Micro 20 - Oligopoly, collusion and concentration ratios

Question 1

What are the two ways of measuring market size?

Answer 1

• Market size by volume
• Market size by value

Question 2

What is market size by volume?

Answer 2

Market size by volume looks at the total number of sales of an item by all firms in that industry

Question 3

What is market size by value?

Answer 3

Market size by value looks at the total amount spent on the item in that industry

Question 4

Define market share

Answer 4

A firm’s market share measures the sales of product/business as a percentage of the total market sales

Question 5

What is the formula used to calculate market share?

Answer 5

The company’s sales / Total market sales * 100

Question 6

Define concentration ratios

Answer 6

• Concentration ratios refer to the proportion/percentage of the total market shared between the nth largest firms
• This is often expressed as a 3 firm, 4 firm or 5 firm concentration ratio
• The n-firm concentration ratio is expressed in percentage terms, therefore a 3 firm concentration ratio would add together the market shares of the 3 largest firms within that market

Question 7

What are concentration ratios used for?

Answer 7

Concentration ratios are used to determine the market structure and competitiveness of the market

Question 8

What does a 89.54% concentration ratio for Google, Yahoo and Bing mean?

Answer 8

Google, Yahoo and Bing occupy 89.54% of the total market share

Question 9

What is the main limitation of using concentration ratios?

Answer 9

Concentration ratios may provide a misleading result as if we are told that the 5-firm concentration ratio is 90% this may mean that one firm has 80% of the market and the other 4 firms have the remaining 10% share

Question 10

What is an oligopoly?

Answer 10

An oligopoly is a market structure where there are a small number of firms which are large and interdependent, each of which has some control over the market. There is a high level of market concentration

Question 11

What are the characteristics of an oligopoly market structure?

Answer 11

• There is a high market concentration ratio, supply is concentrated in the hands of a few firms
• High barriers to entry in the long run which allow supernormal profits
• Firms are interdependent - the actions of one firm will affect the other firms directly
• Each firm will produce slightly different products allowing each firm to be a price maker
• Non-price competition is often used by oligopolists as firms operating in oligopolistic markets tend to keep prices stable causing price rigidity in the industry due to interdependence of firms

Question 12

Define Price rigidity

Answer 12

Price rigidity is when there are only a few firms dominating an industry, the firms will tend to avoid price competition causing price rigidity in the industry

Question 13

Why do firms in an oligopoly tend to avoid price competition (avoid changing their prices)?

Answer 13

• Increasing prices would cause consumers to buy their products from one of the other suppliers and so will experience a drop in revenue
• Decreasing prices will increase sales for the firm but other firms will match the price decrease as well so assuming that overall demand for the industry product is unlikely to raise substantially all firms will find that the rise in demand for their petrol is proportionately small compared with the proportionate fall in price so their revenues fall

Question 14

What are price wars?

Answer 14

Price wars are when in the short term, prices are pushed down so that firms are making losses, however they stay in the market because they are at least covering their variable costs of production which makes some contribution to fixed costs. In the long run, prices must rise perhaps because supply falls as firms leave the market

Question 15

When are price wars likely to occur?

Answer 15

When non-price competition is weak

Question 16

Define Predatory pricing

Answer 16

• Predatory pricing is when prices are deliberately set below average costs by a dominant firm to eliminate competition.
• In the short run the firm will make a loss, however in the long run the firm will increase prices and make higher levels of profit due to a reduction in competition

Question 17

Define Limit pricing

Answer 17

• Limit pricing is when prices are deliberately set below the short run profit maximising price, often somewhere near sales maximising price and quantity by a dominant competitor in the market.
• This is done to restrict/prevent new entrants into the market. Here the incumbent firm exploits its economies of scale to lower price and create additional barriers to entry to the market.

Question 18

What is the main difference between Predatory and Limit pricing?

Answer 18

Predatory pricing is used to force firms out of an industry whereas limit pricing is used to prevent new firms from entering the industry in the first place

Question 19

What do both predatory pricing and limit pricing allowing incumbent firms to do?

Answer 19

Both of these pricing strategies allow incumbent firms to create barriers to entry in to the market and maintain significant market share

Question 20

What is the relationship between non-price competition and perfectly competitive markets and oligopolies?

Answer 20

Non-price competition occurs in oligopolies but does not occur in perfectly competitive markets as firms produce homogenous goods and compete solely on price

Question 21

What is non-price competition?

Answer 21

Non-price competition is a marketing strategy in which one firm tries to distinguish its product or service from the products sold by competitors on the basis of qualities such as design or quality and not by lowering price

Question 22

Generally, what effect will non-price competition have on the cost and revenue diagram for a firm?

Answer 22

It will generally shift the AR curve to the right or prevent it from falling as other firms try to increase their market share. The cost of the strategy must increase costs less than the revenue increase if the aim is to increase supernormal profit

Question 23

What are some examples of non-price competition strategies?

Answer 23

• Trying to improve quality and after sales servicing
• Spending on advertising, sponsorship and product placement
• Loyalty schemes
• Convenience
• Contractual relationships with suppliers - offering exclusive distribution agreements
• Branding and packaging changes

Question 24

What is the aim of non-price strategies?

Answer 24

The aim of non-pricing strategies is to increase demand for the good being sold and to reduce the PED by reducing the availability/closeness of substitutes without changing price

Question 25

Define collusion

Answer 25

Collusion occurs where there are two or more firms working together, cooperating to restrict competition, set prices or output

Question 26

What are the two types of collusion?

Answer 26

• Overt collusion
• Tacit collusion

Question 27

What is Overt collusion?

Answer 27

Overt collusion occurs when firms make agreements among themselves to restrict competition, typically by reducing output, raising prices and keeping potential competitors out of the market

Question 28

What is Tacit collusion?

Answer 28

Tacit collusion occurs when firms collude without any formal agreement having been reached and where there is no explicit communication between firms. Firms monitor each other’s behaviour closlely

Question 29

What is the relationship between price leadership and tacit collusion?

Answer 29

Price leadership is an example of tacit collusion. Price leadership refers to a situation where prices and price changes established by a dominant firm are usually accepted by others and which other firms in the industry adopt and follow

Question 30

What is the main difference between overt and tacit collusion?

Answer 30

Overt collusion is when the collusion is open for everyone to see whereas tacit collusion is secretive

Question 31

What is game theory?

Answer 31

Game theory is a means of modelling the behaviour of firms. It is the analysis of situations in which players are interdependent which looks at how game players (firms) react to changing circumstances and plan their response. It looks at predicting the outcome of games of strategy in which the participants (two or more firms competing in a market) have incomplete information about the other’s intentions

Question 32

What is the dominant strategy in game theory?

Answer 32

A dominant strategy is the best outcome irrespective of what the other firm chooses. It is often the safest option for the firm

Question 33

What is a payoff matrix?

Answer 33

A payoff matrix/outcome model is a visual representation of the possible outcomes of a strategic decision

Question 34

In payoff matrices what do we assume?

Answer 34

The two firms cannot communicate

Question 35

In payoff matrices what is often the dominant strategy?

Answer 35

The option in which there will always be at least some profit made - avoid the option where there is a possibility of making zero profit or a loss

Question 36

Draw a general blank payoff matrix

Answer 36

See page 20 in pack 20

Question 37

What labels do we have to use on a payoff matrix?

Answer 37

We always have to label the two firms on either side of the matrix and the different combinations of strategies possible

Question 38

When is collusion most likely to work?

Answer 38

• If there are few sources of the product outside of the cartel
• If new firms cannot enter the industry easily - high barriers to entry
• The industry is stable and mature
• The products are homogenous
• Firms have similar costs of production making agreement on price easier to reach
• Cheating is difficult
• Demand is stable/rising

Question 39

What are some reasons why collusion may not work?

Answer 39

• If there enforcement problems, many members of a cartel may cheat for short term gains
• Falling market demand puts pressure on firms to discount prices to maintain revenue
• New firms are able to enter the market reducing cartel power
• Discovery by regulators
• Incentives to whistle blow - whistle blowers are often protected from prosecution and fines

Question 40

What is whistleblowing?

Answer 40

Whistle blowing is when firms tell competition authorities that they have been colluding with other firms. As a result the snitching firm will not face any consequences but the other firm will providing an incentive to whistle blow