Oligopoly Flashcards
What are the features of an oligopoly?
An oligopoly is an industry which is dominated by a few firms. One definition of an oligopoly is a five firm concentration ratio of more than 50%.
Features of oligopoly include:
1. Interdependence of firms: firms will be affected by how other firms set price and output.
- Barriers to entry (but less than monopoly).
- Differentiated products. Advertising and non-price competition are often important in oligopoly.
How do firms in an oligopoly compete?
There are three main possible ways for firms in oligopoly to compete
:
1.Price competitive / price wars. An oligopoly where firms try to gain market share and where prices and profits tends to be low.
- Stable prices / focus on non -price competition. The kinked demand curve suggests prices will be stable and firms focus on non -price competition.
- Higher prices / collusion. If there are barriers to entry, firms may try to maximise price through increasing prices. This may involve collusion.
Factors that determine oligopoly behavior
- The objectives of the firms, e.g. profit max or sales max.
- The degree of contestability, e.g. amount of barriers to entry.
- Government regulation, e.g. preventing collusion and price fixing.
- The nature of the industry, e.g. is the industry in growth phase or decline? A declining industry may be more prone to price competition, as firms try to retain sales.
What is game theory?
This examines the behaviour of firms considering how decisions of other firms affect their own choices. For example, if a firm in oligopoly cuts price, the outcome will largely depend on how other firms react, e.g. do
other firms also follow suit (starting price war), or do they keep prices high?
What is the kinked demand curve model?
•This model assumes firms seek to maximise profits.
- If a firm increases price, then they will lose a large share of the market, because they become uncompetitive compared to other firms, and therefore demand is elastic for price increases.
- If firms cut prices, then they would gain a big increase in market share. However, it is unlikely that firms will allow this. Therefore, other firms follow suit and cut prices as well. Therefore, demand is inelastic for a price cut.
- This suggests that increasing or decreasing prices will lead to lower revenue and therefore prices will be rigid in oligopoly.
KINKED DEMAND CURVE DIAGRAM
What are the limitations of the kinked demand curve?
- The model does not explain how prices were set in the first place.
- Price stability may be due to other factors.
- In the real world, firms often do cut or increase price.
- Firms may not be profit maximisers, but seek increased market share, even if it means less profit.
what are the factors of non price competition?
- Advertising. This creates product differentiation and brand loyalty. Advertising can also be used as a barrier to entry.
- Product development. This could be an effort to improve the quality of the product, such as mobile phones with more features.
- Loyalty cards. A reason for customers to come back.
- Quality of service. Increasing loyalty and making demand more inelastic, through better quality goods.
- Location. Better location for firms. For many products, such as restaurants and cafes, location is everything. Unless you have a good location, you will not pick up passing trade
Advertising pros and cons
Pros:
Increase brand loyalty
Successful advertising can make demand more inelastic
Cons:
It depends on the product, brand loyalty would be relatively ineffective on the likes of petrol
It depends on the effectiveness of the advertising such as using high end celebrities to promote the prooduct
Price cuts pros and cons
Pros:
This will work if demand is elastic and sensitive to price as this involves undercutting competitors by cutting prices. This might work for a product such as petrol and budget airlines.
Cons:
It depends on how other firms react to this as it could start a price war which wouldnt increase sales.
It depends on the existing brand loyalty.
What are the factors of a price war?
- Price wars are more likely in a recession, when demand is falling and markets become more competitive.
- Price wars tend to be short-term because, otherwise, firms will make a loss.
- Price wars are often selective, e.g. supermarkets have selective price cuts on “loss leaders”. This can give a misleading impression of price competition.
- Price wars can be in the public interest, but only if firms don’t get forced out of business by the low prices.
What is predatory pricing?
- This occurs when a firm lowers prices in some sections of the market, with the intent of forcing another firm out of business.
- To set price below cost, the firm will need to cross subsidise the market from other profitable markets.
- Predatory pricing is against the public interest, because the dominant firm can increase prices when its rival has left. There is legislation which makes predatory pricing illegal.
What is collusion?
•Collusion occurs when firms agree to limit competition, by setting output quotas and fixing prices.
•A cartel is a formal collusive agreement. For example, OPEC is a cartel of the major oil producers.
•Tacit collusion is an unwritten agreement where firms observe informal rules, such as not undercutting rivals. Tacit collusion often occurs if there is government regulation against cartels and collusion.
•Overt collusion is where firms are open about their deals to set prices and output.
•Through collusion, firms are able to maximise profits of the industry. There will be a similar price and outcome to a monopolistic industry, with firms effectively sharing the supernormal profits.
•Collusion is seen as against the public interest, because of higher prices leading to allocative inefficiency. There is legislation against collusion and
cartels in the UK.
Evaluation of collusion
- Collusion enables higher profits. However, if firms are found guilty of collusion, they can be fined and so end up with lower profits.
- Collusion is unlikely to occur if they aim at sales maximisation.
- Firms may justify collusion on the grounds that it encourages stability, and the higher profits can be used to finance investment, leading to better products. However, under collusions, firms may become inefficient, because it is easy to make profit and they don’t have to try hard.
