3.6 Oligopoly

Cartel

A collusive agreement by firms, usually to fix prices. Sometimes there is also an agreement to restrict output and to deter the entry of new firms.

Price agreement

An agreement between a firm, similar firms, suppliers or customers regarding the pricing of a good/service. These usually last for a specified period of time.

Concentration Ratio

Measures the market share (percentage of the total market) of the biggest firms in the market. For example, a five-firm concentration ratio measures the aggregate market share of the largest five firms.

Market Conduct

The price and other market policies pursued by firms. This is also known as market behaviour, but is not to be confused with market performance, which refers to the end results of these policies.

Price leadership

The setting prices in a market, usually by a dominant firm, which is then followed by other firms in the same market. In barometric price leadership one firm acts as a 'barometer' or a benchmark, whose prices other firms follow. Common in imperfectly competitive markets.

Explain oligopoly, collusive oligopoly and cartels, include a diagram

[Figure 3.18] A competitive oligopoly is known as a non-collusive oligopoly as firms act independently in the sense that they do not form agreements with each other. Uncertainty facing competitive oligopolists can be reduced and perhaps eliminated by the rival firms colluding together eg by forming a cartel agreement or price ring. In the diagram, five firms jointly agree to charge a price to keep firm E, which is the least productively efficient firm, in the market. In a competitive market, E would have to reduce costs or go out of business. Cartel agreements enable inefficient firms to stay in business, while other more efficient members of the price ring enjoy supernormal profit. By protecting inefficient firms and reducing risk of competition, cartels display the disadvantages of monopoly (high prices and restriction of choice). However, this is usually without the benefits that monopoly can sometimes bring, namely economies of scale and improvements in dynamic efficiency.

Discuss joint-profit maximization in collusive oligopoly, and provide a diagram

[Figure 3.19] Joint-profit maximization, shown in the diagram, occurs when a no of firms decide to act as a single monopolist, yet keep their separate identities. Oligopolistic firms undertake joint-profit maximization in the belief that it can lead to higher profits for all the firms taking part. The monopoly MC curve depicted in the right-hand side of the diagram is the sum of the identical MC curves of three firms (one is shown on the left). The three firms share an output of 750 units, determined on the right of the diagram where the industry MR and MC curves intersect. Each firm charges a P of £10, which is the max price consumers a prepared to pay for 750 units of the good. The monopoly output of 750 units is well below 1,000 units, which would be the output if the industry were perfectly competitive. The shaded area in the right-hand panel shows efficiency or welfare loss caused by the cartel raising the price to £10 and restricting output to 750 units. The shaded area on the left shows the supernormal profit made by each firm. However, there is an incentive for a firm to cheat on the agreement. Marginal cost of producing 250th good is only £4, yet for the firm (but not the whole industry) the marginal revenue received from selling one more unit is £10. One member can increase it's profit at the expense of the other firms by secretly selling an output over and above its quota of 250 units at a price below £10, but greater than the marginal cost of £4. Firms' collective interest is to maintain the cartel so as to keep total sales down and the price up. But each firm can benefit by cheating on the agreement, provided all the others do not cheat.

Explain the kinked demand curve model of competitive oligopoly, and use a diagram.

[Figure 3.20] Kinked demand curve theory illustrates how a competitive oligopolist may be affected by a rivals' reaction to its price and output decisions. An oligopolist produces at Q1, selling at P1. To anticipate how sales may change following a price change, firms need to know the position and shape of demand and revenue curves for their products. In imperfectly competitive markets, firms lack, accurate information about these curves, particularly at outputs different from those being produced. Thus the demand curve or AR curve in the diagram is not necessarily correct. Instead, it represents an estimate of how demand changes when the firm changes the price it charges. When incr. price from P1 to P2, oligopolist expects rivals to react by keeping their own prices stable. By holding their prices steady, rivals try to gain profit and market share at the firm's expense. Oligopolist expects demand to be relatively elastic in response to a price increase. Rise in price from P1 to P2 is likely to result in a more than proportionate fall in demand from Q1 to Q2. When cutting price from P1 to P3, rivals are expected to react by following suit immediately w a matching price cut. As market demand curve slopes downward, each firm will benefit from some incr in demand. However, oligopolist fails to gain sales from rivals within the market, so they expect demand to be less elastic, and probably inelastic to a price cut. Fall from P1 to P3 results in a less than proportionate incr in demand from Q1 to Q3. Oligopolist thus expects rivals to react asymmetrically when price is raised or lowered. In diagram, firm's initial price and output of P1 and Q1 intersect at X, or at the kink at the two demand curves of different elasticity, each reflecting a diff assumption of how rivals may react to a change in price. If when price is raised, demand is elastic, and when price is cut, demand is inelastic, any change in price will reduce the oligopolist's total revenue. Best policy in this instance is to keep price static in an oligopoly.

Discuss collusion versus market cooperation

Cartels are unlikely to benefit consumers. For this reason, cartels are usually illegal and judged by governments as being anti-competitive and against the public interest. Nevertheless, some forms of cooperation/collusion may be justifiable and in public interest. Include joint product development, and cooperation to improve health and safety within the industry or to ensure that product and labour standards are sustained. Industry collaboration, or overt collusion, in the full public view are normally deemed to be good, as opposed to price collusion. Price collusion, and other market-rigging agreements is likely to take place in secret, this is covert collusion. Tacit collusion, by contrast, occurs when there is 'an understanding' without any explicit agreement between firms.

Explore interdependence and uncertainty in oligopoly

Competitive oligopoly exists when the rival firms are interdependent in the sense that they must take account of each other's reactions when forming a market strategy, but independent in the sense that they decide their market strategies w/out cooperation or collusion. Consequently, uncertainty is a characteristic of competitive oligopoly; a firm can never be completely certain of how rivals will react to its price, marketing and output strategy.

Explore the market structure and concentration ratios in oligopoly

Concentration ratio can be a good indicator of an oligopolistic market structure. If few, for example five, firms own the majority market share in an industry, then economists would label it an oligopoly market. For example, the top five supermarkets in the UK owned 82.7% market share (2014), and this is therefore an oligopolistic market.

Discuss criticism of the kinked demand curve theory

Few economists accept this theory: - Incomplete theory, since it does not explain how/why a firm chooses in the first place to be at X in Fig 3.20. - Evidence provided by pricing decision of real-world firms gives little support to the theory. Competitive oligopolists seldom respond to price changes in the manner assumed in the curve. More reasonable to expect a firm to test the market. If rivals do not follow suit, then the firm must surely revise the shape of the demand curve. Research determines that oligopoly prices tend to be stable or sticky when demand conditions change in a predictable/cyclical way, but that oligopolists usually raise/lower prices quickly or by large amounts, both when production costs change drastically and when unexpected shifts in demand occur.

Price war

Occurs when rival firms continuously lower prices to undercut each other. Take place in monopolistic competition and in oligopoly. May be stated accidentally or instigated deliberately to damage competitors. Price wars centre on price cutting aimed at the very least on incr market share, and in the extreme forcing rival firms out of business.

Explore market behaviour of oligopolies

Oligopoly is best defined, not only by market structure or number of firms, but also by market conduct. An oligopolistic firm affects its rivals through its price and output decisions, but its own profit can also be affected by how rivals behave and react to the firm's decisions. Suppose, for example, the firm reduces its prices in order to increase market share and boost profits. Whether the price reduction increases or reduces the firm's profits depends on the reactions of other firms.