Oligopoly Flashcards
(42 cards)
1
Q
Characteristic of an oligopoly
A
- Best defined by the actual behaviour of firms
- A market dominated by a few large firms
- High market concentration ratio
- Each firm supplies branded products
- Barriers to entry and exit
- Interdependent strategic decisions by firms
2
Q
Oligopoly
A
- Firms in Oligopolistic Markets are ‘interdependent’. This means the actions of one firm will have a direct effect on the other firms in the market
- Price wars are a common feature of oligopolistic markets. However firms will look to avoid this as it will mean lower revenue for all involves. Instead oligopoly firms tend to use ‘non-price competition’
3
Q
Basics of an oligopoly
A
- An oligopoly is an imperfectly competitive industry where there is a high level of market concentration.
- Oligopoly is best defined as the actual conduct (day to day behaviour) of firms within a market
- The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms
- A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total market sales
4
Q
Market structure (characteristics)
A
Market structure details the characteristics of a market:
- Few firms in the industry
- Significant barriers to entry making it difficult for firms to leave or enter the industry
- High concentration ratios
- Smaller firms are likely to operate but will not have a significant impact on market share
- Products can be homogenous or differentiated
- Firms are interdependent e.g. the actions of one firm will impact on other firms in the industry
5
Q
Market conduct (behaviour)
A
Market conduct or behaviour refers to the policies that a firm uses to market its products
Firms in oligopolistic markets:
- May be collusive or competitive
- Will be interdependent and react to the behaviour of other firms
- Are likely to be price leaders or price followers
- Are subject to price stickiness and non-price competition
- GAME THEORY suggest that oligopolists face uncertainty as they do not know how other firms will react to their market behaviour
6
Q
Concentration ratio
A
- The concentration ration (CR) tells us the number of firms that dominate the market
- Example
> 3:75 means that 3 firms have 75% market share - Traditionally economists use four and eight firm concentration ratios
- If the market has a concentration ration of CR1 = 100% - the industry is a monopoly
- If CR8 = 0% - the industry is perfectly competitive
7
Q
Strategic independence
A
- Strategic independent means that one firms output and price decisions are influenced by the likely behaviour of competitors
- Because there are few sellers, each firm is likely to be award of the actions of the others
- Decisions of one firm influence, and are influenced by the decisions of other firms
- This causes oligopolistic industries to be at high risk of tacit (expected) collusion or explicit collusion which can lead to allegations of anti-competitive behaviour
- In oligopoly there is a high level of uncertainty
8
Q
The kinked demand curve - AR curve
A
A model designed to explain and illustrate interdependence and price ‘stability’ in competitive oligopoly
- Equilibrium is p1 q1
- Demand above the equilibrium is price elastic. If the firm increase the price competitors would not follow these actions and instead keep their prices stable
- Therefore the initial firm would see large falls in the quantity demanded and therefore lose market share and see revenuer fall
- Demand below the current price of P1 is assumed to be relatively inelastic
- If the firm chose to reduce their price, this is assumed to lead to rival firms following suit immediately, initiating a price war
- The initial firm therefore sees very little increase in output and will see there revenue fall
- Therefore this model shows that firms will neither seek to increase or decrease the prices therefore ‘price stability’ is a feature of oligopolistic markets
9
Q
Kinked demand curve - MR curve
A
- The marginal revenue (MR) is always twice as steep as the average revenue (AR)
- There will be two MR curve if AR is kinked
- We find a vertical intersection - at quantity Q1 the two curve do not actually intersect
10
Q
Kinked demand curve - Price rigidity
A
- One of the key predictions of the kinked demand curve model is that prices will be rigid or “sticky” even when there is a change in the marginal costs of supply (this is assuming that firms in the market are profit seeking)
11
Q
Kinked demand curve - Overview
A
- On oligopoly firms have price-setting power but may be reluctant to use it
- Rivals unlikely to match a price rise and rivals likely to match a price fall
- If a firm is settled on one price, there may be little point in changing it
- Even is costs change we often see price rigidity/ stability in an oligopoly
- This increase the importance attached to non-price competition
11
Q
3 key aims of collusion
A
- Businesses in a cartel recognise their mutual interdependence and act together - the main aim is to maximise joint profits
- Collusion lowers the costs of competition e.g. wasteful marketing wars which can run into millions of pounds
- Collusion reduces uncertainty in a market - and higher profits increases producer surplus/ shareholder value - leading to higher share prices
12
Q
Legal collusion
A
- Not all instances of collusive behaviour are deemed to be illegal
- Collusive: OPEC for oil price setting
- Non-collusive: Airlines engaging in price wars for tickets
- Practices are not prohibited if the respective agreements “contribute to improving the production or distribution of goods or to promote technical progress in a market”
- Joint industry standards in Europe for mobile phone chargers
- Information sharing designed to give better information to consumers
- Research joint ventures and know-how agreements which seek to promote innovative and inventive behaviour in a market
13
Q
Benefits from collusion
A
General industry standard can bring social benefits
- Pharmaceutical research
- Car safety technology
- Faster acceleration in developing new technologies
Fairer price for producer cooperatives in lower and middle income developing counties
- Competing with powerful monopsonistic corporations
- May help in reducing rates of extreme income poverty
Profits have value
- Capital investment projects
- Research and development - leading to dynamic efficiency
- Higher wages for employees - increased consumption
14
Q
Drawbacks of Oligopoly
A
Price leadership
- Its common in oligopoly
- The dominate firm sets price and other firms seek to follow suit, normally over a period of time
- This is likely to see increased prices and lower output
Price agreements (fixing)
- Explicit where the firms overtly agree to set price
- Implicit where there is a tacit agreement over set prices that is more difficult for regulators to identify
Price wars
- Occur in competitive oligopoly where firms set price in order to profit maximise individually rath than in collusion
Barriers to entry
- Are obstacles preventing firms from entering the market such as R&D costs
- These are an important reason for the existence of oligopolistic markets
15
Q
Price fixing (collusion) is easier when
A
- Industry regulators are weak/ ineffective
- Penalties for collusion are low relative to the potential gains in revenues/ operating profits
- Participating firms have a high percentage of total sales - this allows them to control market supply
- Firms can communicate well and trust each other and they have similar strategic objectives
- Industry products are standardised and output is easily measurable
- Brands are string so that consumers will not switch demand when collusion raises price
16
Q
Examples of Anti-competitive behaviour
A
- Dec 2015: Telecoms firm Orange fined €350m (£254m) for abusing its market dominance in France
- April 2015: EU competition commission accused Google of illegally abusing it dominance in web search to steer European consumers to its own in-house shopping services
17
Q
Why do many cartels break down
A
- Falling market demand in recession
- Over-production by some members
- Exposure by competition authorities
- Entry of non-cartel firms into industry
18
Q
Drawbacks of collusion
A
- Collusive oligopoly allows firms to reduce the uncertainty that exists under competitive oligopoly
- Unless cartel members merge and form a monopoly, uncertainty can never be eliminated
- There is always an incentive to cheat on a cartel agreement
- Cartel may exploit consumers and allow firms to remain productively inefficient
- As a result governments usually make these restrictive practises and anti-competitive agreements illegal
19
Q
Game theory and Oligopoly
A
-Games theory is the study of how people and business behave in strategic situations (e.g. when they must consider the effect of other peoples responses to their own actions)
- Oligopoly theory often makes heavy use of game theory to model the actual behaviour of business in concentrated markets
A game consists of:
- Players
- Strategies
- Payoffs
- Might also involve some form of pre-commitment
20
Q
Different types of games
A
- Simultaneous games
- Sequential games
21
Q
Simultaneous games
A
- When players effectively make their decisions at the same time
- They don’t know the choices of other players when making their decisions
Examples
- The prisoners dilemma
- Rock, paper, scissors
- Split or steal
- Penalty shoot outs
- Athletes choosing to dope or not to dope
22
Q
Sequential games
A
- A sequential game is one in which the players take alternate turns to make their choices
Classic examples
- A game of chess
- Open-outcry with sequential bidding
- Salary negotiations
- Haggling to buy a second hand car
- Making offers on property
- It is important to know who is going to move first in a sequential game as their may be a first mover advantage, or even a first mover disadvantage
23
Q
Game theory - Prisoners Dilemma
A
Prisoner A and Prisoner B both silent
- 6 months each
Prisoner A silent and prisoner B betray
- Prisoner A 10 years
- Prisoner B no time
Prisoner A betray and prisoner B silent
- Prisoner A no time
- Prisoner B 10 years
Prisoner A and prisoner B both betray
- 5 Years each
- The prisoners dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is the best interest of both parties
- Both players are assumed to select their own dominant strategies for short-sighted personal gain/ self interest
- Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could agree to select an alternative (non-dominant) strategy
24
Nash equilibrium
- Nash equilibrium is an important idea in game theory
- It describes any situation where all of the participants in a game are pursuing their best possible strategy given the strategies of all of the other participants
- In Nash equilibrium, the outcome of a game that occurs is when player A takes the best possible action given the action of player B, and player B takes the best possible action given the action of player A
25
Topical applications of game theory
- Tacit collusion between firms in an Oligopoly
- Patent races/ innovation effort/ product testing
- Central bank currency policy - intervention
- Business reactions to the new UK living wage
- Market entry/ exit decisions
- Auction tactics e.g. bidding for a franchise
26
Evaluating relevance of game theory
- Game theory becomes relevant to analysing business decisions making when there are relatively few firms
- Standard game theory assumes rational agents are looking to maximise there own self interest
- More complex game theory reveals that people/ businesses can develop co-operative/ collaborative behaviours e.g. the rise in joint ventures
Key evaluation point for the exam
- Game theory can over-simplify complex decisions, and wen there are more than two rival firms in a market the degree of complexity increases. Many firms fall back on heuristics
27
Contestable markets
- Contestable markets are constantly changing
- Contestable markets be seen at a local, regional, national and international level
- In a contestable market, the number of firms & the size distributions of firms is not considered to be important
- More focus given to credible threat of entry from rivals
- Almost all markets are contestable to some degree
-Technology is changing contestability
> E.g. Barriers to entry have lowered because of digital advances
> Many start-ups use the web as a platform o enter markets
- Contestable markets often show high dynamic efficiency
> Challenger brands attacking established operators
28
Contestable markets in action
- Peer to peer lending
- Fast food industry
- Hotel/ Room sharing sector
- City transport services
- Private education
- Bookselling
Examples
- Jan 2016: Netflix announces their streaming service is now available in 130 countries
- Nov 2015: Apple 'to launch peer-to-peer payment app' in competition with PayPal
- Nov 2015: Uber taxi app set to launch in Edinburgh
29
Contestability and dynamic efficiency in action
Examples
- Dec 2015: Porsche to make electric sports cars in €700m project - aimed at challenging Tesla's dominance of the battery powered sports car market
- Nov 2015: Huawei reveals a new quick-charge battery
- Dec 2015: Ford says it will invest $4.5bn (£3bn) to expand its fleet of plug-in hybrid electric vehicles, and will start selling 13 new electric models by 2020
30
Difference between contestable and perfectly competitive
- It is possible for one or a few firms to dominate the industry
- Each firm produces differentiated product
- Price setting power
4 key conditions for market contestability
- Ability/ legal right to use the best available technology
- Legal freedom to enter a market/ pool of firms willing and ready to enter market
- Relative absence of sunk costs/ exit costs
- Consumer switching
31
Perfect knowledge
- Perfect knowledge occurs when all producers and consumer in a market are fully aware of price, quantity available and other relevant information for all products when making buying and production decisions
- This means that all firm shave access to the same technology and can use it at the same cost
- If a firm has a competitive advantage due to better technology this will lower its average costs and impede the entry of new firms into the market
- Therefore, the market is less likely to be contestable
32
Freedom to enter or exit the market
- Freedom to enter or or exit the market means that factors of production are perfectly mobile so no barriers to entry or exit exist
- All firms have access to the same technology
- If firms in the market raise price and earn supernormal profits new entrants will take advantage and move into the market
- If the original firms lower price and supernormal profits no longer exist the hit and run competition will leave the market
- As there is free entry and exit the hit and run competitor does not have any substantial costs e.g. their machines can still be put to use for other purposes
- This guarantees only normal profits in the long run
- Firms might use limit pricing, deliberately keeping price low to deter new entrants into the market
- This leads to normal profits being made in the industry
33
Sunk costs
Costs that are invested into a business which they cant get back as they cant take it out (e.g. getting specific seats in a cinema that are custom to them and cant be used elswhere)
- Sunk costs cannot be recovered if a firm leave an industry
- When sunk costs are high then a market becomes less contestable
- High sunk costs act as a barrier to entry of new firms because they risk making significant loses if they decide to exit the sector
- In markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets there are low sunk costs so barriers to exit are low and contestability is high
33
Examples of sunk costs
Asset-write offs:
- E.g. writing off the value of plant and machinery, stocks and the goodwill of a consumer brand
Closure or project cancellation costs:
- Including redundancy costs, bad debts, contracts with suppliers and the penalty costs from ending leases for property & equipment
The loss of business reputation and goodwill
- A decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain
BUT
A market downturn
- It may be perceive as temporary and could be overcome if and when the economic or business cycle turns and conditions become more favourable
34
Exit costs - Barriers to exit
- Asset write-offs
- Lost consumer goodwill/ brand loyalty
- Redundancy costs
35
Key barriers to market contestability
- International economies of scale
- Vertical integration
- Strength of customer brand loyalty
- Control of important technologies
- Expertise and reputation
36
Policies to increase contestability
- Deregulation of an industry
- Open up networks of monopolies
- Tough rules on predatory pricing
- Encouraging integration trade
37
Key concepts - contestable markets
Key concept:
- Contestable market
Definition:
- Where an entrant has access to all production techniques available to pre existing firms and entry decisions can be reversed without cost
Key concept:
- Hit and run entry
Definition:
- When a business enters an industry to take advantage of temporarily high (supernormal) market profits.
Key concept:
- Sunk costs
Definition:
- Sunk costs cannot be recovered if a business decides to leave an industry
- The existence of sunk costs makes a market less contestable
38
Contestable markets - Price and profit
- The more contestable a market is, the more likely than an allocatively efficient outcome is achieved
- The threat of entry affects the day-to-day behaviour of firms
- Firms making supernormal profits are vulnerable to "hit and run" competition
- Often smaller disruptive business challenge the monopoly power of existing businesses
- The threat of entry is as important as actual competition
39
Contestable markets evaluation
- The threat of new competition is often a powerful an influence on the behaviour of existing established firms
- A highly contestable market will resemble perfect competition, regardless of the number of firms, since incumbents behave is if there was intense competition
- Competition policies such as liberalisation of a market that help to open up an industry to ne suppliers or persuade consumers to switch in greater numbers help to increase contestability
40
Market contestability and the performance of an industry
Contestability will impact on efficiency in a market:
Productive efficiency
- Productive efficiency will exists as firms operate at the lowest point on their average cost curve (AC). If they didn't new firms would enter the market with lower AC and could charge a lower price
Allocative efficiency occurs as firms:
- Only make normal profits (AR or P = AC)
- Operate at the lowest cost output (MC = AC)
- Thus, P = MC the criterion for allocative efficiency
Dynamic efficiency
- Dynamic efficiency might occur as firms innovate production processes in order to lower AC. This is made easier as firms have greater access to industry wide technology
