3.4.4 - oligopoly

Question 1

What does the concentration ratio measure ?

Answer 1

It measures the market share of the largest firms in an industry

Question 2

How can the concentration ratio be useful ?

Answer 2

The concentration ratio is useful for giving a first impression of how the market is likely to function.

Question 3

What is an oligopoly market ?

Answer 3

A market with just a few sellers

Question 4

What is an important characteristic of an oligopoly ?

Answer 4

• An important characteristic of oligopoly is that each firm has to act strategically, both in reacting to rival firms’ decisions and in trying to anticipate their future actions.
• The firms are therefore interdependent.

Question 5

When are oligopolies likely to arise ?

Answer 5

An oligopoly is likely to develop in a market where there are modest economies of scale

Question 6

What are modest economies of scale ?

Answer 6

Modest economies of scale are economies that are not substantial enough to require a natural monopoly, but are large enough to make it difficult for too many firms to operate at minimum efficient scale.

Question 7

What does non cooperation lead to ?

Answer 7

Non cooperation will tend to take the market towards the monopoly end of the spectrum

Question 8

What does cooperation lead to ?

Answer 8

Cooperation will take the market towards the competitive end.

Question 9

What are the characteristics of an oligopoly ?

Answer 9

There is a small number of large firms

There are high barriers to entry

An additional barrier to entry in oligopoly involves high start-up costs associated with developing a new or differentiated product

Products produced by oligopolistic firms may be differentiated or homogeneous

There is mutual interdependence

Question 10

What is strategic behaviour ?

Answer 10

Strategic behaviour is based on plans of action that take into account rivals’ possible courses of action.

Question 11

What causes strategic behaviour in an oligopoly ?

Answer 11

Strategic behaviour of oligopolistic firms is the result of their mutual interdependence

Question 12

What are conflicting incentives ?

Answer 12

Firms In oligopoly face incentives that conflict, or clash with each other:

Question 13

What is the incentive to collude ?

Answer 13

The term collusion refers to an agreement between firms to limit competition between them, usually by fixing price and therefore lowering quantity produced.

Question 14

What can colluding to limit competition lead to ?

Answer 14

The firms reduce uncertainties resulting from not knowing how rivals will behave, and maximise profits for the industry as a whole.

Question 15

What is the Incentive to compete ?

Answer 15

Each firm faces an incentive to compete with its rivals in the hope that It will capture a portion of Its rivals’ market shares and profits, thereby Increasing profits at the expense of other firms.

Question 16

Is collusion legal ?

Answer 16

No, the CMA will investigate it

Question 17

What does collusion do for consumers ?

Answer 17

It takes away their choice, price competition and quantity being produced

Question 18

What is game theory ?

Answer 18

It is a mathematical technique analysing the behaviour of decision-makers who are dependent on each other, and who use strategic behaviour as they try to anticipate the behaviour of their rivals.

Question 19

What is the prisoners dilemma ?

Answer 19

When two players act selfishly resulting in a sub optimal result for both, just by cooperating is not always in ones best interest

Question 20

What is the nash equilibrium ?

Answer 20

Where each player has nothing to gain by changing strategies given the choices of the other player

Question 21

What real world aspects of oligopolistic firms does the game theory illustrate ?

Answer 21

Firms are mutually interdependent

Firms display strategic interdependence

Firms face conflicting incentives

Firms become worse off as a result of price competition

Firms have a strong interest in avoiding price wars

Question 22

What is collusion ?

Answer 22

Collusion in oligopoly refers to an agreement between firms to limit competition, increase monopoly power and increase profits

Question 23

What is the most common form of collusion ?

Answer 23

price- fixing agreements such as by holding prices constant at some level, raising prices by some fixed amount, fixing price differences between different products, adopting a formula for calculating prices, and others.

Question 24

What is a cartel ?

Answer 24

A cartel is a formal agreement between firms in an industry to take actions to limit competition in order to increase profits it therefore involves formal collusion or open collusion

Question 25

What is the key objective of a cartel ?

Answer 25

The key objective of a cartel is to limit competition between the member firms and attempt to maximise joint profits

Question 26

What do cartel members behave like ?

Answer 26

Cartel members collectively behave like a monopoly

Question 27

Are cartels legal ?

Answer 27

They are illegal This is because they restrict competition and are therefore held to be against consumers' and society's best interests.

Question 28

What factors make it hard for a cartel to be established and maintained?

Answer 28

The incentive to cheat Cost differences between firms Number of firms The possibility of a price war Recessions Potential entry into the industry The industry lacking a dominant firm

Question 29

How can the incentive to cheat make it hard for a cartel to be established ?

Answer 29

A firm that cheats can increase its market share and its profit at the expense of other firms, but if many firms cheat, or if cheating is discovered by other firms in the cartel, then the cartel is in danger of collapsing.

Question 30

How can the cost differences between firms make it hard for a cartel to be established ?

Answer 30

Since the price agreed upon by the cartel is common to all the firms, firms with higher average costs have lower profits, while lower- cost firms enjoy higher profits. Cost differences between firms lead to difficulties in agreeing on a common price and on how to allocate the output among the firms

Question 31

How can the number of firms make it hard for a cartel to be established ?

Answer 31

The larger the number of firms, the more difficult it is to arrive at an agreement regarding price and the allocation of output, as the greater number of differing views make agreement and compromise more difficult to achieve.

Question 32

How can the possibility of a price war make it hard for a cartel to be established ?

Answer 32

The result of a price war is to make all the firms of an industry collectively worse off due to lower prices and lower profits

Question 33

How can the possibility of a recession make it hard for a cartel to be established ?

Answer 33

During recessions sales fall and profits are reduced; at such times firms have a stronger incentive to lower prices and cheat on the agreement, endangering the survival of the cartel.

Question 34

How can barriers of entry make it hard for a cartel to be established ?

Answer 34

If a cartel is successful, it will make large economic profits, encouraging entry of new firms into the industry. If there are new entrants, increased industry supply will drive price down cutting into the cartel's profits. The cartel's long-run survival therefore depends on high barriers to entry that block potential new entrants.

Question 35

How can the lack of a dominant firm make it hard for a cartel to be established ?

Answer 35

he presence of a dominant firm facilitates reaching agreement, as this firm can assume a leadership position in the negotiations leading to the agreement

Question 36

What is overt collusion ?

Answer 36

- This is formal collusion and is the only legal one It involves agreements, price agreements and a cartel

Question 37

What is covert collusion ?

Answer 37

- It is not openly acknowledged or displayed - Formal collusion It involves agreements, price agreements and cartels it is common and does happen on a regular basis

Question 38

What is tacit collusion ?

Answer 38

- Implied without being stated - if tacit collusion doesn’t work there could be a price war, they both decide to lower prices without telling each other because they want to increase profit

Question 39

Define tacit collusion

Answer 39

Tacit collusion (or informal collusion) refers to co-operation that is implicit or understood between the co-operating firms, without a formal agreement.

Question 40

What are the objectives of tacit collusion ?

Answer 40

The objectives of tacit collusion are also to co-ordinate prices, avoid competitive price-cutting, limit competition, reduce uncertainties and increase profits.

Question 41

What is price leadership ?

Answer 41

where a dominant firm in the industry (which may be the largest, or the one with lowest costs) sets a price and also initiates any price changes. The remaining firms in the industry become price-takers, accepting the price that has been established as the leader

Question 42

What type of agreement is price leadership ?

Answer 42

The implicit agreement (as there is no formal agreement) binds the firms as far as price goes, but they are free to engage in non-price competition

Question 43

What is one of the characteristics of price leadership ?

Answer 43

price changes tend to be infrequent, and are undertaken by the leader only when major demand or cost changes occur.

Question 44

What obstacles are there to price leadership ?

Answer 44

- Cost differences between firms make it difficult for firms to follow a leader - Leader risks losing sales and market share if it initiates a price increase that is not followed - Firms still face the incentive to cheat by lowering their price, leading to a price war - High profits can attract new firms that will then cut into the profits and endanger the price leadership agreement - Price leadership may or may not be legal

Question 45

What is limit pricing ?

Answer 45

Firms informally agree to set a price that is lower than the profit-maximising price, thus earning less than the highest possible profits and so discouraging new firms from entering the industry.

Question 46

What do firms end up sacrificing in limit pricing ?

Answer 46

firms may end up sacrificing some profit in order to avoid attracting new firms into the industry.

Question 47

What is predatory pricing ?

Answer 47

- This type of pricing is illegal - You are pushing out competitors - Setting price below your AC to drive out competition