Oligopoly

Question 1

Oligopoly

Answer 1

Where the industry is dominated by a few suppliers

Question 2

Market Concentration Ratio

Answer 2

The percentage share of the market of a given number of firms

Question 3

Why can the concept of concentration ratios be useful in understanding the degree of competition?

Answer 3

When there is a high (few firm) market concentration ratio who dominate the market, they are able to control prices and are able to collude

Question 4

Criticisms of concentration ratios

Answer 4

1. Difficult to define the market
- the narrower the definition of the market, the greater a firms market power, regardless of market share

2. Doesn’t take into account the size of different firms in the market

Question 5

Assumptions of an oligopoly

Answer 5

1. A high 3-5 market concentration ratio
- supply in the industry is concentrated in the market or relatively few firms
- therefore a lot of firms in the industry but there are only a few firms that dominate market power

2. Firms are interdependent
- if one firm was to lower their prices, consumers will start buying from that firm instead of others
- the actions of one firm will directly affect the other this means that in the industry there are relatively similar products

3. High barriers to entry and exit
- maintains the power of the oligopoly
- may be hard for new firms to start up and maintain profits

4. Short run profit maximizers
- operate where MC = MR

Question 6

The kinked demand Curve

Answer 6

Assumes that the way firms respond to another firm changing price depends on whether the prices increased or decreased
- there will be an asymmetrical reaction to the changing price

Question 7

How will other firms respond if a firm decides to reduce its price?

Answer 7

If one firm was to lower their price every other firm would also want to lower their prices as they don’t want their market power eroding

Question 8

What impact will this have on the demand for the firm which initially reduced its price?

Answer 8

demand won’t increase more than proportionally
- means that it is an inelastic demand curve

Question 9

How will other firms respond if a firm decides to increase its price?

Answer 9

other firms will keep their prices the same as firms compete with lower prices

Question 10

What impact will this have on the demand for the firm which initially increased its price?

Answer 10

demand will decrease more than proportionally
- means that it is a elastic demand curve

Question 11

Why isn’t the demand curve perfectly elastic?

Answer 11

• brand loyalty
• inertia
• time lag with consumers = takes time for them to realise prices have changed so wont immediately switch

Question 12

Why isnt the demand curve perfectly inelastic?

Answer 12

• time lag = people will move when prices go down and by the time prices go down they will have already moved
• lower prices will attract new customers that are not already in the industry

Question 13

Why is the marginal revenue curve discontinuous?

Answer 13

If go beyond Q1, would need to lower prices which leads to a less than proportional increase in quantity demanded which would lead to a lower total revenue
- this means that MR is negative beyond Q1 as increasing output by one, total revenue decreases

Question 14

Market equllibrium output

Answer 14

MC = MR

Question 15

What would the level of profit be like?

Answer 15

Very high as there is few firms in the industry that have a high market share and so make collude and set high prices
- to make supernormal profit
- also high barriers to entry so other firms cannot enter

Question 16

Collusion

Answer 16

Firms make agreements to each other over prices and output
- collude to maximize profits

Question 17

Types of collusions

Answer 17

1. Formal
- agreements are reached by citing a contract
- may decide to limit output which leads to prices being higher
- illegal when firm and firm but legal when country and country

2. Informal
- informal chats/meetings/agreements
- also illegal but not as easy to uncover as formal
- this takes the form of price leadership
- when a large and bigger firm in the industry sets a high price and everyone else follows

3. Strategic Alliances
- when firms work together more loosely
- not on prices, could be anything else
- not really a collusion

Question 18

Two conditions for collusion to hold

Answer 18

1. Firms have similar costs
- less likely to hold when vast differences in costs

2. When all firms in the industry are in the collusion together
- if one firm not in the collusion , it can break

Question 19

Price War

Answer 19

When firms keep lowering their prices

Question 20

Why is a price war likely to occur when a firm breaks a collusion?

Answer 20

• other firms will also lower their prices to maintain their own market share and so that their consumers don’t start buying from other firms

Question 21

Price rigidity

Answer 21

Because of the price wars which would result if prices were to adjust,prices tend to remain stable at the agreed price via collusion
- prices will remain unchanged even if there is a relatively small change in cost of production
- output and price still remains the same because the MC still intersects MR at the discontinuous part

Question 22

Non-price competition

Answer 22

firms cannot compete with price so have to compete with non-price factors
- better quality
- branding
- advertising

Question 23

What is the dominant strategy?

Answer 23

Regardless of what one firm decides to do, the other firm always has the incentive to blame (or lower price) as it benefits them the most

Question 24

Nash equilibrium

Answer 24

When both firms choose the dominant strategy

Question 25

How could joint welfare be improved through collision?

Answer 25

If both firms decide to collude, joint welfare is maximised
- the collusion box

Question 26

Why do both firms have an incentive to collude?

Answer 26

Both companies have the incentive to lower prices

Question 27

Why might a collusion not hold?

Answer 27

firms have the incentive to lower prices to gain more market share

Question 28

Efficiency implications

Answer 28

1. Productive inefficiency
- not operating at the MES on the AC Curve
- output is restricted due to an already colluded price

2. Allocative inefficiency
- P > MC
- consumers are willing to pay more for the good but do not have access to the good
- many people values the good more than the cost of producing in additional units so the price is higher than MC
- firms collude at a higher price

3. Dynamic efficiency
- make super-normal profit so can invest in R&D
- due to price rigidity, they are not able to compete with prices and so compete with non-price factors

4. X-inefficiency
- workers may slack due to guaranteed supernormal profits

Question 29

Implications for consumer welfare

Answer 29

1. High Price
- restrict output and increase price if collusion holds
- if the collusion doesn’t hold there is lower prices

2. High quality
- dynamically efficient
- cannot compete with price so may invest in R&D to improve quality

3. Low/High Choice
- in an oligopoly market firms compete with non-price factors and so sell slightly differentiated products
- there might not be so much choice as assume they sell similar products

Question 30

Advantages of an oligopoly

Answer 30

High quality goods
- due to dynamic efficiency and firms earning supernormal profit
- firms can’t compete with prices as very stable and so have to compete with non-price factors
- slightly differentiated products and so more choice for consumers

2. Price rigidity
- prices tend to remain stable at the price agreed via collusion
- prices remain unchanged even if relatively small changing costs the production output remains the same so easier for consumers to plan

3. Price wars
- prices become lower
- price wars can happen in the short-term as firms making SNP incentivized to lower their prices to steal market share from competition and gain even greater profit
- in response other firms are likely to respond by also dropping their prices causing prices to fall rapidly to the nash equilibrium
- kinked demand curve shows the interdependency of firms so if one firms decreases price so will others, leading to price wars

Question 31

Disadvantages of oligopoly

Answer 31

1. High prices
- due to the market concentration, a small number of firms have a lot of market power and so are able to collude instead very high prices which can ration a low-income consumers out of the market
- use predatory pricing and other barriers to entry to prevent new firms from entering the industry and increasing the market concentration ratio

2. Inefficiencies
- this is because they restrict output due to an already colluded price

3. Limited choice
- although there are some similar products that are differentiated they are similar as there is limited competition
- consumers in an oligopolistic market have fewer options for products