3.4 - Oligopoly

Question 1

Characteristics of an oligopoly

Answer 1

• High Barriers to Entry and Exit
• High Concentration Ratio
• Interdependence of Firms
• Product Differentiation

Question 2

Characteristics of an oligopoly: High barriers to entry and exit

Answer 2

• Entering the industry is difficult due to the existing dominance of relatively few firms.
• Start-up costs tend to be high
• These barriers can include high capital requirements, economies of scale, patents, and government regulations.
• Leaving the industry is difficult due to the high level of sunk costs

Question 3

Characteristics of an oligopoly: high concentration ratio

Answer 3

• A concentration ratio reveals what percentage of the total market share a specific number of firms have
• in oligopolistic markets, this ratio is typically high
• Oligopolies are charactersed by a small number of large firms dominating the market.

Question 4

Characteristics of oligopolies: Interdependence of firms

Answer 4

• Oligopolistic firms are highly aware of the actions and decisions of their competitors.
• They must consider how their own choices, such as pricing and marketing strategies, will affect the behaviour and reactions of rival firms.
• This interdependence generates the use of game theory

Question 5

Characteristics of oligopolies: Product differentiation

Answer 5

• Oligopolistic firms often engage in product differentiation to distinguish their offerings from competitors.
• This can include branding, quality variations, and advertising to create brand loyalty.

Question 6

Game theory

Answer 6

A framework which is used for optimal decision making of player (firms) in a strategic setting where there is a high level of interdependence

Question 7

Calculation of n-Firm Concentration Ratios

Answer 7

The n-firm concentration ratio measures the combined market share of the largest n firms in an industry.
total sales of n firms /
total size of market x100

Question 7

A five-firm concentration ratio of around 60% is considered to be an (1)

A one-firm concentration ratio of 100% would be a pure (2)

Answer 7

(1) oligopoly
(2) monopoly

Question 8

The UK Competition Commission defines a monopoly as a firm with more than…

Answer 8

25% of market share

Question 9

Uk competition commission

Answer 9

• 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 10

Significance of Calculation of n-Firm Concentration Ratios

Answer 10

It can provide insights into the degree of market power held by the largest firms and potential antitrust concerns.

Question 11

Higher concentration ratios indicate…

Answer 11

a more concentrated industry with fewer dominant firms.

Question 12

Lower concentration ratios suggest

Answer 12

a more competitive industry with a greater number of smaller firms.

Question 13

Collusive behaviour

Answer 13

• Collusive behaviour in oligopolies occurs when firms cooperate to fix prices and restrict output
  > collective agreements that reduce competition

Question 14

Non-collusive behaviour

Answer 14

In oligopolies occurs when firms actively compete to maintain/increase market share

Question 15

Reasons For Collusion

Answer 15

• Maintaining High Prices
  > Firms in an oligopoly may collude to set high prices and limit competition, increasing their profits collectively.
• Stability
  > Collusion can provide market stability, reducing uncertainty for firms and consumers.
• Avoiding Price Wars
  > Collusion helps firms avoid destructive price wars.
• Few firms/competitors
  > This makes it relatively easy for each firm to understand other competitors’ actions and responses, or to collaborate on prices/output
• Similar costs
  > Firms face almost identical costs as any remaining competitors have all experienced economies of scale
• Similar revenue
  > 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
• Ineffective regulation
  > A lack of regulation empowers firms to collude as there is little consequence for their actions
• Brand loyalty
  > 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 16

Reasons for non-collusive behaviour

Answer 16

• Competition:
  > Firms may choose to compete aggressively to gain market share and increase profits individually.
• Legal Constraints:
  > Antitrust laws and regulations prohibit collusion, encouraging firms to compete independently.
• Differences in Objectives: > Firms may have differing goals and incentives that make collusion difficult.

Question 17

net effect of collusion

Answer 17

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

Question 18

Overt Collusion

Answer 18

Occurs when firms openly agree to cooperate and set prices or output levels. This can lead to the formation of cartels, which are explicit agreements among firms to coordinate their actions.

Question 19

The consequences of overt collusion include:

Answer 19

• Higher prices for consumers
• Less output in the market
• Poor quality products and/or customer service
• Less investment in innovation

Question 20

Overt collusion often happens in the following ways

Answer 20

• Price fixing
  > occurs when competitors agree a fixed price for all of their competing products and this price is usually above market equilibrium
• 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 21

Cartel

Answer 21

Occurs when a group of firms providing the same/substitute products join together to limit output and raise prices

Question 22

Example of a cartel

Answer 22

OPEC
(Oil producing exporting countries)

Question 23

Tacit Collusion

Answer 23

• Involves firms behaving in a manner that resembles collusion without any explicit agreement.
• Firms may follow observed pricing patterns set by competitors or engage in price leadership, where one dominant firm sets the price and others follow suit.
  ( firms avoid formal agreements but closely monitor each other’s behaviour usually following the lead of the largest firm in the industry)

Question 24

The most common form of tacit collusion is price leadership or price matching

Answer 24

- 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

Prisoner's Dilemma in a Two-Firm Model

Answer 25

- The prisoner's dilemma is a classic game theory scenario where two rational players, in this case, two firms, make decisions that result in suboptimal outcomes. - In an oligopolistic context, if both firms choose to compete aggressively, they may trigger a price war and both suffer lower profits. - However, if both firms collude and set high prices, they both earn higher profits. - The dilemma arises because each firm has an incentive to betray the collusion agreement to gain a larger share of the profits, but if both firms do this, they both end up worse off.

Question 26

How firms use game theory

Answer 26

> Firms typically use game theory in the following situations: - 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

Question 27

Pay off matrix

Answer 27

A payoff matrix which illustrates the strategies and payoffs available to firms when they are making decisions

Question 28

Types of Price Competition

Answer 28

1) Price wars: > 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) > often results in reduced profits for all. 2) Predatory pricing: > firms make short term losses to force firms out > 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 3) Limit pricing: > A strategy where a dominant firm sets prices low enough to discourage new entrants from the market > 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 disincentivised

Question 29

Types of Non-Price Competition

Answer 29

- Product Differentiation: Firms emphasize the unique qualities and features of their products through branding, quality, design, or advertising. - Advertising and Marketing: Firms engage in extensive advertising and marketing campaigns to create brand loyalty and awareness. - Innovation: Competing through the development of new products, technologies, or processes. - Customer Service: Offering exceptional customer service and support as a competitive advantage. - Distribution Channels: Establishing efficient distribution networks to reach customers faster and more conveniently.