Oligopoly Flashcards
Explain the key features of an oligopolistic market.
1) Number of producers: Dominated by a few large firms where market concentration is high - remember to calculate the market concentration ratio of the larger 3 to 5 firms and link it to there being a few dominant firms which is the key characteristic of oligopolies. Hence, there is a high degree of interdependence or rival consciousness that exists amongst firms. Every action - price, non-price and output decisions taken by a firm will affect the sales of all the other firms in the market significantly and rivals’ actions cannot be ignored as they are likely to result in significant effects.
2) Extent of barriers to entry and exit: High
Strategic barriers such as:
- Limit and Predatory pricing - usually illegal occurs when prices are deliberately set very low by a dominant firm to restrict or prevent competition. Limiting prices involves charging a price that is lower than the profit-maximising price so as to prevent rivals who typically operate on a smaller scale, higher AC from entering the market because they cannot match the price without incurring a cost. Predatory pricing involves lowering prices below costs to drive out existing competitors and scare off potential entrants.
- Advertising and branding establishes brand loyalty and makes it difficult and costly for potential firms to enter.
Statutory barriers (Monopoly)
Natural barrier arise from substantial iEOS, meaning AC for existing firms falls over a very large output and a new entrant is unlikely to be able to produce at a scale that is equal to that of the incumbent due to lack of an initial customer base. Since it cannot produce near MES, higher AC makes it harder for new entrants to compete with the incumbent.
3) Nature of good: Homogeneous (pure/perfect oligopoly) or differentiated (imperfect) where there may be less fear of immediate reaction from rivals as rivals may perceive the change in price to be due to modifications to the product. Product differentiation occurs on a greater scale compared to monopolistic firms as a result of larger funding in innovation and advertising and their ability to retain supernormal profits in the long run.
4) Imperfect knowledge about production methods and prices which also serves as a BTE and increases the price-setting ability of the oligopoly.
5) Market power: Price setter
Explain how these features lead to firms’ behaviour (price rigidity, price leadership, cartel, and non-pricing behaviour)
Price rigidity: Each oligopolist is assumed to want to protect and maintain its own market share hence it conjectures that its rivals will match any price decreases and not price increases. This gives rise to the kinked demand curve theory which explains why prices in an oligopoly are generally stable because of fear of competitors reactions. Note that analysis of the kinked demand curve theory is not required. However, the key points are that:
When a firm increases price beyond its equilibrium price, competitors do not follow suit and there will be a more than proportionate fall in quantity demanded for the firm to an increase in its own price, leading to a fall in total revenue. When a firm lowers its price beyond its equilibrium price, competitors follow suit and there will be a less than proportionate increase in quantity demanded for the firm to a fall in its own price, leading to a fall in total revenue. The firm will also not gain market share as its sales expand only in proportion to the expansion in industry sales. Hence, the firm’s demand curve above equilibrium price is more elastic than the demand curve below the equilibrium price and it is kinked at the equilibrium price.
cartels - formal, explicit collusion (e.g. OPEC) are an agreement between firms to maximise joint or industry’s profits by acting as a monopoly. Each firm is given a production quota based on the cartel’s profit-maximisation output and each firm must agree on how to divide the market (usually according to the current market share)
However, there are risks and uncertainty involved such as the:
1) Incentive to cheat secretly by increasing production beyond its given quota to maximise its own profits, above its own share of the joint profits. When this happens, other members will also increase output beyond the quota, increasing market supply, causing prices to fall and a collapse of the collusive agreement.
2) Cartels are deemed illegal by many countries but it is also hard to prove that a group of firms have deliberately joined together to increase prices
It will be easier to achieve if:
1) fewer firms so output can be monitored
2) more standardized products, more similar the production methods and cost conditions
3) market demand is not too variable
4) less secrecy between members
5) lack of government intervention to curb collusion
price leadership model - informal, tacit collusion
Incomplete information about the motivations of other firms may induce tacit collusion where unwritten rules of collusive behaviour arise and firms take care not to engage in price-cutting, excessive advertising or other forms of competition.
It involves the price set by the market leader being accepted by the other firms as the market price (deemed to be the best way of protecting their market share and profits. Hence, prices tend to be stable.).
The market leader is chosen through:
1) The barometric model - the firm that is more adept at identifying changes in market conditions and hence the ability to respond efficiently within the market section will be the market leader. Other firms follow suit, assuming that the market leader is aware of something they have yet to realise.
2) Dominant firm model - the firm which controls the vast majority of the market share will be the market leader and other smaller firms will follow suit to maintain the small market shares they have.
Non-pricing strategies include product development, product proliferation (making many different types, uses, giving rise to variety) and other strategies such as free gifts.
Price Wars
Arise when there is considerable excess capacity in the industry and they are likely to be initiated by the firms with the largest MES. Rivals who operate on a smaller scale, higher AC, shutdown/continue in SR and shutdown in LR, giving the victorious firms a larger market share, market power and hence profitability.
By initiating price wars, firms may make losses in SR but gain market share and maximise profit in the LR.
Define market concentration ratio and state its mathematical formula.
The concentration ratio is calculated as the sum of the market share percentage held by the largest specified number of firms in an industry. The concentration ratio ranges from 0% to 100%, and an industry’s concentration ratio indicates the degree of competition in the industry. The four-firm concentration ratio is calculated by adding the market shares of the four largest firms: in this case, 16 + 10 + 8 + 6 = 40. This concentration ratio would not be considered especially high, because the largest four firms have less than half the market.
Explain why oligopolies avoid price competition and prefer non-price-competition.
Firms in an oligopoly may compete intensely for a period and realising there is no winner before deciding to collude and jointly raise prices and lower advertising costs. Competition may later erupt when a new firm enters, a new product emerges or simply because firms cannot resist the urge to cheat. Due to the mutual dependence and uncertainty in an oligopoly, oligopolists can compete or collude. Thus, they prefer to use non-pricing strategies to differentiate their products to minimise the risk of price wars or breaking a collusive agreement.
Explain the concept of ‘collusion’ for oligopoly. Name the two types of collusion.
Collusion is a formal or informal agreement among oligopolistic firms on what prices to charge and how to divide the market. The two types of collusion are the cooperative model - collusive oligopoly and the competitive model
It is to reduce uncertainty/unpredictability of a rival’s reactions to a firm’s pricing strategies and cut costs of competition (marketing wars).
This is done by firms agreeing on output quotas or fixed prices, putting limits on the extent of product promotion, development and agreeing not to poach each other’s markets.
Evaluate the merits and demerits of oligopoly using the following criteria: productive efficiency, allocative efficiency, dynamic efficiency, consumer surplus, choice and equity
Firms in imperfect competition have a downward-sloping DD curve as they are price-setters and hence its AR or price is greater than MC and at the profit-maximising level, P > MC and are thus allocatively inefficient unlike firms in a perfectly competitive market. However, where there are substantial EOS to be reaped, and where industries with huge MES, the monopolists are able to enjoy significant iEOS, meaning AC keeps falling over a very large output and gives rise to a very low MC which is much lower than that of a PC, hence consumers enjoy the benefits of lower prices and higher quantity.
It does not achieve productive efficiency as it retains supernormal profits in the long run due to the presence of complete or high BTEs and can afford to be X-inefficient while existing in the industry. However, it still results in a waste of resources. Due to globalisation and the removal of protectionist barriers, there has been a growth of international competition from big foreign conglomerates that vie for a share of the lucrative domestic market and these firms can be competing in terms of price-cutting or other non-pricing strategies. Hence, the sales of the incumbent will be affected and it must reduce its X-inefficiency to survive in the market.
Consumers often suffer from exploitative pricing as it tends to exacerbate inequity in the economy with its supernormal profits being concentrated at the hands of a select few monopolies which have the ability to block potential entrants or a few dominant producers at the expense of consumers who pay higher prices for a limited quantity of goods. Anti-competitive behaviour in oligopolies serves to further reduce consumer surplus. However, due to the substantial iEOS, consumer surplus may not be reduced.
An oligopolistic firm has the incentive and ability to innovate.
Oligopolies tend to engage in multiple branding where they produce essentially the same products but package them under different brand names and engage in extensive advertising in order to maintain their market share, this limits consumer choice to the existing dominant firms in the market.
