Oligopoly to Monopoly: How to measure, Adv, Disadv, Price Discrimination, Collusion, Game theory, Kinked Demand Curve and Natural Monopoly

Question 1

What is an Oligopoly? Give examples

Answer 1

A small number of firms dominate the market Eg: cars, General Motors, Ford, Toyota - Phones, Samsung and apple

Question 2

How would you measure if a market is an Oligopoly?

Answer 2

Concentration ratios: Add up the market shares of the biggest firms in the market. Anything above 40% is considered an Oligopoly but this can vary. The closer the market shares of the companies are the more competitive the Oligopoly is likely to be.

Question 3

What are the characteristics of an Oligopoly? (7)

Answer 3

There’s no single theory of Oligopoly, instead most tend to feature the following main characteristics:

1. Few large firms dominate the market
2. Very big firms so very high barriers to entry, behavioural barriers, high entry cost
3. Firms tend to be earning supernormal profits as new firms struggle to enter and take them away, the market isn’t very contestable
4. Firms under Oligopoly are very interdependent and must always take into account what the competitors actions may be in response to what they do
5. High levels of non-price competition
6. Most of the businesses are large enough to benefit from economies of scale
7. Collusion is most likely to be seen in an Oligopoly due to there being few large firms in the market, this is illegal.

Question 4

What is non-price competition (give an example) and why do firms in Oligopoly choose this?

Answer 4

Non-price competition is where businesses compete in ways that don’t involve reducing price

For example: leading companies in mobile phone markets compete by the best tech not by price.

Firms in Oligopoly avoid price competition to get more profits and avoid a price war. This can be explained by game theory and the kinked demand curve.

Question 5

What is Informal collusion?

Answer 5

When there is no agreement between the firms but they know how to act from past experience.

E.g: Price leadership- The largest most powerful business in the market sets the price, the other businesses follow and set the same price.

There are two reasons why they’re willing to do that:

1. They can charge a higher price so it’s easier to earn supernormal profits
2. They’re reluctant to challenge the price because they suspect that it may lead to a price war, they would lose out and possibly be forced out of the market.

Question 6

What is formal collusion?

Answer 6

Nothing is written down, but they all agree verbally to set the same prices.

When businesses do this it’s called a cartel.

Question 7

What are the laws and risks of collusion?

Answer 7

Any type of collusion is illegal, if caught a business could be fined of up to 10% of their revenue

Collusion is very risky because if any of the firms involved goes to the government and tells them what’s happening then that firm won’t be fined (whistle blowing).

Question 8

What are the 2 main advantages of an Oligopoly?

Answer 8

1. Businesses should be big enough to benefit from economies of scale, this will reduce their costs and if the market is competitive enough it will reduce the price for consumers
2. Firms in Oligopoly tend to feature high levels of dynamic efficiency, this is the main way they compete because customers expect the product to keep getting better and it helps to avoid a price war; furthermore they can easily afford it as they’re making super-normal profits.

Question 9

What are the 5 main disadvantages of Oligopoly

Answer 9

1. Due to the downward sloping demand curve these firms face it’s impossible to feature allocative efficiency; average revenue will always be higher than marginal revenue
2. Low competitive pressure may result in less choice for consumers
3. Unlikely to feature productive efficiency for the same reasons
4. Firms are more likely to collude and form cartels in Oligopoly
5. A Grade point: Under Oligopoly we expect firms to be spending large amounts of money on advertising, inreasing costs, this may lead to higher prices for consumers. However if the advertising helps them to attract more customers they will have an increased market share, they may benefit from more economies of scale and therefore costs and prices might lower. BUT too much advertising will tend to influence what their customers do, it might encourage them to be loyal to their product. If that is true then consumers are no longer in full control of what they do and therefore are no longer in consumer sovereignty.

Question 10

What is the kinked demand curve?

Answer 10

A model used to explain why Oligopolies are reluctant to compete in terms of price

Question 11

Explain the shape of the kinked demand curve

Answer 11

Reducing price:

Firms in Oligopoly suspect that if they tried to sell a lot more phones by reducing their price, all of their rivals will likely do the same, this will mean they wont get many more customers, making their demand below P very price inelastic; therefore there is no incentive to reduce price.

Increasing Price:

If they increase their price, rivals are unlikely to do anything and so rivals products will now be cheaper than the other firm’s which will result in a loss of customers, this is why the kinked demand curve is shaped elastically above the equilibium price (P).

Question 12

What is the nash equilibrium? (draw it)

Answer 12

Used to explain why businesses under Oligopoy don’t like competing in terms of price. It assumes there are just 2 firms and consists of a matrix to show why businesses avoid competing in terms of price.

The danger is that once the firms move out of box one they’ll both have to reduce their prices and will very quickly end up in box 4

Detailed description of each box:

Box 1: Perfect position for the firms as they’re both charging a high price so they’re both making large profits.

Box 2: Firm A has chosen to reduce it’s price but firm B has kept it’s price the same, this means thatfirm A will get more customers and market share; but the opposite will happen for firm B.

• *Box 3:** Firm A is charging a high price and B a low price, this will be the opposite of Box 2
• *Box 4:** IN box 4 both firms are earning low profts in equilibrium.

Question 13

Why might a price war occur? (3 reasons explained)

Answer 13

1. Economy goes into recession- Businesses have to reduce prices as consumers have less income
2. New business tries to enter the market- Other firms retaliate by reducing their prices to force them out of the market
3. One business feels they’ve become so powerful that theireconomies of scale are much greater so they feel they can take the other businesses on, charge lower prices and icnrease their market share in the long term even if it means decreasing profits in the short run.

Question 14

What are profits levels for firms in Oligopoly in the short and long run, and why?

Answer 14

Profits are supernormal for both due to very high barriers to entry in the short and long run.

New firms struggle to enter and take them away which makes the market quite incontestable.

(Ask mike to clarify this)

Question 15

What is a natural monopoly and why do they occur?

Answer 15

When it’s not efficient to have competition in a market, it’s better as a monopoly.

If you did have competition in the market those businesses would not benefit from as many economies of scale, they would have to pay for all the same capital equipment, which will largely be a waste of resources and because of that the market will become less efficient.

Question 16

In what type of markets is a natural monopoly most commonly found? Give an example and explain why

Answer 16

A natural monopoly tends to occur where a business has to pay for a very expensive infrastructure required to supply that good to every single consumer in the market.

E.G:

• Water companies - Pipes connecting all of the houses in the UK
• Trains- Tracks and carriages

It would be very expensive for different businesses to reproduce this infrastructure all over the UK. In practise the fixed costs of paying for the infrastructure is very high but the variable cost of supplying each consumer is very low. Therefore the more of the market they control the more economies of scale they can get, the better they can spread their fixed costs over each customer, the lower these average costs will be.

Question 17

What is a monopoly and pure monopoly?

Answer 17

A market dominated by a single business

Legally a monopoly is defined as any business with 25% market share, this is very low so it gives the governement power to investigate most large businesses.

E.g- Tesco is legally a monopoly but not really in practice

A “pure monopoly” is where they have 100% market share, the thoery of monopoly is based on this and assumptions which can be found in a different card.

Question 18

What are the 4 assumptions monopoly theory is based on?

Answer 18

1. A-Grade: Only one firm in the market, this means that the firm faces the market demand curve for that product (downward sloping)
2. We assume that the monopoly is trying to profit maximise (produce to where MC=MR)
3. Very high barriers to entry, assume it’s more or less impossible for new firms to enter. Therefore under monopoly there’s no distinction between the short and long run.
4. Under monopoly the firm is usually big enough to benefit from economies of scale

Question 19

Fully explain the first assumption of monopoly theory (what the demand curve depends upon)

Give examples

Answer 19

The market and the firms demand curve are the same, but this depends on 2 things:

1. Whether the monopoly faces competition from other businesses producing similar products, if they do demand will be more price elastic.
2. Whether the monopoly is producing a necessity or a luxury, if it’s a necessity demand will be more price inelastic so the monopoly will have more power.

E.g- Water has no real substitute and is a necessity so their demand will be very price inelastic. The government sets a price limit.

Trains- There are substitutes, sometimes necessity but water companies have more power.

Question 20

What are profits like for firms in monopoly in the short and long run?

Answer 20

The monopoly controls the whole market so it has a lot of control over it’s price and customers have no choice, therefore we can expect them to make supernormal profits.

If they’re making supernormal profits in the short run becasue it’s not possible for new firms to enter the market they’ll also make them in the long run . This means that in the short and long run equilibrium will be exactly the same

Question 21

What is price discrimination and what methods do businesses have of discriminating?

Answer 21

Where the business charges different prices to different groups of customers for the same basic good/service.

Number of different methods businesses can use to split their customers up:

1. Time- E.g Cinemas and trains
2. Geographical- E.g A business with a monopoly in the UK will charge more in the UK than in another country where they aren’t the market leader
3. Personal characteristics of consumers- E.g- Age for trains, disabilities.

Question 22

What are the conditions needed to price discriminate?

Answer 22

1. Must be able to keep the different groups of customers apart. E.g- Time
2. The business needs some degree of control over the whole market, therefore it’s easier for a monopoly business to do this.
3. Different types of customers must be willing and able to pay different prices

The business must identify the customers that really have to buy that product, their demand will be very price inelastic and so you can charge those people more. Other people that don’t really need the product that much can be charged less.

Question 23

Give an example of price discrimination and draw a graph that shows the changes in consumer surplus.

Answer 23

Southwest trains:

Commuters -> to get to work -> often have little choice-> Demand quite price inelastic (0.4ish) -> can charge higher price.

This increases revenue from that group.

Leisure -> Non work purposes -> Don’t have to make journey -> their demand is price elastic -> more customers if lower price -> revenue increases

Question 24

What are the 3 advantages of price discrimination?

Answer 24

1. Businesses will icnrease revenue and probably profit
2. Can use price discrimination to spread demand out across the day in attempt to make better use of fixed costs (capacity utilisation)
3. Consumer surplus increases as some people would be willing to pay more to travel off peak

Question 25

What are the 2 disadvantages of price discrimination?

Answer 25

1. For commuters consumer surplus decreases
2. If you’re a consumer you may not be happy if other countries are paying less than you

Question 26

What are the 2 main advantages of monopoly?

Answer 26

1. Firms are large enough to benefit from large economies of scale, that means that consumers may well end up paying lower prices than in competitive markets.
2. Monopolies are likely to feature high levels of dynamic efficiency as:
   
   • They can afford it
   • Incentive to do it because it protects their monopoly position by making it harder for new firms to enter the market (increased barriers to entry).

Question 27

Explain the first advantage of monopoly in full detail

Answer 27

Big enough to benefit from leage economies of scale which could save consumers money (increase consume surplus), prices may go lower than competitive markets.

Continuation from graph:

In a perfectly competitive market P and Q are equilibrium.

suppose this industry was taken over by a monopoly, assume that there are no economies of scale, therefore the monopolies supply curve (costs) will be exactly the same as under perfect competition. BUT our monopoly isnt a price taker so its MR curve is below AR

Assuming the monopoly is looking to profit maximse it will produce where it’s marginal revenue is equal to it’s costs. If there’s no economies of scale the monopoly is better for consumers. If our monopoly could benefit from economies of scale it’s costs will go down to S_1M

Therefore if a monopoly is better than perfect competition depends on the extent top which economies of scale save costs.

Question 28

What are the 3 disadvantages of monopoly?

Answer 28

1. Consumers have less choice which might lead to higher prices
2. No real competition so businesses are unlikely to feature allocative or productive efficiency. Often monopolies feature “X Inefficiency”, this is where the monopoly is so big, they have so much control that they can become complacent and efficiency falls. This means advantage 1 will almost never happen (lower prices due to increased efficiency won’t happen due to lack of competitive pressure).
3. Monopolies raise barriers to entry, behavioural barriers, advertising, reducing prices.