3.4.4 Oligopoly

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    a) Characteristics of oligopoly
    High barriers to entry and exit
    High barriers of entry to and exit from an oligopoly – makes market less competitive
    Economies of Scale and high degree of technology in the industry allows for high barriers to entry and exit
    Where it is possible to attain technical economies of scale the process of merger has drastically reduced the number of firms in an industry and bought into being some very large business units
    High concentration ratio
    Only a few firms dominate and supply the majority of the market
    • E.g.in UK the supermarket industry is an oligopoly
    The high concentration ratio makes the market less competitive.
    • In several industries in UK 90% of the market is supplied by no more than three or four firms
    Interdependence of firms
    Firms are interdependent in an oligopoly – means the actions of one firm affect another firm’s behaviour – means firms tend to keep price stable (sticky)
    The firms also know a lot about each other
    If firm were to raise prices – others wouldn’t follow as customers will move to lower cost option
    If firm were to lower prices – other firms would follow suit – results in a price war and none of the firms benefit
    Product differentiation
    Firms differentiate their products from other firms using branding but their products are similar
    Profits in long run
    The firms in this industry are capable of making supernormal profit in the long run
    But in practice profits may not be as high as possible due to firms engaging in limit pricing to deter new entrants from the market or predatory pricing to drive new entrants out of the market.
    Note:
    Economists find it difficult to predict the behaviour of firms within an Oligopolistic market but one of the clear things is the degree of Non Price Competition that will occur

    b) Calculation of n-firm concentration ratios and their significance
    Concentration ratio of a market – % of the market controlled by the 3, 4, 5 largest firms (combined market share of the top few firms in a market)
    E.g. the market share for each of the top supermarkets in the UK is shown in the table:

    If the 4 firm concentration ratio was calculated, the market share of the 4 largest firms would be added together: 28.4% + 17.1% + 16.4% + 10.9% = 72.8%
    The 2 firm concentration ratio is the market share of the 2 largest firms added together: 28.4% + 17.1% = 45.5%
    The concentration ratio indicates whether an industry is comprised of a few large firms or many small firms. The four-firm concentration ratio, which consists of the market share (expressed as a percentage) of the four largest firms in an industry, is a commonly used concentration ratio.
    The higher the concentration ratio, the less competitive the market, since fewer firms are supplying the bulk of the market
    A low concentration ratio in an industry would indicate greater competition among the firms in that industry than one with a ratio nearing 100%, which would be evident in an industry characterised by a true monopoly.

    c) Reasons for collusive and non-collusive behaviour
    Collusive behaviour occurs if firms agree to work together on something
    • E.g. they choose to set a price or fix the quantity of output they produce – minimises competitive pressure they face.
    Collusion – lower consumer surplus, higher prices and greater profits for the firms colluding.
    Firms in an oligopoly have a strong incentive to collude
    By making agreements, they can maximise their own benefits and restrict their output, to cause the market price to increase – deters new entrants and is anti-competitive
    Collusion is more likely to happen when:
    • There are only a few firms • They face similar costs • There are high entry barriers • It isn’t easy to be caught • There’s ineffective competition policy • There should be consumer inertia
    All of these factors make the market stable
    Non-collusive behaviour occurs when the firms are competing
    This establishes a competitive oligopoly
    This is more likely to occur where:
    • There are several firms • One firm has a significant cost advantage • Products are homogenous • The market is saturated • Firms grow by taking market share from rivals

    d) Overt and tacit collusion; cartels and price leadership
    Collusion can be overt or tacit – common feature of many oligopolistic markets
    Collusion – desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry
    To collude on price, producers need to exert some control over market supply
    Overt collusion
    When a formal agreement is made between firms
    Works best when only a few dominant firms, so one doesn’t refuse
    Illegal in the EU, US and several other countries
    E.g. often suspected that fuel companies partake in overt collusion
    • In form of price fixing, which maximises their join profits • Cuts cost of competition by preventing firms using wasteful advertising, and reduces uncertainty
    Tacit collusion
    When no formal agreement, but collusion is implied
    E.g. in UK supermarket industry, firms are competing in a price war
    Price wars are harmful to supermarkets and their supplies

    Collusion in a market or industry is easier to achieve when:
    Only small numbers of firms in industry – significant barriers to prevent new firms entering industry
    Market demand isn’t too variable (predictable and not subject to violent fluctuations – may lead to excess demand or excess supply)
    Demand is fairly price inelastic – a higher cartel price increases total revenue to suppliers (easier when product is necessity)
    Each firm’s output can be easily monitored (important) – enables cartel to more easily control total supply and identify firms who are cheating on output quotas
    Incomplete information about motivation of other firms may induce tacit collusion
    Price Leadership
    Occurs when one firm changes their prices, and other firms follow
    This firm is usually the dominant firm in the market
    Other firms are often forced into changing their prices otherwise they risk losing their market share
    Explains price stability in an oligopoly, other firms risk losing market share if they don’t follow price change
    Price leader has best knowledge of prevailing market conditions
    Cartels
    Group of two or more firms – agreed to control prices, limit output, or prevent entrance of new firms into the market
    Famous example of a cartel is OPEC – fixed their output of oil
    • Possible – they controlled over 70% of the supply of oil in world • Reduces uncertainty for, which would otherwise exist without a cartel.
    Cartels can lead to higher prices for consumers and restricted outputs
    Some cartels might divide the market up, so firms agree not to compete in each other’s markets.

    In diagram a producer cartel is assumed to fix cartel price at P
    Distribution of the cartel output may be allocated on basis of an output quota system or another process of negotiation
    The cartel as a whole is maximising profits – the individual firm’s output quota is unlikely to be at profit max
    For any one firm, expanding output and selling at a price that slightly undercuts cartel price can achieve extra profits
    But if one firm does this, it’s in each firm’s interests to do exactly the same and if all firms break the terms of their cartel agreement, the result will be excess supply in the market and a sharp fall in price
    Breaks down a cartel agreement

    Kinked Demand Curve
    Kinked demand curve model assumes a business might face a dual demand curve for its product based on likely reactions of other firms to a change in its price or another variable
    Limited real world evidence for the kinked demand curve

     

    e) Simple game theory: the prisoner’s dilemma in a simple two firm/two outcome model
    Game theory related to concept of interdependence between firms in an oligopoly
    Used to predict outcome of a decision made by one firm, when it has incomplete information about the other firm
    Can be explained using Prisoner’s Dilemma
    Model based around 2 prisoners, who have the choice to either confess or deny a crime
    Consequences of choice depend on what other prisoner chooses.

    Two prisoners aren’t allowed to communicate, but can consider what the other prisoner is likely to choose – relates to the characteristic of uncertainty in an oligopoly.
    Maximax – Maximum benefit for the individual – Option 2 or 3
    Maximin – Minimum benefit – Option 4
    Dominant strategy is option which is best, regardless of what the other person chooses
    • This is for both prisoners to confess (Option 4) – since this gives minimum number of years they have to spend in prison – most likely outcome
    Still higher than if both prisoners deny crime but if collusion is allowed in this dilemma, then both prisoners would deny – Nash equilibrium
    Nash equilibrium – concept in game theory which describes optimal strategy for all players, whilst taking into account what opponents have chosen – they can’t improve their position given the choice of the other
    But even if both prisoners agree to deny, each one has an incentive to cheat and confess – this could reduce their potential sentence from 2 years to 1 year – makes the Nash equilibrium unstable
    Essentially sums up interdependence between firms when making decisions in an oligopoly
    Model assumes a zero sum game – there will be a winner and a loser

    f) Types of price competition:
    Price wars
    Type of price competition
    Involves firms constantly cutting prices below their competitors
    Their competitors then lower their prices to match
    Further price cuts by one firm will lead to more firms cutting their prices
    E.g.UK supermarket industry
    Predatory pricing
    Illegal – involves firms setting low prices to drive out firms already in the industry
    In short run, they make a loss but as firms leave, the remaining firms raise their prices slowly to regain their revenue – they price their goods and services below their average costs
    Limit pricing
    Not necessarily illegal – low prices discourage entry of other firms, so there are low profits
    Ensures price of a good is below which a new firm entering the market would be able to sustain
    Potential firms are unable to compete with existing firms
    Evaluated by considering how low profits of existing firms might dissatisfy shareholders, since they receive lower dividends
    g) Types of non-price competition
    Firms use non price competition because they have agreed not to compete on price (collusion) or because they are afraid they will lose out in a price war
    Aim to increase the loyalty to a brand, which makes demand for a good more price inelastic – attracts customers and increases their demand and market share
    • E.g. by improving quality of customer service – more available delivery times • Might keep shops open for longer – so consumers can visit when it is convenient • Special offers like buy one get one free, free gifts, or loyalty cards
    Advertising and marketing used to make their brand more known and influence consumer preferences
    But – difficult to know effect of increased advertising spending – might be ineffective for some firms and will make them incur large sunk costs – unrecoverable
    In perfect oligopoly competition is based on research, after sales service e.g. guarantees. In imperfect oligopoly the main form of non price competition is advertising.

     

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