Schedule H - Oligopoly

Question 1

What is an oligopoly?

Answer 1

An oligopoly is an imperfectly competitive industry where there is a high level of market concentration (dominated by a few firms)

Question 2

What are the key characteristics of an oligopolistic market? (Hint: 5)

Answer 2

1. Firms sell differentiated goods but they are often relatively similar, with the differentiation mainly on things like brand image or customer service.
2. High barriers to entry and exit
3. Firms are interdependent
4. Firms are likely to compete using non-price competition, e.g. loyalty cards, ads, branding, fancy packaging, customer service
5. Firms MAY profit maximise, but are likely to be concerned with gaining more market share (hence profit max is not their sole objective)

Question 3

What does it mean if firms are interdependent?

Answer 3

“Interdependence means that one firm’s output and price decisions are influenced by the likely behaviour of competitors.”
It means they take into account the likely actions of other firms in the industry when deciding how to behave.

Question 4

What is the chain of analysis we can make for the question ‘explain the meaning of interdependence’?

Answer 4

• Because there are few sellers, each firm is likely to be aware of the actions of the others
• This means that the decisions of one firm influence, and are influenced by, the decisions of other firms
• As a result, firms in the market must take into account the likely reactions of their rivals to any change in price, output or forms of non-price competition.
• This market behaviour is a key aspect of business competition in an oligopoly and can be modelled by the use of game theory
• this causes oligopolistic markets to be at high risk of tacit or explicit collusion which can lead to allegations of anticompetitive behaviour
• consequently, in an oligopoly, there is a high level of uncertainty

Question 5

What is an example of the concentration ratio, shown by petrol retailing in the UK?

Answer 5

Tesco dominates the fuel market, with the most fuel sold through its many high volume petrol stations throughout the country. Next is BP, then Shell. The 5 firm concentration ratio in this market = 66.5%

Question 6

Collusion is when firms work together to ____

Answer 6

Collusion is when firms work together to determine price and/or output

Question 7

There are three main categories of collusion that we learn. Collusion between businesses can be:

Answer 7

1. Horizontal
2. Vertical
3. Explicit versus tacit

Question 8

What is the difference horizontal and vertical collusion?

Answer 8

Horizontal collusion is between firms at the same stage of production. Vertical collusion is between businesses at different stages of production.

Question 9

What are the main aims of businesses collusion in an oligopoly?

Answer 9

1. Businesses in a cartel recognise their interdependence and work together = the aim is to maximise joint profits
2. Collusion lowers the costs of competition e.g. wasteful marketing wars which can run into millions of pounds.
3. Collusion reduces uncertainty - and higher profits increase producer surplus/shareholder value - leading to higher share prices.

Question 10

What is the difference between overt (formal or explicit) and tacit collution?

Answer 10

Overt collusion is when oligopolistic firms agree to certain behaviour (usually setting prices and/or restricting output) whereas tacit collusion is when oligopoly firms have an unwritten agreement to not compete on price or duplicate services.

Question 11

What is it called when collusion is legal?

Answer 11

Cooperation

Question 12

What makes collusive behaviour legal (according to EU competition authorities)?

Answer 12

1. Practices are not prohibited if the respective agreements “contribute to improving the production or distribution of goods to promoting technical progress in a market”
2. Development of improvised industry standards of production and safety which BENEFIT THE CONSUMER - e.g. joint industry standards in Europe for mobile phone chargers
3. Information sharing designed to give better information to consumers
4. Research joint ventures and know-how agreements which seek to promote innovative and inventive behaviour in a market. The EU introduced R&D block exemption regulation

Question 13

What is price leadership?

Answer 13

When other businesses accept the price changes established by a dominant firm

Question 14

When oligopolists colluded, they can act as a monopoly. This increases their market power. They can use this additional monopoly power charge higher prices to consumers. However, oligopoly firms have two conflicting aims. What are these aims?

Answer 14

1. To collude with other firms to maximise their combined profits
2. To compete with other firms to take away business from them and make profit more independently.
   As a result, there is always an INCENTIVE TO CHEAT on collusive agreements - collusion might break down.

Question 15

What kind of conditions make price-fixing cartels likely to happen in an oligopoly? Give 4

Answer 15

1. Penalties for collusion are low relative to gain in profits - fines therefore do not act as a proper deterrent
2. There are few firms in the market and price inelastic demand - higher prices then lead to increased revenues
3. Products are standardised and output within the cartel is easily measurable so that supply can be controlled
4. Brands are so strong that consumers will not switch demand when collusion raises price

Question 16

Why is collusive behaviour dangerous to consumer welfare?

Answer 16

• higher prices / lost consumer surplus
• loss of allocative efficiency
• hits lower income families i.e. has regressive impact

Question 17

Why is collusion dangerous for efficiency?

Answer 17

• X-inefficiencies leads to higher unit costs
• Less incentive to innovate / loss of dynamic efficiency
• Output quotas penalise firms who want to expand

Question 18

On the kinked demand curve, why are prices rigid at Q1P1?

Answer 18

If an individual firm produces at Q1, selling at price P1, it perceives its demand curve as being relatively elastic if it raises its price and inelastic if it cuts its price. This is because the firm expects rival firms not to follow a price rise but to follow a price cuts.

Question 19

As per the kinked demand curve, why is it unwise for a firm to raise its price or to lower it?

Answer 19

If the firm increases its price and its rivals do not follow suit, it will lose some, but not all, market share because consumers will swap to buying substitutes. If the firm cuts its price, other firms will have no option but to follow - this will lead to a small expansion of market size but no increase in market share for the individual firm. Since a price increase/decrease is perceived as being likely to reduce revenue and subsequent profit for the individual firm, each firm understands its best strategy is to be holding price at P1 and quantity at Q1.

Question 20

The kinked demand curve can explain real-world observation that prices in an oligopoly are relatively stable over time. It can also be used explain how price wars might occur. It is also suitable for use in the small number of oligopolistic markets where products are relatively homogenous. What are some criticisms (evaluation points) for the kinked demand curve?

Answer 20

1. Not a particularly dynamic model i.e. does not help explain how a new stable price might be achieved, after firms have decide to lower or raise prices.
2. Does not consider the likelihood of collusion
3. Not relevant for oligopolistic markets that sell differentiated products.

Question 21

What are some strategies that oligopolists use to compete?

Answer 21

1. Quality of product
2. Design, look and feel
3. Environmental impact
4. After sales services
5. Other marketing factors such as branding and advertising
6. Loyalty products e.g. loyalty cards, warranties and guarantees