5.5 - OLIGOPOLY

5.5 - OLIGOPOLY

• CHARACTERISTICS
• MARKET STRUCTURE V. BEHAVIOUR
• CONCENTRATION RATIO
• high barriers of entry to and exit from an oligopoly. high barriers to entry make market less competitive. in an oligopoly, only a few firms supply majority of market. for example, in UK supermarket industry is an oligopoly. high concentration ratio makes market less competitive. firms are interdependent in an oligopoly. actions of one firm affect another firm’s behaviour. firms differentiate products from other firms using branding. degree of product differentiation can change how far market is an oligopoly.
• firms can either operate in market which is oligopolistic, or several firms can display oligopolistic behaviour. firms which display oligopolistic behaviour might be interdependent, have stable prices, collude or have non-price competition.
• concentration ratio of market is combined market share of top few firms in market. higher concentration ratio, less competitive market, since fewer firms are supplying bulk of market.

Slide 2

• occurs if firms agree to work together on something. leads to a lower consumer surplus, higher prices and greater profits for firms colluding. can allow oligopolists to act as monopolist and maximise joint profits. firms in oligopoly have strong incentive to collude. by making agreements, can maximise own benefits and restrict output, to cause market price to increase. deters new entrants and is anti-competitive. more likely to happen where only few firms, face similar costs, high entry barriers, is not easy to be caught and an ineffective competition policy. , should be consumer inertia. factors make market stable.
• occurs when the firms are competing. establishes a competitive oligopoly. more likely to occur where there are several firms, one firm has significant cost advantage, products are homogeneous and market is saturated.firms grow by taking market share from rivals.
• formal agreement made between firms. works best when only a few dominant firms, so one does not refuse. illegal in the EU, US and several other countries. suspected that fuel companies partake in overt collusion. could be in form of price fixing, which maximises joint profits, cuts cost of competition, such as by preventing firms using wasteful advertising, and reduces uncertainty.
• no formal agreement, but collusion is implied. in UK supermarket industry, firms competing in a price war. price wars harmful to supermarkets and suppliers.
• COLLUSION
• NON COLLUSIVE BEHAVIOUR
• OVERT COLLUSION
• TACIT COLLUSION

Slide 3

• cooperation is allowed in market, whilst collusion is not. collusion is usually with poor intentions, whilst cooperation will be beneficial. collusion generally refers to market variables, such as quantity produced, price per unit and marketing expenditure. cooperation might refer to how a firm is organised and how production is managed.
• COOPERATION V COLLUSION

Slide 4

• 
• illustrates feature of price stability in an oligopoly. assumes other firms have an asymmetric reaction to price change by another firm. illustration of interdependence between firms. if price increases from P1 to P3, other firms do not react, so the firm which increases their price loses a significant proportion of market share (Q1 to Q3). if firm decreases price from P1 to P2, firm only gains a relatively small increase in market share (Q1 to Q2). first part of diagram shows a relatively price elastic demand curve. second part shows a relatively inelastic demand curve. when firms deviate from rigid, equilibrium price and quantity, they enter different demand elasticities

Slide 5

• group of two or more firms which have agreed to control prices, limit output, or prevent entrance of new firms into the market. famous example of a cartel is OPEC, which fixed output of oil. was possible since they controlled over 70% of supply of oil in world. reduces uncertainty for firms, which would otherwise exist without a cartel. can lead to higher prices for consumers and restricted outputs. some cartels might involve dividing market up, so firms agree not to compete in each other’s markets.
• occurs when one firm changes prices and other firms follow. is usually dominant firm in the market. other firms are often forced into changing prices too, otherwise risk losing market share. explains why there is price stability in an oligopoly; other firms risk losing market share if they do not follow price change. price leader is often one judge to have best knowledge of prevailing market conditions.
• involves firms constantly cutting prices below that of its competitors. competitors then lower prices to match. further price cuts by one firm will lead to more and more firms cutting prices. example of this is the UK supermarket industry
• CARTEL
• PRICE LEADERSHIP
• PRICE WAR

Slide 6

• aims to increase loyalty to brand, makes demand for good more price inelastic. firms might improve quality of customer service, such as having more available delivery times. might keep shops open for longer, so consumers can visit when convenient. special offers, free gifts, or loyalty cards, might be used to attract consumers and increase demand. advertising and marketing might be used to make brand more known and influence consumer preferences. difficult to know what effect of increased advertising spending will be. for some firms, might be ineffective. would make them incur large sunk costs, which are unrecoverable. brands used to differentiate between products. if firms can increase brand loyalty, demand becomes more price inelastic. increasing brand loyalty means firms can attract and keep customers, which can increase their market share.
• firms might try to drive competitors out of industry in order to increase own market share. barriers to entry designed to prevent new firms entering market profitably. increases producer surplus.
• NON PRICE COMPETITION
• BARRIERS TO ENTRY

Slide 7

• related to concept of interdependence between firms in an oligopoly. used to predict outcome of decision made by one firm, when has incomplete information about other firm.
• can be explained using Prisoner’s Dilemma, which is a model based around two prisoners, who have the choice to either confess or deny a crime. consequences of choice depend on what other prisoner chooses. two prisoners are not allowed to communicate, but can consider what the other prisoner is likely to choose. relates to characteristic of uncertainty in an oligopoly.
• option which is best, regardless of what other person chooses. this is for both prisoners to confess, since gives minimum number of years that they have to spend in prison. is the most likely outcome. is still higher than if both prisoners deny the crime, if collusion is allowed in this dilemma, both prisoners would deny. is the Nash equilibrium.
• concept in game theory which describes optimal strategy for all players, whilst taking into account what opponents have chosen. cannot improve their position given the choice of the other. however, even if both prisoners agree to deny, each one has an incentive to cheat and therefore confess, since this could reduce their potential sentence from 2 years to 1 year. makes the Nash equilibrium unstable. sums up interdependence between firms when making decisions in an oligopoly.
• GAME THEORY
• PRISONER'S DILEMMA
• DOMINANT OPTION
• NASH EQUILIBRIUM

Slide 8

• can earn significant supernormal profits, so might invest more in research and development. can yield positive externalities and make oligopoly more dynamically efficient in long run. could be more invention and innovation as a result. firms are more likely to innovate if they can protect ideas. more likely to happen in a market with high barriers to entry. higher profits could be source of government revenue. industry standards could improve. especially true in pharmaceutical industry and for car safety technology because firms can collaborate on technology and improve. saves on duplicate research and development. since oligopolies are large, can exploit economies of scale so have lower average costs of production. long run average cost curve can be used to show this.
• basic model of oligopoly suggests that higher prices and profits and inefficiency may result in misallocation of resources compared to outcome in a competitive market. if firms collude, there is a loss of consumer welfare, since prices are raised and output is reduced. collusion could reinforce monopoly power of existing firms and makes it hard for new firms to enter. absence of competition means efficiency falls. increases the average cost of production.
• ADVANTAGES
• DISADVANTAGES