Oligopolies Flashcards
What are the characteristics of an oligopoly market
- Few firms dominate the market so high concentration ratio
- Differentiated goods so firms are price makers
- High barriers to entry/exit
- INTERDEPENDENCE leading to price rigidity
- Price rigidity leads to non-price competition like branding, advertising and quality of good or service
- Firm’s objective is based on whatever gives them the most market share so not necessarily profit max
What are examples of oligopoly industries in the real world
- UK supermarket industry
- UK energy industry
- UK airline industry
- Global soft drink industry (coke and pepsi)
- Global Car industry
- OPEC (organisation of petroleum exporting countries)
What does interdependence mean
Firms don’t make decisions independently, they make decisions based on the actions and reactions of rival firms
i.e. They think about what rival firms are going to do first
What does the kinked demand curve look like
- AR = D label
- Price P1 and Q1
- Above P1, ped is elastic
- Below P1, ped is inelastic
Why is the kinked demand curve elastic above P1
If a firm raises their price above P1, other firms will not follow this price rise as they look to gain market share i.e. other firms are trying to undercut them in price
Causes demand to drop off significantly compared to the increase in price
Why would a firm not raise their price past P1
- Market share will decrease as consumers move to other firms charging a lower price (to gain CS)
- Total revenue will decrease as P hasn’t risen as much as Q has fallen so P*Q decreases
Why is the kinked demand curve inelastic below P1
- If a firm lowers their price below P1, other firms will follow this price drop as they look to protect market share i.e. other firm is engaging in price war
- Causes demand to not increase much compared to the fall in price as consumers don’t gain any CS from changing firms
Why would a firm not lower their price below P1
- Market share would not change in the long term as they don’t gain CS from changing to a different firm (every firm is still charging the same)
- Total revenue will fall as P*Q decreases
What 2 conclusions can be drawn from the kinked demand curve
- Firms don’t want to raise their price
- Firms don’t need to lower their price
What does the MR curve of the kinked demand curve look like
- Twice as steep for the elastic section
- Vertical line until P=0 for kinked section
- Twice as steep for inelastic section at negative P
What can drawing the MR and MC curves on a kinked demand curve show
- If oligopoly is a profit maximiser, as long as MC changes (i.e. shifts up or down) within vertical gap of MR curve, the firm will always charge a price of P1 (read off AR curve at MC=MR)
- This further shows that the firm doesn’t need to change their price from P1 as long as MC is within the vertical gap
When could there be price competition in an oligopoly
- Firms still try lowering their price to gain market share as even if it doesn’t make theoretical sense, it could work in the real world
- This leads to a price war, which we see a lot in industries like UK supermarket
Why may an oligopoly collude
- Firms don’t want to have to worry about how rivals will react and what to do with their price
- Therefore, there is a strong temptation for firms to join together and act as a monopoly, making very high profits
How can you show interdependence using game theory
- 2 x 2 matrix with firms A and B and options as £1 or 90p (for example)
- pay-offs are:
3mil , 3mil if both charge £1
4mil , 0.5mil where 4mil is for the one that charges 90p and 0.5mil for the one that charges £1
1mil , 1mil if they both charge 90p
(Basically just a prisoners dilemma but with money)
What are the outcomes from the game theory interdependence matrix
- Both charging 90p is the nash equilibrium so is the stable price that firms will charge in the long run
- Both charging 90p is a dominant strategy so the firm should charge 90p no matter what the other firm does
What are the conclusions about firm behaviour from the game theory interdependence matrix
- Nash equilibrium at 90p , 90p means price rigidity as no incentive for firms to change from the stable long run outcome. This means firms rely on non-price competition
- Shows temptation to collude as if firms break independence and collude, they could both charge £1 and earn 3mil each instead of 1mil
- Shows temptation to cheat on the collusive agreement as they can undercut the other firm and make 4mil instead of 3mil, meaning collusion may not last in the long term
What is an overt collusion
Where firms explicitly agree to fix prices, fix quantity (i.e. limit output) or restrict competition. It is usually illegal under competition law.
e.g. formal cartels like OPEC or secret meeting between CEOs to agree on prices
What is a tacit collusion
When firms coordinate prices without an explicit agreement. It is normally legal as it is harder to prove and happens naturally in concentrated markets
e.g. price leadership where firms follow the behaviour of one firm in the market
What factors promote a competitive oligopoly
- Less concentrated oligopoly (i.e. large number of firms) means it’s harder to organise collusion
- If there are low barriers to entry, supernormal profits from collusion would get eroded
- If one firm has significant cost advantages, difficult to know what level to set the fixed price of the collusion at as firms will disagree with each other
- If there are homogenous goods, firms don’t have the price-making power to fix prices or elastic ped means profits are low
- Saturated market means firms care a lot about market share so would be more likely to cheat on collusion
What factors promote a collusive oligopoly
- Concentrated oligopoly (i.e. small number of firms) means it’s easier to organise collusion
- High barriers to entry means the firms can make supernormal profits in the LR
- If firms have similar costs, it’s easier to know what fixed price and quantity to use to maximise profits for the collusion and firms will agree with each other
- Ineffective competition policy means firms are likely to get away with colluding and making high supernormal profits
- If consumers are loyal to their firms, undercutting price won’t attract many new consumers so cheating on collusion is less likely
- If there is consumer inertia (barriers to switching firms) cheating on collusion is less likely
How can you evaluate whether the competitive oligopoly is good
The market has a competitive outcome as there are a large number of firms so speak about pros and cons of a competitive market e.g. with efficiency, EoS etc
How can you evaluate whether the collusive oligopoly is good
Collusive oligpoly acts like a monopoly so speak about the pros and cons of a monopoly e.g. with efficiency, EoS etc
