4.1.3 oligopoly

Question 1

What is an oligopoly?

Answer 1

A market where very few firms dominate, exerting significant control over prices and output.

Question 2

When is a market an oligopoly?

Answer 2

When the top 5 firms in the market account for more than 60% of market share.

Question 3

What are some characteristics of an oligopoly? [5]

Answer 3

• High barriers to entry
• Interdependence
• Stable prices
• Collusion
• Non-price competition

Question 4

What is concentration ratio?

Answer 4

The combined market share of the top few firms in a market.

Question 5

What is collusive behaviour?

Answer 5

When firms agree to work together on something, for example choosing to set a price or fix the quantity of output they produce to minimise competitive pressure they face.

Question 6

What does collusion lead to? [3]

Answer 6

• Lower consumer surplus
• Higher prices
• Greater profits for firms colluding

Question 7

Why do firms in an oligopoly have a strong incentive to collude?

Answer 7

They can maximise their own benefits and restrict their output, causing market price to increase. This deters new entrants and is anti-competitive.

Question 8

When is collusion more likely to happen? [5]

Answer 8

When there are only a few firms, they face similar costs, there are high entry barriers, it is not easy to be caught, there is an ineffective competition policy.

Question 9

What is non-collusive behaviour?

Answer 9

When firms are competing.

Question 10

When is non-collusive behaviour more likely to occur? [4]

Answer 10

When there are several firms, one firm has significant cost advantage, products are homogeneous and the market is saturated.

Question 11

What are the two types of collusion?

Answer 11

• Overt
• Tacit

Question 12

What is overt collusion?

Answer 12

When a formal agreement is made between firms. It is illegal in EU, US and several other countries.

Question 13

When does overt collusion work best?

Answer 13

When there are only a few dominant firms, so one does not refuse.

Question 14

What is a real life example of overt collusion?

Answer 14

It is suspected that fuel companies partake in overt collusion. Could be by price fixing.

Question 15

What is tacit collusion?

Answer 15

When there is no formal agreement but collusion is implied.

Question 16

What is an example of tacit collusion?

Answer 16

The UK supermarket industry, where firms are competing in a price war.

Question 17

What is a cartel?

Answer 17

A group of two or more firms which have agreed to control prices, limit output, or prevent the entrance of new firms into the market.

Question 18

What is a famous example of a cartel?

Answer 18

OPEC, which fixed their output of oil. This was possible cine they controlled over 70% of supply of oil in the world.

Question 19

What do cartels lead to? [2]

Answer 19

• Higher prices for consumers
• Restricted outputs

Question 20

What is price leadership?

Answer 20

When one firm changes their prices, and other firms follow.

Question 21

When does price leadership usually occur?

Answer 21

When the dominant firm in the market changes prices, and other firms are forced into doing so too otherwise they risk losing their market share.

Question 22

Why does price leadership explain why there is price stability in an oligopoly?

Answer 22

As other firms risk losing market share if they do not follow the price change.

Question 23

What is a price war?

Answer 23

A type of price competition, which involves firms constantly cutting their prices below that of its competitors. Their competitors then lower their prices to match.

Question 24

What is game theory?

Answer 24

Related to the concept of interdependence between firms in an oligopoly, and is used to predict the outcome of a decision made by one firm, when it has incomplete information about the other firm. It can be explained using the Prisoner’s dilemma.

Question 25

What is the Prisoner's dilemma?

Answer 25

A model based around 2 prisoners who have the choice to either confess or deny a crime. The 2 are not allowed to communicate but can consider what the other prisoner is likely to choose, this relates to characteristic of uncertainty in an oligopoly.

Question 26

What is the dominant strategy in the Prisoner's Dilemma?

Answer 26

The option which is best, regardless of what the other person chooses. This is for both prisoners to confess, since this gives the minimum number of years that they both have to spend in prison.

Question 27

What is the Nash equilibrium?

Answer 27

A concept in game theory which describes the optimal strategy for all players, whilst taking into account what opponents have chosen.

Question 28

Why is the Nash equilibrium unstable?

Answer 28

As there is an incentive to cheat and take the upper hand, such as confessing in the prisoner's dilemma whilst you know the other will deny.

Question 29

What are the advantages of an oligopoly? [4]

Answer 29

- Can earn significant supernormal profit. Might invest which can make the market more dynamically efficient in the long run and yield positive externalities - Higher profits could be a source of government revenue - Industry standards could improve, especially true in the pharmaceutical industry as firms can collaborate on technology and improve it, saves on duplicate R&D - Can exploit economies of scale, so have lower average costs of production

Question 30

What are the disadvantages of an oligopoly? [3]

Answer 30

- Basic model suggests higher prices and profits and inefficiency may result in misallocation of resources compared to competitive markets - If firms collude there is loss of consumer welfare - Collusion could reinforce monopoly power of existing firms and make it hard for new firms to enter. Absence of competition means efficiency falls and average cost of production increases

Question 31

When does price discrimination occur?

Answer 31

When different prices are charged to different groups of consumers for the same good or service.

Question 32

What is first degree price discrimination?

Answer 32

When each consumer is charged a different price. For example a lawyer might charge a high income family more than a low income family.

Question 33

What is second degree price discrimination?

Answer 33

When prices are different according to the volume purchased.

Question 34

What is third degree price discrimination?

Answer 34

When different groups of consumers are charged a different price for the same good or service. For example, the higher price at peak times on trains, than off-peak times.

Question 35

What are the costs to consumers of price discrimination? [2]

Answer 35

- Results in loss of consumer surplus since P > MC, there is a loss of allocative efficiency - Strengthens the monopoly power of firms which could result in higher prices in long run for consumers

Question 36

What are the benefits of price discrimination to consumers? [2]

Answer 36

- Could benefit from net welfare gain as result of cross subsidisation, if they receive a lower price - Some who were previously excluded by high prices might now be able to benefit from the good. This can sometimes yield positive externalities

Question 37

What are the costs of price discrimination to producers? [2]

Answer 37

- Firm could face investigation by the Competition and Markets Authority if it is used as a predatory pricing method - Might cost the firm to divide the market, which limits the benefits they could gain

Question 38

What are the benefits of price discrimination to producers? [3]

Answer 38

- Make better use of spare capacity - Higher supernormal profits could stimulate investment - If more profits are made in one market, a different market making losses could be cross subsidised, especially if it yields social benefits. This will limit or prevent job losses which may result from closure of the loss-making market