynamic efficiency

Question 17

What are some pricing strategies to increase market power?

Answer 17

Predatory pricing: firm sets its price below average variable cost to force out a rival or prevent a new entrant (illegal)
Limit pricing: firm sets its price low enough to deter new entrants (AR=AC)
Price discrimination: firm charges a different price for the same good in different sub-markets. The goal for firms is to increase their profits; they may take a short term hit for a longer term gain

Question 18

What are some non-pricing strategies to increase market power to increase profits?

Answer 18

• Branding/loyalty
• Advertising
• New product development
• New production methods
• Product service quality & differentiation
• Mergers/takeovers
• Collusion
Many of these can act as a barrier to entry or give a firm a competitive edge. Some may increase costs in the short term, but increase demand and revenue in the long term

Question 19

What is mutual interdependence in oligopolistic firms?

Answer 19

It’s when firms’ profits depend on each other’s actions, influencing their behavior and strategy. When the profit of one firm depends on the strategies adopted by other firms, this is known as strategic interdependence.

Question 20

What are conflicting incentives in an oligopoly?

Answer 20

Firms face both the incentive to collude for mutual profit and the incentive to compete to capture market share.

Question 21

Define the incentive to collude.

Answer 21

Collusion involves firms agreeing to limit competition (e.g., by fixing prices) to reduce uncertainty and increase industry profits.

Question 22

Define the incentive to compete in an oligopoly.

Answer 22

Each firm aims to capture a portion of rivals’ market shares and profits by competing, which could mean lower prices.

Question 23

Describe the prisoner’s dilemma in an oligopoly context.

Answer 23

Two firms may both choose low prices to outcompete each other, leading to lower profits for both, even though colluding would yield higher profits.

Question 24

What is Nash Equilibrium?

Answer 24

A situation where each firm, acting in its own self-interest, ends up worse off than if they had cooperated.

Question 25

What happens when firms engage in price competition in an oligopoly?

Answer 25

All firms lower their prices to attract customers, resulting in reduced profits for everyone.

Question 26

Why do oligopolistic firms avoid price wars?

Answer 26

Price wars reduce profits for all firms, creating an incentive to compete on factors other than price, such as quality or service.

Question 27

Describe a real life example of a legal cartel

Answer 27

OPEC is a cartel est1960, whose main aim is to regulate the supply of oil to control global oil prices, thus maximizing collective profits for its 12 member states: Saudi Arabia, Iraq, Iran, and Venezuela, etc.

Cartels are illegal in many industries due to anti-competitive laws, but OPEC is an organization of sovereign states rather than private companies, allowing it to operate with limited international regulation.

OPEC controls ~ 40-45% of global oil production and about 80% of proven oil reserves. By limiting supply, OPEC reduces competition, influencing global oil prices. This affects energy costs, inflation, and economic stability worldwide. Non-OPEC producers like the U.S. and Russia can be incentivise by high oil prices to increase their output, weakening OPEC’s control over global prices.

Oil demand is relatively inelastic (its a necessity) so OPEC can raise prices without causing a significant drop in consumption, maximizing revenues.