Oligopoly

Question 1

Features of Oligopoly

Answer 1

1. dominated by a few firms. The UK definition of an oligopoly is a five firm concentration ratio of more than 50%.
2. Interdependence of firms: firms will be affected by how other firms set price.
3. Barriers to entry, (but less than monopoly.)
4. Differentiated products. Advertising is often important in oligopoly.

Question 2

Firms in oligopoly will compete in different ways. It depends upon factors such as:

Answer 2

• The objectives of the firms - e.g. profit max or sales max.
• The degree of contestability – e.g. amount of barriers to entry.
• Government regulation – e.g. preventing collusion and price fixing.

Question 3

Game Theory

Answer 3

• This examines the behaviour of firms considering how decisions of other firms affect their own choices.
• For example, if a firm in Oligopoly cuts price, the outcome will largely depend on how other firms react, e.g. do other firms also follow suit (starting price war) or do they keep prices high?
• One way of explaining game theory is the kinked demand curve model.

Question 4

The Kinked Demand Curve Model

Answer 4

• This model assumes firms seek to maximise profits.
• If a firm increases price, then they will lose a large share of the market because they become uncompetitive compared to other firms, therefore demand is elastic for price increases.
• If firms cut price, then they would gain a big increase in market share. However other firms will follow and cut price as well. Therefore, demand is inelastic for a price cuts.
• This suggests that increasing or decreasing prices will lead to lower revenue and therefore, prices will be rigid in oligopoly.

Question 5

The Kinked Demand Curve Model limitations

Answer 5

1. The model does not explain how prices were set in the first place
2. Price stability may be due to other factors
3. In the real world firms often do cut or increase price.
4. Firms may not be profit maximisers, but seek increased market share - even if it means less profit.

Question 6

Non Price Competition

Answer 6

If prices are rigid and firms have little incentive to change prices they will concentrate on non-price competition. This occurs when firms seek to increase revenue and sales by various methods such as:

1. Advertising. This creates product differentiation and brand loyalty. Advertising can also be used as a barrier to entry.
2. Product Development. This could be an effort to improve the quality of the product such as mobile phones with more features.
3. Loyalty cards. A reason for customers to come back.
4. Quality of service. Increasing loyalty through better quality.
5. Location. Better location for firms

Question 7

Price Wars

Answer 7

Firms may not seek to maximise profits but have other aims such as increasing market share and expanding the firm. This can explain why firms seek to reduce prices and start price wars.

Question 8

price wars information

Answer 8

• Price wars are more likely in a recession when demand is falling and markets become more competitive.
• Price wars tend to be short term because otherwise firms will make a loss.
• Price wars are often selective, e.g. supermarkets have selective price cuts on “loss leaders”
• A multinational will often subsidies a price war by cross subsidising the price war from different markets in different countries.
• Price wars can be in the public interest, but only if firms don’t get forced out of business by the low prices.

Question 9

Predatory Pricing

Answer 9

• This occurs when a firm lowers price in some sections of the market with the intent of forcing another firm out of business.
• This is clearly against the public interest because the dominant firm can increase prices when its rival has left. Therefore there is legislation to make predatory pricing illegal.

Question 10

Limit pricing

Answer 10

This occurs when a firm sets price sufficiently low to deter entry. For example, if a monopolist set a very high price, he would maximise his profits but new firms may enter. Limit pricing means he reduces prices a little - making less profit, but maintaining his monopoly position.

Question 11

Collusive Behaviour

Answer 11

• Collusion occurs when firms agree to limit competition by setting output quotas and fixing prices.
• A cartel is a formal collusive agreement.
• Tacit collusion is an unwritten agreement where firms observe unwritten rules, such as, not undercutting rivals.
• Through collusion firms are able to maximise the profits of the industry. There will be a similar price and outcome to a monopolistic industry.

Question 12

breakdown of collusion

Answer 12

• Under collusion there is always an incentive for a firm to cheat because an individual firm could increase its profits by exceeding its quota and undercutting its rivals.
• However this may lead to the breakdown of the cartel as other firms retaliate by also cutting price.

Question 13

Evaluation of Collusion

Answer 13

• Collusion enables higher profits.
However, if firms found guilty of collusion they can be fined and so end up with lower profits.
• Tacit collusion through dominant price leadership may be an effective way to increase profits and avoid detection.
However, this relies on other firms being willing to follow suit. Also it’s Unlikely to occur if they aim at sales maximisation.

Question 14

Factors Favouring Collusion

Answer 14

1. A small number of firms who are well known to each other.
2. A dominant firm who is able to have a lot of influence in setting the price.
3. Barriers to entry; this is important to stop other firms entering to take advantage of the high profits.
4. Effective communication and monitoring of output and costs.
5. Similar production costs.
6. Effective punishment strategies for firms who cheat.
7. No effective government legislation, e.g. collusion is illegal in the UK.

Question 15

Efficiency of Oligopoly 1

Answer 15

1. In collusion, the industry acts like a monopolist, therefore there will be:
   • Allocative inefficiency P > MC
   • Productive inefficiency; production is not at the lowest point on SRAC.
   • X inefficiency, there is less incentive for firms to cut costs

Question 16

Efficiency of Oligopoly 2

Answer 16

2. Oligopoly means that there are a few large firms and therefore they are likely to benefit from economies of scale, leading to lower average costs.
3. If there are low barriers to entry in an oligopoly, it will be more contestable, therefore firms have incentives to cut costs and be productively efficient. Also prices are more likely to be competitive and therefore closer to MC.