Theme 3 Topic 4.4

Question 1

Oligopoly

Answer 1

A market structure in which a few large firms dominate the industry with each firm having significant market power

Question 2

Imperfect competition

Answer 2

Most markets are imperfectly competitive
Most imperfectly competitive industries operate in an oligopoly market structure
E.g., Banks, insurance companies, department stores, supermarkets, petrol retailers, sport stores etc.

Question 3

Concentration ratios

Answer 3

The most commonly used concentration ratios in the UK are the five-firm, ten-firm, and twenty-firm concentration ratios
A five-firm concentration ratio of around 60% is considered to be an oligopoly
A one-firm concentration ratio of 100% would be a pure monopoly
The UK Competition and Markets Authority (CMA) defines a monopoly as a firm with more than 25% market share
It prevents mergers or acquisitions from taking place which would give one firm more than 25% market share

Question 4

Calculations of concentration ratios (5 firms example)

Answer 4

Step 1: Identify the top five firms by value of sales and add the value of their sales together

Step 2: Calculate the percentage of total sales that the top five firms have

Question 5

4 characteristics of ogopolies

Answer 5

1. High barriers to entry and exit
2. High concentration ratio
3. Interdependence of firms
4. Product differentiation

Question 6

High barriers to entry + exit

Answer 6

Entering the industry is difficult due to the existing dominance of relatively few firms.

Start-up costs tend to be high e.g. setting up a renewable energy company costs billions

Leaving the industry is difficult due to the high level of sunk costs

Question 7

Sunk costs

Answer 7

An investment that has been made that cannot be recovered

Question 8

High concentration ratio

Answer 8

A concentration ratio reveals what percentage of the total market share a specific number of firms have

A 10-firm concentration ratio reveals the total market share (concentration) of the top 10 firms in the industry

A 5-firm concentration reveals the total market share (concentration) of the top 5 firms in the industry

The higher the value - and the lower the number of firms - the more concentrated the market power in the industry e.g. the UK supermarket’s 5-firm concentration ratio is constantly around 67%

Question 9

Interdependence of firms

Answer 9

With relatively few competitors, firms study each other’s behaviour and are highly interdependent in their actions

This interdependence generates the use of game theory

Question 10

High product differentiation

Answer 10

Occasionally products are similar (e.g. petrol).

However, the brand around the product is highly differentiated to the point where consumers perceive it as different and are extremely brand loyal

Question 11

Collusive behaviour

Answer 11

occurs when firms cooperate to fix prices and restrict output

they cease to compete as vigorously as they can

Question 12

non collusive behaviour

Answer 12

occurs when firms actively compete to maintain/increase market share

Question 13

reasons for collusion - few firms

Answer 13

This makes it relatively easy for each firm to understand other competitors’ actions and responses, or to collaborate on prices/output

Question 14

reasons for collusion - similar costs

Answer 14

Firms face almost identical costs as any remaining competitors have all experienced economies of scale

Question 15

reasons for collusion - similar revenue

Answer 15

Competitors’ goods/services sell for similar prices as there is little incentive to lower them as other firms would respond by keeping their market share the same but decreasing the profits

Question 16

reasons for collusion - high barriers to entry

Answer 16

The barriers to entry make it unlikely that new entrants will emerge to disrupt the status quo

Question 17

reasons for collusion - ineffective regulation

Answer 17

A lack of regulation empowers firms to collude as there is little consequence for their actions

Question 18

reasons for collusion - brand loyalty

Answer 18

There is usually a high degree of brand loyalty in oligopoly markets and firms have an established market share.

This decreases the benefits of competition as consumers are unlikely to change brands

Question 19

What’s the net effect of collusion

Answer 19

A group of firms end up acting like a monopoly in the market

Question 20

Overt collusion

Answer 20

Overt collusion occurs when firms explicitly agree to limit competition or raise prices (price fixing)

A cartel is the most restrictive form of collusion and is illegal in most countries

Question 21

Overt collusion consequences

Answer 21

Higher prices for consumers

Less output in the market

Poor quality products and/or customer service

Less investment in innovation

Question 22

Overt collusion happens by

Answer 22

Price fixing

Setting output quotas which limit supply and naturally results in price increases

Agreements to block new firms from entering the industry

Agreements to pay suppliers the same price thereby driving down prices in the supply chain (monopsony power)

Question 23

What is tacit collusion

Answer 23

Tacit collusion occurs when firms avoid formal agreements but closely monitor each other’s behaviour usually following the lead of the largest firm in the industry

Question 24

Tacit collision most common forms

Answer 24

price leadership or price matching

This occurs when firms monitor the price of the largest firm in the industry and then adjust their prices to match

It is difficult for regulators to prove that collusion has occurred

It provides similar benefits to firms as overt collusion, but perhaps not to the same degree

It has similar consequences for consumers as overt collusion, but perhaps not to the same degree

Question 25

What is game theory

Answer 25

mathematical framework which is used by firms to ensure optimal decisions are made in a strategic setting where there is a high level of interdependence (such as in oligopoly markets)

Question 26

What is a cartel

Answer 26

Occurs when a group of firms providing the same (or substitute) products join together to limit output & raise prices e.g OPEC (oil producing exporting countries). The group effectively acts as a monopoly

Question 27

3 elements of game theory

Answer 27

The players - (firms) The strategies available to the players The payoffs (outcomes) that each player receives for each combination of strategies

Question 28

When was game theory first illustrated

Answer 28

using a simple model called The Prisoners Dilemma

Question 29

Firms use game theory when

Answer 29

When making decisions to raise or lower prices When making decisions about new advertising and branding initiatives When making decisions about investment in product innovation When making decisions on product bundling e.g. combined phone and broadband package

Question 30

What is a payoff matrix

Answer 30

The strategies and payoffs available to the prisoners

Question 31

Burger King and McDonald’s payoff matrix analysis

Answer 31

If Burger King and McDonald's collude and agree not to advertise (top left), they can each enjoy £3 bn. in profits There is a strong incentive to collude Both firms decide to advertise and receive £2 bn. of profits each This outcome is called the dominant strategy as it carries the least risk The risk of collusion is that one player will cheat and by doing so, get ahead The payoffs (outcomes) that each player receives for each combination of strategies

Question 32

3 types of price competition

Answer 32

1. Price wars 2. Predatory pricing 3. Limit pricing

Question 33

Price wars

Answer 33

occur when competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share. This often occurs when there is a lower level of non-price competition and where firms find it difficult to collude (either formal or tacit)

Question 34

Predatory pricing

Answer 34

this is the practice of lowering prices when a new competitor joins the industry in order to drive them out. Prices are often lowered to a point below the cost of production. Once they have left the market, prices are raised again. This pricing strategy is usually illegal as it is anticompetitive

Question 35

Limit pricing

Answer 35

occurs when firms set a limit on how high the price will go in the industry. A lower price reduces profit and disincentivize other firms from joining the industry. The greater the barriers to entry the higher the limit price is likely to be as firms are already disincentivized

Question 36

What is the aim of non price competition

Answer 36

Increase product differentiation, develop, or increase brand loyalty and to increase market share.

Question 37

Non price strategies used

Answer 37

1. Loyalty cards + rewards 2. Branding 3. Packaging 4. Celebrity/ influencer endorsement 5. Corporate sponsorship e.g. Nike sponsoring Nadal 6. After sales service 7. Delivery policies 8. Product warranties

Question 38

Context

Answer 38

German shops fined for beer fixing Fined 71 million pounds for price fixing