Oligopoly and concentrated markets 1

Question 1

Imperfect competition

Answer 1

Describes the range of market structures lying between perfect competition and pure monopoly.

Question 2

Spectrum of imperfect competition

Answer 2

Stock exchange - approximate to perfect competition.

Duopoly - market structure closest to pure monopoly.

Question 3

Duopoly

Answer 3

Special case of oligopoly.

Describes a market where there are two dominant firms.

Question 4

Oligopoly

Answer 4

Imperfectly competitive market containing only a few firms. Oligopolistic firms are not pure monopolies , but they possess monopoly power.

Question 5

Pure monopoly

Answer 5

Precise market structure.

Question 6

Imperfectly competitive market structure and monopoly power

Answer 6

Firms in all imperfectly competitive market structures can exercise a greater or lesser degree of monopoly power

e.g. by imposing entry barriers that enable the firm to raise the price of a good.

Whenever firms exercise producer sovereignty in this way, monopoly power exits.

Question 7

Concentration ratio

Answer 7

Measures the market share of the biggest firms in the market.
Good indicator of oligopolistic market structures.

Question 8

Oligopoly best defined

Answer 8

Oligopoly is best defined by market conduct (behaviour of firms) rather than market structure or concentration ratios.

Question 9

Oligopoly and market conduct

Answer 9

Oligopolistic firms affect its rivals through its price and output decisions, but its own profit can also be affected by how other firms behave and react to the firms decisions.

eg. Firm reduces prices in order to increase market share and boost profit. Whether this leads to an increase in profit depends on reactions of other firms. So when making this decision the firm must consider the likely responses by other firms.

Question 10

Perfect oligopoly

Answer 10

Exists when oligopolists produce a homogenous product eg. petrol.
One petrol brand is a perfect substitute for any other brand.

Question 11

Imperfect oligopoly

Answer 11

Products differentiated by nature and are imperfect substitutes eg. automobiles.

Question 12

Competitive oligopoly

Answer 12

Displays reactive market behaviour and strategic interdependence amongst firms.

Rival firms are interdependent:

1: Must take into account the reactions of one another when forming a market strategy.
2: Independent in the sense that they decide their market strategies without cooperation or collusion.

Question 13

Characteristic of competitive oligopoly

Answer 13

Uncertainty - a firm can never be sure how another firm is going to react to its marketing strategy.
If a firm raises its price will the others follow suit or hold steady in the hope of gaining sales and market share.

Question 14

Why use kinked demand curve?

Answer 14

• illustrate how a competitive oligopolist may be affected by rival’s reaction to its price and output decisions.
• why there is not much price war in an oligopolists price market.
• illustrate how oligopolists are interdependent and affected by uncertainty

Question 15

Kinked Demand Curve Theory

Answer 15

1: In order to know how sales might change following a change in price, firms need to know the position and shape of the demand and revenue curves for their products.
2: In imperfectly competitive markets, firms lack accurate information about these curves, especially at outputs significantly different to those being produced. Therefore demand curve is not necessarily the actual demand curve for the oligopolists output. It represents an estimate.

Question 16

Kinked Demand Curve Theory: Increasing price

Answer 16

Firm expects rivals to react by keeping prices stable.
Rivals hope to gain profit and market share at the firms expense.
Oligopolist expects demand to be relatively elastic in response to price change. Expects more than proportionate change in demand when prices changing.

Question 17

Kinked Demand Curve Theory: Decreasing price

Answer 17

Expects rivals to react by matching price cut.
As downward sloping demand curve, each firm will benefit from some increase in demand. However, oligopolist fails to gain sales revenue within the market. There expects demand to be less elastic, and possibly relatively inelastic proportionate change in demand. Expects rivals to react asymmetrically.

Question 18

Kinked demand curve theory: Conclude

Answer 18

Price decreasing and increasing curve intersect, therefore kinked demand curve. In this situation, the oligopolist fears that both a price increase and a price cut may reduce total profit.
Given this fear, best policy may be to leave price unchanged.

• Firms can co-exist
• Large cost changes will impact prices.
• KDC is only true for small changes.
• This is one model of oligopoly but not the only one. NOT complete model of oligopoly.

Question 19

Why prices are stable in oligopoly

Answer 19

Vertical section MR curve. Links MR curve with relatively less elastic demand curve.

Question 20

MR curve on Kinked demand curve

Answer 20

MC can rise and fall within the vertical range of the MR, without altering the profit-maximising output. If it leaves this region then oligopolist would have to set a different price to maximise profits, providing the AR accurately measures demand.
Oligopolists selling price remains stable on vertical marginal cost curve, despite considerable changes in marginal costs.

Question 21

Criticisms of Kinked Demand Theory

Answer 21

• Few economists now accept
• Incomplete model as it does not explain how the market reaches the initial scenario
• Evidence provided by the pricing decisions of real-world firms gives little support to the theory. Competitive oligopolists rarely change prices in manner assumes by kinked demand curve.
• – This is only a model, it suggests price stability however there are several very severe price wars in oligopoly as many may not be operating on KDC.
• Research shown oligopoly prices tend to be stable or sticky when demand conditions change in a predictable or cyclical way, BUT oligopolists usually raise or lower prices quickly and by significant amounts, when production costs change substantially, and when unexpected shits in demand occur.

Question 22

Aspects of pricing in oligopolistic markets

Answer 22

Cost-plus pricing
Price parallelism
Price leadership
Limit pricing
Predatory pricing
Price discrimination

Question 23

Cost-plus pricing

Answer 23

• Most common pricing procedure used by firms in imperfectly competitive markets
• Firm sets its selling price by adding a standard percentage profit margin to average costs

P = AFC + AVC + profit margin

If customers are captive and willing to pay high prices, the profit mark up can be high. eg. fashionable goods.
When markets are more competitive, firms find it much more difficult to charge a mark-up.

Question 24

MR = MC … real world

Answer 24

• Necessary condition for profit maximisation HOWEVER, not the decision making-rule in the real world, much more likely to take cost plus pricing.

Question 25

Price parallelism

Answer 25

• Identical prices and price movements within an industry.
  1: Can occur in a very competitive market which resembles perfect competition, where all firms all charge a ruling market price determined by demand and supply.
  2: Price parallelism results from price leadership in tightly oligopolistic industries, where overt or tacit price collusion takes place.
  Make it difficult to decide whether market is highly competitive or collusive.

Question 26

Overt collusive agreements

Answer 26

• Overt collusive agreement to fix market price are usually illegal, imperfectly competitive firms often use less formal or tacit ways to coordinate their pricing decisions.

Question 27

Price leadership

Answer 27

Covert collusive agreement

- One firm becomes the market leader and other firms in the industry follow its pricing example

Question 28

Limit pricing

Answer 28

• Natural barriers to entry are low
• Incumbent firms set low prices, known as limit prices, to deter new firms from entering the market
• Do this because they fear increase competition and loss of market power.
• Firms already in the market sacrifice short run profit maximisation in order to maximise long run profits, achieved through deterring the entry if new firms.

DETERS MARKET ENTRY

Question 29

Limit pricing EV

Answer 29

Competitive pricing strategy, or anticompetitive and restrictive practice?
Depends on circumstances, when limit pricing extends into predatory pricing, there is a much clearer case that this pricing strategy is anti competitive and against consumers interest.

Question 30

Predatory pricing

Answer 30

• If successful removes recent entrants to the market.
• Incumbent firm deliberately sets prices below costs to force new market entrants out of business.
• Once new entrants left the market, the established firm may decide to restore prices to previous levels.

Question 31

Price discrimination

Answer 31

Charging different prices to different customers with the prices based on different willingness to pay.
- differences are not based on any differences in cost of production or supply.

Question 32

Price discrimination where there may be different costs of supply?

Answer 32

Bulk buying:
consumers are charged lower prices than consumers purchasing smaller quantities of the good.
Generally have lower average costs of production than smaller purchases.