Oligopoly Flashcards
What is an oligopoly and what are its key features(3)?
Oligopoly is a market which has a few large firms competing with each other. The features are:
- Small number of firms: a small number of firms dominate the market so that they are able to set the price. Domination is measure by the % of total industry output (sales) accounted for by the top few firms (x firm concentration ratio). For example the UK supermarket industry has a 4 firm concentration ratio of about 75%.
- Interdependence: when there are only a few large firms they cannot act independently of each other - each firm will react to what the other does. A complete model would have to include predictions of how other firms might react to the actions of others.
- Barriers to entry: this means LR abnormal profits are possible. These may be the brand loyalty/image of the bigger firms, EoS of existing firms, existence of patents, sunk costs or limit pricing strategies.
How do firms tend to act(3) in an oligopolistic market and what are examples of some oligopolistic markets?
Firms in an oligopoly tend to act in a certain manner:
- Non-Price competition: oligopolistic firms tend to compete using al 4 Ps (Promotion, Price, Place, Product), not just price. In particular the development of a strong brand by the major firms is a common feature.
- Price Rigidity: empirical evidence suggest that prices of not change as often in an oligopolistic market, even when costs of production change.
- L-Shaped LRAC: this suggests at some point AC curve becomes flat. At output levels below this level (minimum efficient scale of production) AC will be considerably higher.
In reality most markets we are familiar with are probably oligopolies. The soft drinks market (Coke & Pepsi), sports wear (Nike, Adidas & some smaller but significant firms like Puma), supermarkets (Tesco, Sainsburys, Morrisons & Asda in the UK, with Aldi & Lidl gaining), cars, computers etc.
What does the oligopoly model look like?
All other models are based on ‘ceteris parabus’ (other things reman equal) but this is certainly not the case in an oligopoly, as firms are interdependent, i.e. if one firm changes its price, its competitors will react.
The traditional model is the ‘kinked demand curve’. If we start at P, then if the firm increased its price, its competitors would not react and keep their prices the same so the firm would lose lots of customers, D is elastic above P. However, if the firm cuts the price its competitors would react and also cut prices, so the firm gains only a few sales, D is inelastic below P.
Diagram:
Looks the same as for monopolies but D is elastic above P and inelastic below P, hence MR consists of two curves, one for the D above P and one for the D below P.
However, this model has been criticized (why do we start at P? If a firm did change P then the demand curve would be kinked around a different point etc)
What is game theory and how does it relate to oligopolies?
Game theory explores the reactions of one player to changes in the strategy by another player. In other words it tells us if player X takes one course of action how might/should player Y react. This is basically how an oligopoly works.
In oligopolies we use “The Pay Off Matrix”. This is an example of “the prisoners dilemma”. It assumes that if one firm cuts its price it would gain lots of customers (& the other would lose lots of customers). It also assumes that if both firms cut their prices they will both be worse off (the market is elastic as a whole). It is a table, Firm A on the left, Firm B on the right(top). It can be used to show changes in price, advertising, collusion. The “pay offs” are usually changes in profit.
The dominant strategy is always to cut price, for both firms, this leads to the Nash equilibrium of (cut, cut). This explains why oligopolistic often enter a price war, each cutting prices until there is only normal profit.
What is collusion?
Collusion is where firms come together for a collective agreement which will restrict competition. The tactics of collusion are called restrictive and anti-competitive practices.
The clearest form of collusion is in price setting, where a firm large firms may agree what prices to charge and to not enter price competition: a “cartel”.
When firms collude they effectively turn the oligopolistic market into a monopoly - this means they can make supernormal profits, which may be competed away in a more competitive market. Game theory shows how firms can be better of colluding.
How likely is collusion?(6)
Game theory shows that both firms can benefit from collusion, hence there is clearly a strong incentive to collude.
Also the model shows that collusion is inherently unstable. There is a strong incentive to both firms to break the deal, not only because it gives them short term profits, but also in fear that the other firm will break the deal.
How stable a collusion deal is depends on:
- Number of firms - fewer firms makes collusion easier
- Similar cost structure - easy to justify similar prices
- Barriers to entry - high barriers stop new entrants from undercutting firms
- Existence of a “credible threat” - is there punishment for firms who break the deal?
- Level of government regulation & penalties for collusion (amnesties for confessing and fines)
- Expanding economy - makes it harder to monitor a market. Alternatively if firms have ‘spare capacity’ there is greater incentive to break a deal.
What are the different types of collusion?(2)
Overt collusion - where firms make a formal agreement to limit competition. Given that this is illegal in almost all countries, it is rare! However it does happen between countries (OPEC).
Tacit collusion - where there is no agreement, not even a verbal agreement. Instead “unwritten riles” develop over time and firms understand ways in which they can & cannot compete. One form of tacit collusion is “price leadership” where the dominant firm is a price leader (i.e. sets the price) and the smaller firms are price followers (i.e. set a price usually just below the price leader).
What are the pricing strategies that firms in an oligopoly can use?(4)
If firms want to compete on price there are a number of pricing strategies they could use:
- Revenue Max Pricing - as opposed to profit max, it would increase market share (but means less profit)
- Sales Max Pricing - increased market share
- Limit Pricing - setting a price at the minimum point on the AC/AVC, in order to discourage new entrants to the market, who have higher costs due to EoS
- Predatory Pricing - setting a price below AC/AVC (make a loss) and so force other firms out of the market. You can then raise prices once other firms have been forced out. It may involve cross-subsidisation, where a firm uses profits in one area to finance another, loss making, part of the business. Predatory pricing is illegal with large fines
What are the various forms of non-price competition?
Given the damage a price war can do, a key feature of oligopolies is the focus on non-price competition. The most obvious form of this is advertise & develop a brand image. This gives firms a greater level of consumer recognition, greater brand loyalty and a perceived uniqueness, and so boosts sales. There are many other forms of non-price competition, such as: improving the quality of the product, offering better after-sales service, loyalty cards etc.
However all these have a cost to the firms, which may outweigh the benefits. A game theory matrix can be used to show how other firms may react to an increase in advertising by another firm.
