Oligopoly

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Oligopoly

A market dominated by a few large firms

A few firms between them share a large proportion of thte output or sales

Increased market concentration ratios

Many markets tend to be oligopolies in the long run

Characteristics of an Oligopoly

High level of market concentration

Branded / differentiated good or service

Entry barriers

Long-run abnormal profits

Non-price competition

Occasional price wars

Examples of Oligopoly Markets

Petrol retailers

Food retailers

Hotels

Banks

Low cost airlines

Package holidays

DIY stores

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Non-Price Competition

When firms compete on other things other than price

Examples of Non-Price Competition

Marketing techniques

Loyalty cards

Banking and other financial services

In store chemists / post offices

Home delivery systems

Discounted petrol

Extension of opening hours

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Collusion

Where oligopolists agree formally or informally to limit competition between themselves.

They may set output quotas, fix prices or limit product promotion/development or even agree not to poach each others' target markets

Types of Collusion

Overt collusion - No attempts to hide their collusive acts from the authorities

Covert collusion - Making attempts to hide the results from their collusion, usually to avoid detection by regulators such as when fixing prices

Tacit collusion - When firms act together, but when there is no formal or even informal agreement between them e.g it may be accepted that one firm is the price leader and other firms just simply follow their lead, all firms understand this but no agreement or record exists to prove it

Cartels

Hardcore cartel - an agreement between competitors to fix prices, share markets, rig bids or limit output at the expense of the interests of customers and without any countervailing customer benefits. Usually secret arrangements under which competitor businesses agree to coordinate their activity

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The Structure / Conduct / Performance Model

Analytical framework that makes relations between market structure, market conduct and market performance

Structure

What the market consists of in terms of:

Concentration

Barriers to entry

Product differentiation

Number of competing firms

Ownership - public or private sector

Amount of technology available

Conduct

How the business behaves, which is usually affected by the market structure

How does the market structure affect:

Pricing

Output

Any anti-competitive behaviour - collusion or control over supply chain

Non-price competition

Interdepence

Market Conduct Affects Structure

Decision about research and development and marketing

Performance

How well the business performs compared with competitors in terms of:

Profits

Spending on R&D

Labour productivity

Environmental issues

Efficiency - allocative, productive, dynamic, social

Performance Can Affect Market Structure

Top performing firms will gain market share at the expense of their rivals

This gives them more market power

There is a fine line between market dominance and economic efficiency

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Pricing in an Oligopoly

Oligopolies use a variety of pricing techniques

In practice, the pricing strategies in an oligopoly will probably change over time

Pricing Strategies

1. Collusion to charge a high monopoly price

2. Predatory pricing to force rivals out of the market

3. Limit pricing to deter entrants

Collusion for Pricing

Oligopolies may collude with rivals and raise their prices together

Advantages of this Pricing Technique

High prices means higher average revenue

Disadvantages of this Pricing Technique

If the colluding firms are caught by the authorities, it could result in a hefty fine

High prices attracts new entrants

Lower consumer welfare (CSR)

Predatory Pricing

Keeping the prices artificially low, and often below the full cost of production, to force rivals out of the market

Advantages of this Pricing Technique

Forces rivals out of the market so increased market share

Good for consumer as they benefit from low prices - higher consumer welfare (CSR)

Disadvantages of this Pricing Technique

Extremely low / or sometimes no profit margins

Anti-competitive behaviour

Limit Pricing

Reducing price to push competitors to make only normal profits

The oligopoly sarcifises their profit maximisation to push competitors to make only normal profits.

Deters new entrants as there are no abnormal profits in the market

Advantages of this Pricing Technique

Pushes competitors to make only normal profits

No new entrants have the incentive to enter as there are no abnormal profits to be made

Disadvantages of this Pricing Technique

Short term profits are sacrificed

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Pricing in an Oligopoly

Price leadership

Price agreements

Price wars

Price Leadership

Where one firm is considered the most dominant (market leader) and has the ability to set a market price

Other firms then follow their lead

Tacit collusion

Price Agreements

An agreement between two competing firms (cartels) regarding pricing of their good or service

Overt collusion

Price Wars

When rival firms continually lower their prices to undercut their competitors

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The Kinked Demand Curve (Paul Sweezy)

A model which makes describes the pricing and output in an oligopolistic market

Shows the reaction of rivals to a price change, depending on whether the price is raised or lowered

The elasticity of demand, and hence the gradient of the demand curve, will also be different. The demand curve is kinked at the stable/current price

It has created a price and output where it is in equilibrium (P1/Q1)and any change in the equilibrium will not benefit the firm

If you put your price up, competitors will remain at the same price which allows them to take your market share from the loss of your customers as a result of your higher price

If you put your price down, competitors will also put theirs down so your revenue will not change much as all the competitors would have followed

The firm is unable to change their price without having an effect on their profit maximisation

The model shows how the firm is in a time of price stability, which is shown by the vertical discontinuity in the MR curve

Inelastic demand at lower prices, elastic demand at higher prices

Advantages of the Kinked Demand Curve as a Model

It is one possible model of how firms in an oligopoly might behave if they have to consider the responses of their rivals

Gives a theory

Disadvantages of the Kinked Demand Curve as a Model

There is limited real-world evidence for the kinked demand curve model

The theory can be criticised for not explaining why firms start out at the equilibrium price and quantity

Lays emphasis on price rigidity, but does not explain price itself

Ignores non-price competition/price leadership/cartels among organisations

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Reaction Curves (Antoine Cournot)

Shows the reaction of firms in response to the action of a competing firms

Shows how both firms adapt their price

Stable Equilibrium Reaction Curve

If firm B sets a price of B1, firm A will respond by setting a price of A1.

However, A1 price is lower than B1 so firm B responds by setting a price of B2 and so on.

The price will carry on falling until they meet the stable equilibrium of A*B* as if they lower the price anymore they will make a loss

Unstable Equilibrium Reaction Curve

If firm B sets a price of B1, firm A will respond by setting a price of A1.

However, A1 price is lower than B1 so firm B responds by setting a price of B2 and so on.

The price will carry on falling until someone leaves the market and this is the creation of a price war as there is no equilibrium to be stable at

This is price instability