Monopolies and oligopolies

Question 1

what is the nash equilibrium

Answer 1

a rational equilibrium that can last in the long term

Question 2

what is a dominant strategy

Answer 2

is where one single strategy is best for a player regardless of what strategy the other player in the game decides to use

Question 3

impacts of game theory

Answer 3

1. price rigidity
   - knowing that lowering prices can trigger retaliatory price cuts for competitors, oligopolistic firms may focus on branding/ advertising and quality to attract consumers without reducing profit margins. leads to price stability within the market
2. temptation to collude
   - firms may see benefits in collusion to maintain high prices and maximise joint supernormal profits, eg starting a cartel
   - such collusive practices may limit competitive pressures
3. challenges of long run collusion
   - collusion offers short term profitability, but may not be sustainable in the long run
   - in the long run, firms may cheat to gain a competitive advantage of due to external pressures like fines
   - collusion often ends as firms start competing again, leading to price reductions
4. incentive to cheat on collusive agreements
   - individual firms have a strong incentive to cheat on a collusive agreement to gain more customers by slightly lowering prices
   - by offering lower prices, a firm can increase its market share at the expense of colluding partners, maximising short term gains
   - this undermines the stability of collusive agreements, leading to eventual breakdowns

Question 4

what is game theory

Answer 4

a theory that explores the reaction of one player to a change in strategy of another player

Question 5

characteristics of an oligopoly

Answer 5

• few firms dominate the market
• high concentration ratio
• differentiated goods, so firms are price makers
• high barriers to entry and exists
• interdependence - firms make decisions based on the actions and reactions of rival firms
• price rigidity
• non price competition
• profit maximisation not the sole objective

Question 6

meaning of high concentration ratio

Answer 6

when a group of firms share most ≈70% of market share

Question 7

examples of oligopolies

Answer 7

• soft drink industry - pepsi,coke,sprite
• car industry - mercedez ,bmw
• supermarket - sainsburys,aldi,tescos
• airlines
• energy - SSE british gas etc

Question 8

explain the kinked demand curve - interdependence

Answer 8

• if a firm raises its price above market level, competitors are unlikely to follow, as they can increase market share by keeping prices stable
• competitors will shift to competitors offering lower prices, causing the original firm’s qd to fall disproportionately to the price increase

2. if a firm decreases their price, qd will increase by a v small amount
   - if a firm lowers its price, competitors are likely to match the reduction to protect their own market share
   - the price matching diminishes the individual firms ability to attract more customers
   - the demand curve is more inelastic at this point, as all firms in the market lower their prices, limiting the qd increase and reducing revenue for all firms

Question 9

using the linked demand curve, explain why oligopolistic firms do not need to change prices

Answer 9

• firms aim to max profit at MC = MR
• if the MC curve shifts within the vertical gap in the MR curve:
  
  • the profit maximising price and output remain unchanged, as there’s no unique MR to cross the new mc within the gap
• so even with minor changes in costs, firms don’t need to adjust prices to maintain profit maximisation
• so the price stays fixed despite cost fluctuations, contributing to price rigidity

Question 10

conclusions from linked demand curve

Answer 10

1, price competition may still happen
- a firm may reduce prices to try and increase market share (even though this wouldn’t work)

2. non price competition
   - the kinked demand curve shows the drawbacks of price changes, leading firms to focus on non price factors such as product quality, branding, advertising etc
   - as this is a safer way to differentiate and attract customers without risking profitability through lower prices
3. temptation to collude
   - the stability suggested by the linked demand curve may make firms consider collusion to maximise profits collectively, as maintaining stable prices benefits all players
   - collusion avoids the risks of price wars while ensuring higher collective profitability

Question 11

what is overt collusion

Answer 11

where firms get together and agree to fix prices/quantity

Question 12

what is tacit collusion

Answer 12

when there is no formal communication between firms, they follow prices set by price leader

Question 13

what factors are likely to promote a competitive oligopoly

Answer 13

• if there are many firms - as organising collusion when there are a lot of firms is harder
• if new market entry is possible - then making huge supernormal profits by colluding together is not sustainable as it will only incentivise new firms to enter the market and take those profits
• if there is one firm with significant cost advantage - it makes it difficult to organise/fix prices
• if there are homogenous goods, then firms don’t have price making power
• saturated market - where there are a lot of price wars and price competition

Question 14

factors that promote collusive oligopolies

Answer 14

1. small number of firms - they can get together easily to fix prices
2. if firms have similar costs
3. high entry barriers- eg predatory pricing
4. ineffective competition policy
5. if there’s high consumer loyalty and consumer inertia means lower incentive to cheat

Question 15

pros and cons of a competitive oligopoly

Answer 15

pros:
- higher consumer welfare and lower prices
- as firms compete with each other
- consumers benefit from higher choice and more affordable goods, increased CS

Non price competition :
- competition forces firms to innovate to maintain or increase market share, leading to advancements in product quality, technology , etc
- leads to increased dynamic efficiency

• increased allocative efficiency, as firms operate close to where P = MC, ensuring resources follow consumer preferences

cons
Price Wars
- Intense price competition between firms in a competitive oligopoly can lead to price wars, driving prices below costs for extended periods.
- This harms smaller firms that may lack the resources to sustain losses.
- Smaller firms may exit the market, reducing long-term competition.
- Consumers may face higher prices once dominant firms regain control after eliminating competitors.

Reduced Profits for Innovation
- The pressure to compete on price can reduce firms’ profit margins, leaving less capital available for investment in research and development (R&D).
- A lack of innovation can slow industry progress, reduce product quality improvements, and limit consumer benefits over time.

Question 16

cons of a competitive oligopolistic market

Answer 16

Price Volatility
- Competition can lead to frequent price changes and uncertainty in the market, especially if firms aggressively try to undercut each other.
- Consumers might face confusion and difficulty predicting prices, leading to instability in the market.

Potential for Inefficiencies
- Firms in a competitive oligopoly may engage in wasteful activities like excessive advertising and marketing, which increase costs without necessarily improving quality.
- This reduces productive efficiency, as resources could be better allocated elsewhere.

Short-Term Focus
- Firms in a competitive oligopoly might focus on short-term profits and quick market gains, rather than long-term investment in innovation or sustainability.
- This could lead to underinvestment in areas that drive long-term growth, such as research and development.

Question 17

pros of a collusive oligopoly

Answer 17

Price Stability and Predictability
- Colluding firms can agree on prices, reducing volatility and providing consumers with stable, predictable pricing.
-This can benefit consumers in terms of knowing what to expect, although it may come at the cost of higher prices.

Increased Profitability for Firms
- By colluding, firms can agree to set higher prices and reduce competition, leading to higher profits for all members of the cartel.
- Firms benefit from a more secure market and higher returns on their investments.

Efficiencies in Resource Allocation
- Collusion can lead to economies of scale if firms combine resources or coordinate on production strategies.
- This could improve productive efficiency in some cases, as firms may be able to reduce costs through shared infrastructure or joint investment.

Question 18

cons of a collusive oligopoly

Answer 18

Allocative Inefficiency
- In a collusive oligopoly, firms often restrict output and set higher prices than they would in a competitive market (P > MC), leading to allocative inefficiency.
- Consumers face higher prices, which reduces overall welfare, as they are paying more than they would in a competitive market.

Reduced Innovation
- With less competition, firms may have less incentive to innovate or improve their products since they can achieve high profits without needing to differentiate.
- This leads to dynamic inefficiency, as firms do not invest in research and development to improve products or services, stifling technological advancement.

Risk of Regulatory Penalties
- Collusion is illegal in many countries and can attract heavy fines, penalties, and reputational damage if discovered.
- Firms may face legal and financial consequences, which can harm their long-term prospects and erode consumer trust in their products.

Reduced Consumer Choice
- Collusive behavior often leads to limited product variety as firms focus on maintaining high prices rather than offering diverse or improved products.
- Consumers face fewer options and are unable to choose products that better meet their preferences, reducing consumer welfare.

Question 19

what is a cartel

Answer 19

a form of collusion between suppliers. it occurs when two or more firms enter into agreements to restrict market supply and thereby fix the price of a product in a particular industry

Question 20

example of cartel

Answer 20

OPEC - oil
KLM - airline who got fined 127 million for price fixing in cargo sector

Question 21

what is a monopoly

Answer 21

a single dominant seller in the market
CMA defines it as one firm having over 25% of market share

Question 22

features of a monopoly

Answer 22

• differentiated products
• high barriers to entry/exit, so sustainable spn profits
• price makers
• imperfect information
• firms are profit maximisers

Question 23

comment on efficiencies in a monopoly

Answer 23

• allocative efficiency not being reached, as P ≠ MC, price is greater than MC so they exploit consumers with higher prices and lower cs, they also restrict output
• productive efficiency not being reached, they are voluntarily forgoing (going without) economies of scale by not producing at the minimum point ofAC
• There is X inefficiency as they may become complacent as they consistently make supernormal profits
  so no static efficiency
• dynamic efficiency can be reached as there are long run supernormal profits. there are high barriers to entry as well as imperfect information and this keeps new forms out of the market. the monopolist can reinvest back into the company in the form of tech etc

Question 24

benefits of a monopoly (FOR A FIRM)

Answer 24

1. Eos
   - monopoly firms can operate on a large scale, benefiting from economies of scale, which reduces their LRAC
   - lower costs enhance supernormal profits, which can be reinvested into R&D,improving innovation and efficiency
   - this reinvestment can potentially lead to long term benefits for the firm and consumers, such as higher quality goods or cost savings passed on in lower prices

Cross-subsidisation
- Monopoly firms can use profits from one profitable sector to subsidize losses in less profitable or loss-making sectors.
- This diversification helps the firm maintain market presence in multiple areas, contributing to its resilience and brand reputation.

Market Stability
- As the sole supplier, a monopoly can avoid price wars and instability associated with competition, allowing for predictable revenue streams.
- Stability supports long-term planning and investment, enabling the firm to focus on improving operations and expanding its market influence.

Price Discrimination
- Monopoly firms can engage in price discrimination, charging different prices to different consumer groups based on their willingness to pay. This maximizes revenue and profits.
- Higher profits from price discrimination can be reinvested into the firm, contributing to innovation and product development.

Question 25

costs of a monopoly (FOR A FIRM)

Answer 25

1. Risk of investigation by competition authorities
   - Monopoly power may attract scrutiny and investigation by regulatory bodies such as the CMA
   - penalties and legal challenges can impose significant costs to the firm and harm its reputation, potentially reducing profitability
2. Deos
   - if a firm grows too large, it may face diseconomies of scale, such as higher managerial/coordination costs
   - these inefficiencies can erode cost advantages and negatively impact profitability
3. Complacency and inefficiency
   - lack of competitive pressure may lead to complacency, leading to X inefficiency and organisational slack
   - resulting in higher costs and lower productivity, reducing the potential benefits of monopoly power over time

Question 26

benefits of a monopoly for consumers

Answer 26

1. Economies of scale and lower prices
   - monopolies achieving eos can reduce production costs, potentially lowering prices for consumers
   - lower costs also allow firms to produce at a larger scale, meeting consumer demand more
2. innovation through r&d
   - supernormal profits allow monopolies to invest in research and development, creating higher quality products or entirely new goods over time
   - consumers benefit from access to innovative and improved products over time
3. International competition
   - a domestic monopoly may face competition from foreign firms, incentivising it to maintain efficiency and competitive pricing
   - this ensures consumers still gain access to better prices and quality

Question 27

costs of a monopoly for a consumer

Answer 27

1. Allocative inefficiency and higher prices
   - monopolies set prices above marginal cost, leading to higher prices for consumers and reduced allocative efficiency
   - consumers end up paying more than the optimal price for goods and services, reducing their overall welfare
2. deadweight loss
   - monopolies create DWL by reducing consumer and producer surplus, as fewer goods are produced and consumed than in a competitive market
   - this represents a loss of societal welfare and economic efficiency
3. no guarantee of reinvestment
   - monopolies, facing no competition, may not reinvest profits into improving products or processes
   - consumers may experience stagnant quality and limited choices, as the firm lacks incentive to innovate or enhance services
4. Lack of incentive to improve products
   - with no threat from competitors, monopolies may not prioritise product development or customer satisfaction
   - consumers may face outdated products or substandard service qualities

Question 28

costs of a monopoly to suppliers

Answer 28

1. monopsony power over suppliers
   - a monopoly with monopsony power may exploit suppliers by forcing lower prices, which can reduce suppliers revenues and stifle innovation or production at earlier stages of the supply chain
   - this can have knock on effects of the broader economy, such as reduced investment and job losses in upstream industries

Question 29

what is a natural monopoly

Answer 29

where one large business can supply the entire market at a lower long run avg cost, contrasted with multiple providers
- own 100% market share

Question 30

examples of natural monopolies

Answer 30

• national grid
• tfl
• thames water

Question 31

features of a natural monopoly

Answer 31

• huge fixed costs
• rational for 1 firm to supply the entire market
• competition is undesirable
• competition would result in wasteful duplication of resources and non exploitation of economies of scale, as only the first firm has economies of scale advantage

Question 32

in a natural monopoly, what might competition cause

Answer 32

• wasted products
• productive and allocative efficiency

Question 33

how would a natural monopoly be efficient

Answer 33

if it is regulated

Question 34

describe a non regulated natural monopoly graph

Answer 34

• no allocative efficiency or productive
• firm sets price where costs = mr, this restricts output and increases price
• as they provide essentials, this is unsustainable in the long run, so governments enforce regulations

Question 35

describe a regulated natural monopoly(graph)

Answer 35

• prices are lowered to where P = MC
• increased output
• however AC is greater than AR, so there’s a huge loss
• usually a subsidy is given that is the same value of the loss
• allows them to make normal profits in LR

Question 36

key takeaways from natural monopolies

Answer 36

• significant economies of scale
• minimum efficient scale is very high
• productively efficient for one firm to operate in the industry
• pricing for allocative efficiency leads to losses
• case for government ownership or subsidy, or right regulation

Question 37

what is price discrimination

Answer 37

where a firm charges different prices to different consumers for an identical good with no differences in costs of production

Question 38

conditions necessary for price discrimination

Answer 38

• firm needs price making ability, so need some kind of monopoly power
• need to have information to separate the market into different PED, eg identify consumers with inelastic PED so they can charge higher prices
• prevent reselling (market seepage)

Question 39

what is price discrimination in the third degree

Answer 39

when a firm is able to segment the market into different ped. so there’ll be one group of consumers with inelastic PED and one with elastic PED
- a firm will recognise that based on things like age, income, time differences, and will therefore charge different prices to different groups
- eg rail company

Question 40

advantages of price discrimination

Answer 40

Dynamic Efficiency

• PD enhances firm profitability, enabling greater investment in R&D.
• Supernormal profits generated from higher-paying consumer groups can fund innovation, product development, and technology improvements.
• eg, pharmaceutical firms use profits to develop new drugs,
  Impact: Increased dynamic efficiency can lead to long-term improvements in product quality and availability

Greater Economies of Scale

• Discrimination allows firms to produce at a larger scale, reducing average costs.
• By targeting different consumer groups, firms sell to a wider audience, increasing output.
• Higher sales volumes enable cost savings through economies of scale, particularly in industries with high fixed costs, like airlines or utilities.
• Lower unit costs can ultimately benefit consumers in competitive markets, as firms may pass on savings to some segments.

Some Consumers Benefit

• Price discrimination can make goods and services affordable for price-sensitive consumers.
• Second and third-degree discrimination, such as offering discounts for students or off-peak train tickets, provides access to lower-income groups who might otherwise be excluded.
• Consumers with elastic demand can enjoy lower prices, increasing their consumption and welfare.

Cross Subsidies
- Revenue from high-paying groups can subsidize services for less profitable ones.
- For example, utilities or airlines may charge business users higher rates, allowing affordable pricing for residential customers or economy passengers.
- Cross-subsidies can ensure the availability of services in underserved areas or for marginalized groups, supporting equity in access.

Question 41

cons of price discrimination

Answer 41

Allocative Inefficiency
- leads to prices above marginal cost, resulting in reduced consumption and allocative inefficiency.
- In some forms of price discrimination, firms charge higher prices to consumers with inelastic demand, restricting the quantity sold to those who might have purchased at a lower price.
- For instance, in first-degree discrimination, the firm extracts maximum consumer surplus, leaving no room for allocative efficiency.
- This misallocation of resources means some consumers are priced out of the market, leading to deadweight loss and societal welfare loss.

Inequality
- Discrimination widens income inequality, as those with lower elasticities pay disproportionately higher prices.
- Third-degree price discrimination often targets groups with less bargaining power, such as older individuals or those in specific locations, leading to regressive effects.
- Price disparities can exacerbate societal inequality, making essential goods or services less accessible to vulnerable groups, particularly in sectors like transportation or healthcare.

Anti-Competitive Pricing
- Price discrimination may undermine competition and lead to monopolistic practices.
- Predatory pricing in third-degree discrimination allows firms to set lower prices for specific consumer groups or regions, driving smaller competitors out of the market.
- This creates entry barriers and reduces market dynamism.
- Reduced competition can lead to long-term consumer harm, as dominant firms consolidate power and potentially increase prices once competitors are eliminated.