Download Monopolistic Competition

SECTION 1.5D THEORY OF THE FIRM
AND MARKET STRUCTURES (HL ONLY)
MONOPOLISTIC COMPETITION,
OLIGOPOLY & PRICE DISCRIMINATION
SECTION 1.5 THEORY OF THE FIRM AND
MARKET STRUCTURES
Monopolistic Competition
1. Describe, using examples, the assumed characteristics of a
monopolistic competition: a large number of firms; differentiated products;
absence of barriers to entry and exit.
The four key characteristics of monopolistic competition are:
(1) large number of small firms, (2) similar but not identical
products sold by the firms, (3) relative freedom of entry into
and exit out of the industry, and (4) extensive knowledge of
prices and technology.
These four characteristics mean that a given monopolistically
competitive firm has a little bit of control over its small corner of
the market.
The large number of small firms, all producing nearly identical
products, mean that a large (very, very large) number of close
substitutes exists for the output produced by any given firm.
This makes the demand curve for that firm's output relatively
elastic.
2. Explain that product differentiation leads to a small degree of
monopoly power and therefore to a negatively sloping demand curve for
the product.
Each firm in a monopolistically competitive market
sells a similar product. Yet each product is slightly
different from the others. The term used to describe this
is product differentiation.
Product differentiation is responsible for giving each
monopolistically competitive a little bit of a monopoly,
and hence a negatively-sloped demand curve.
Differences among products generally fall into one
of three categories: (1) physical difference,
(2) perceived difference, and
(3) difference in support services.
3. Explain, using a diagram, the short-run equilibrium output and pricing
decisions of a profit maximizing (loss minimizing) firm in monopolistic
competition, identifying the firm’s economic profit (or loss).
A monopolistically competitive firm guided by the
pursuit of profit is inclined to produce the quantity of
output that equates marginal revenue and marginal
cost in the short run, even if it is incurring an economic
loss.
The key to this loss minimization production decision is a
comparison of the loss incurred from producing with the
loss incurred from not producing.
If price exceeds average variable cost, then the firm
incurs a smaller loss by producing than by not
producing.
3. Explain, using a diagram, the short-run equilibrium output and pricing
decisions of a profit maximizing (loss minimizing) firm in monopolistic
competition, identifying the firm’s economic profit (or loss).
With profit maximization, price exceeds average total
cost at the quantity that equates marginal revenue and
marginal cost. In this case, the firm generates an
economic profit.
With shutdown, price is less than average variable cost
at the quantity that equates marginal revenue and
marginal cost. In this case, the firm incurs a smaller loss by
producing no output and incurring a loss equal to total
fixed cost.
Price
Result
P > ATC
Stay Open W/ Economic Profit
P = ATC
Stay Open W/ Normal Profit
AVC < P < ATC
Stay Open W/ Loss
P < AVC
Shut Down
3. Explain, using a diagram, the short-run equilibrium output and pricing
decisions of a profit maximizing (loss minimizing) firm in monopolistic
competition, identifying the firm’s economic profit (or loss).
4. Explain, using diagrams, why in the long run a firm
in monopolistic competition will make normal profits.
A monopolistically competitive industry adjusts to
long-run equilibrium through the entry and exit of
firms into and out of the industry.
Because a monopolistically competitive firm has
market control and faces a negatively-sloped demand
curve, this adjustment generates equilibrium on the
negatively-sloped segment of the average cost curve.
This equilibrium is in the economies of scale range of
production that falls short of the minimum efficient
scale.
4. Explain, using diagrams, why in the long run a firm in
monopolistic competition will make normal profits.
Because there is freedom to entry
and exit:
Due to this , when firms make
abnormal profits in the short run, it
will attract more firms in the
industry, (In the long run) each frim
will have less customers, prices will
come down and will be forced to a
long run normal profit.
Similarly, if firms are making losses,
they will exit the industry, this will
lead to fall in supply of firms,
leading to rise in prices, leading to
normal profit for firms.
5. Distinguish between price competition
and non-price competition.
Non-price competition is where "one firm tries to
distinguish its product or service from competing
products on the basis of attributes like design and
workmanship"
Non-price competition typically involves:
 Promotional expenditures such as advertising, selling
staff, the locations convenience, sales promotions,
coupons, special orders, or free gifts
 Marketing research,
 New product development,
 Brand management costs.
5. Distinguish between price competition
and non-price competition.
Pricing decisions are often made according to price or nonprice competitive situations.
Price Competition
 With price competition, a marketer emphasizes price as an
issue and matches or beats the prices of competitors.
 1.
A major advantage of price competition is its
flexibility: Prices can be adjusted to compensate for an
increase in the firm’s operating costs, to offset changes in
demand, or to counteract a competitor’s pricing strategy.
 2.
A disadvantage of price competition is that
competitors usually have price flexibility too and can
quickly respond by lowering their prices—potentially
sparking a price war. Chronic price wars can reduce profits
and weaken an organization.
5. Distinguish between price competition and
non-price competition.
Non-price Competition

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
Non-price competition occurs when a seller decides not to focus on price and
instead emphasizes distinctive product features, service, product quality,
promotion, packaging, or other factors to distinguish its product from
competing brands.
1.
A major advantage of non-price competition is that a firm can build
customer loyalty toward its brand. If customers prefer a brand because of
non-price factors, it is more difficult for competitors to lure these customers
away.
2.
For non-price competition to work, a company must be able to
distinguish its brand through unique product features, higher product quality,
promotion, packaging, or excellent customer service.
3.
Buyers must view the non-price product features as important, and
the features must be difficult for competitors to imitate.
4.
Even when competing on a non-price basis, marketers must remain
aware of competitors’ prices and be prepared to price its brand near or
slightly above that of competing brands.
5. Distinguish between price competition
and non-price competition.
Price competition, which is where a company tries to
distinguish its product or service from competing products
on the basis of low price.
Firms will engage in non-price competition, in spite of the
additional costs involved, because it is usually more
profitable than selling for a lower price, and avoids the
risk of a price war.
Although any company can use a non-price competition
strategy, it is most common among oligopolies and
monopolistic competition, because firms can be
extremely competitive.
6. Describe examples of non-price competition, including
advertising, packaging, product development and quality of
service.
Consider the example of the supermarket sector where
non-price competition has become important in the battle
for sales:
 Traditional advertising / marketing
 Store Loyalty cards
 Banking and other Services (including travel insurance)
 In-store pharmacist and post offices
 Home delivery systems
 Discounted petrol at hypermarkets
 Extension of opening hours (24 hour shopping)
 Innovative use of technology for shoppers including selfscanning and internet shopping services
7. Explain, using a diagram, why neither allocative efficiency nor
productive efficiency are achieved by monopolistically competitive firms.
A monopolistically competitive firm generally
produces less output and charges a higher price than
would be the case for a perfectly competitive firm.
In particular, the price charged by a monopolistically
competitive firm is higher than the marginal cost of
production, which violates the efficiency condition that
price equals marginal cost.
A monopolistically competitive firm is inefficient
because it has market control and faces a negativelysloped demand curve.
7. Explain, using a diagram, why neither allocative efficiency nor
productive efficiency are achieved by monopolistically competitive firms.
In the Short Run a monopolistically
competitive firm will neither
achieve allocative efficiency nor
productive efficiency.
As the diagram show, productive
efficiency is at q1 and allocative
efficiency level of output is q2.
However, in a monopolistically
competitive market, a firm is
producing at profit maximizing level
q does not achieve any of the
efficiency.
7. Explain, using a diagram, why neither allocative efficiency nor productive
efficiency are achieved by monopolistically competitive firms.
EXCESS CAPACITY: A condition that exists when monopolistic
competition achieves long-run equilibrium such that production
by each firm is less than minimum efficient scale. The
implication of this condition is that each firm is not producing up
to its fullest capacity, as would be the case under perfect
competition, and thus more firms are need to produce total
market output compared to perfect competition.
Excess capacity results because market control means a
monopolistically competitive firm faces a negatively-sloped
demand curve.
Long-run equilibrium is thus achieved by the tangency of the
negatively-sloped demand curve and the long-run average cost
curve, which results in economies to scale.
7. Explain, using a diagram, why neither allocative efficiency nor productive
efficiency are achieved by monopolistically competitive firms.
Excess capacity is a result
of a imperfect firm with
market power who does
not produce at
productivity efficiency.
Excess capacity is when MC is less than
ATC in production.
8. Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run, market
power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and
exit, size of firms and product differentiation.
Perfect Competition
Monopolistic competition
Infinite
Many
None
Low
Perfectly elastic
Highly elastic (long run)
None
High
Yes short run, No long run
Yes short run, No long run
Productive Efficiency
Yes
No
Allocative Efficiency
Yes
No
Profit maximization
condition
Pricing power
P=MR=MC
P>MR=MC
Price taker
Price Maker
Number of firms
Market power
Elasticity of demand
Product differentiation
Economic profits
8. Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run, market
power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and
exit, size of firms and product differentiation.
In the long run, firms in both perfectly competitive markets and
monopolistically competitive markets earn only normal profits.
The perfectly competitive firm is both allocative efficient (because
price = MC) and productively efficient (because the equilibrium
output occurs at a level where MC = AC; the bottom of the AC
curve).
The monopolistically competitive firm is neither allocative
efficient (this occurs at output level Q3) nor productively efficient
(which occurs at output level Q4).
The firm's level of production is too low to be efficient in either
sense. There are too many firms producing too little output.
However, the cost to society of this inefficiency is probably made
up for by the increased choice and variety due to the
differentiated products.
8. Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run, market
power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and
exit, size of firms and product differentiation.
8. Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run, market
power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and
exit, size of firms and product differentiation.
Monopoly
Monopolistic competition
Number of firms
One
Many
Market power
High
Low
Inelastic
Highly elastic (long run)
Some
High
Yes short run, Yes long run
Yes short run, No long run
Productive Efficiency
No
No
Allocative Efficiency
No
No
Profit maximization
condition
Pricing power
P>MR=MC
P>MR=MC
Price Maker
Price Maker
Elasticity of demand
Product differentiation
Economic profits
8. Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run, market
power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and
exit, size of firms and product differentiation.
Monopolistic competition VS Monopoly
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Monopolists can earn long-run profits because they have barriers to
entry. The monopolistic competitor will see profits competed away by
new entrants.
Neither industry is efficient. Their down sloping demand curve restricts
output and price goods higher than in perfect competition, lowering
efficiency on both allocative and productive grounds.
The monopolist faces no real competition. Monopolistic competitor do,
and so have an incentive to keep costs down and to differentiate.
Cost-savings of economies of scale are far more likely under
monopoly, whereas the monopolistic competitor in unlikely to grow large
enough to see these benefits.
Meanwhile, the monopoly will have greater capacity to innovate through
research and development investment.
8. Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run, market
power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and
exit, size of firms and product differentiation.
Welfare of M/C Firm
Oligopoly
9. Describe, using examples, the assumed characteristics of an oligopoly: the
dominance of the industry by a small number of firms; the importance of
interdependence; differentiated or homogeneous products; high barriers to entry.
The main characteristics of an oligopoly include:
 Few firms dominate an industry.
 Large proportion of industry's output is shared by a
few firms.
 High barriers to entry may be due to economics of
scale, legal barriers, aggressive tactics such as
advertising or high startup costs
 Products may be identical or differentiated.
 Firms are interdependent and take careful notice of
each other's actions.
9. Describe, using examples, the assumed characteristics of an oligopoly: the
dominance of the industry by a small number of firms; the importance of
interdependence; differentiated or homogeneous products; high barriers to entry.
Barriers to entry
Oligopolies and monopolies frequently maintain their position of dominance in a market might
because it is too costly or difficult for potential rivals to enter the market. These hurdles are called
barriers to entry and the incumbent can erect them deliberately, or they can exploit natural barriers
that exist.
Natural entry barriers include:

Economies of large scale production.

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Ownership or control of a key scarce resource.

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Owning scarce resources that other firms would like to use creates a considerable barrier to entry, such as
an airline controlling access to an airport.
High set-up costs.
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If a market has significant economies of scale that have already been exploited by the incumbents, new
entrants are deterred.
High set-up costs deter initial market entry, because they increase break-even output, and delay the
possibility of making profits. Many of these costs are sunk costs, which are costs that cannot be recovered
when a firm leaves a market, and include marketing and advertising costs and other fixed costs.
High R&D costs
Spending money on Research and Development (R & D) is often a signal to potential entrants that
the firm has large financial reserves. In order to compete, new entrants will have to match, or
exceed, this level of spending in order to compete in the future. This deters entry, and is widely
found in oligopolistic markets such as pharmaceuticals and the chemical industry.
9. Describe, using examples, the assumed characteristics of an oligopoly: the
dominance of the industry by a small number of firms; the importance of
interdependence; differentiated or homogeneous products; high barriers to entry.
Artificial barriers include:

Predatory pricing.
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Limit pricing.
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Schemes such as Tesco’s Club Card, help oligopolists retain customer loyalty and deter entrants who need to gain market share.
Exclusive contracts, patents and licenses

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A strong brand creates loyalty, ‘locks in’ existing customers, and deters entry.
Loyalty schemes
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Advertising is another sunk cost - the more that is spent by incumbent firms the greater the deterrent to new entrants.
A strong brand

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Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete buy-out. As
with other deliberate barriers, regulators, like the Competition Commission, may prevent this because it is likely to reduce competition.
Advertising
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An incumbent may, over time, have built up a superior level of knowledge of the market, its customers, and its production costs. This superior
knowledge can deter entrants into the market.
Predatory acquisition


Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants cannot make a profit at that price. This is best achieved by
selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make.
Superior knowledge


Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals out of the market.
These make entry difficult as they favor existing firms who have won the contracts or own the licenses. For example, contracts between suppliers and
retailers can exclude other retailers from entering the market.
Vertical integration

Vertical integration can ‘tie up’ the supply chain and make life tough for potential entrants, such as an electronics manufacturer like Sony having its
own retail outlets (Sony Centers), and a brewer like Heineken owning its own chain of UK pubs.
10. Explain why interdependence is responsible for the dilemma faced by
oligopolistic firms—whether to compete or to collude.
Strategy is extremely important to firms that are interdependent.
Because firms cannot act independently, they must anticipate the likely
response of a rival to any given change in their price, or their non-price
activity. In other words, they need to plan, and work out a range of
possible options based on how they think rivals might react.
Oligopolists have to make critical strategic decisions, such as:
 Whether to compete with rivals, or collude with them.
 Whether to raise or lower price, or keep price constant.
 Whether to be the first firm to implement a new strategy, or whether
to wait and see what rivals do. The advantages of ‘going first’ or
‘going second’ are respectively called 1st and 2nd-mover advantage.
Sometimes it pays to go first because a firm can generate head-start
profits. 2nd mover advantage occurs when it pays to wait and see
what new strategies are launched by rivals, and then try to improve on
them or find ways to undermine them.
11. Explain how a concentration ratio may be
used to identify an oligopoly.
CONCENTRATION RATIOS:
A measures of the proportion of total output in an industry that is produced
by a given number of the largest firms in the industry. The four-firm
concentration ratio is the proportion of total output produced by the four
largest firms in the industry. Concentration ratios are commonly used to indicate
the degree to which an industry is oligopolistic and the extent of market control
of the largest firms in the industry.
A related measure is the Herfindahl index. Concentration ratios are calculated
based on the market shares of the largest firms in the industry. A four-firm
concentration ratio over 90 (that is, 90 percent of industry output is produced by
the four largest firms) is a good indication of oligopoly and that these four firms
have significant market control.
Alternatively a four-firm concentration ratio of 0.001 (that is, the four largest
firms are responsible for one-thousandth of one percent of industry output) is
good indication that the industry is monopolistically competitive and that the
four largest firms have very little market control. However, because there is a fine
line between oligopoly and monopolistic competition blend into, there is no
distinct concentration ratio that can be used to separate one market structure
from the other.
11. Explain how a concentration ratio may be
used to identify an oligopoly.



Low Concentration: A concentration ratio of 0 to 50
percent is commonly interpreted as an industry with low
concentration. Monopolistic competition falls into the
bottom of this with oligopoly emerging near the upper
end.
Medium Concentration: A concentration ratio of 50 to
80 percent is considered an industry with medium
concentration. These industries are very much
oligopoly.
High Concentration: An industry with a concentration
ratio of 80 to 100 percent is viewed as high
concentration. Government regulators are usually most
concerned with industries falling into this category.
(Monopoly)
12. Explain how game theory (the simple prisoner’s dilemma) can
illustrate strategic interdependence and the options available to
oligopolies.
GAME THEORY:
An analysis that illustrates how the choices between two players affect the
outcomes of a "game."
Game theory is commonly used to explain the behavior and decision making of
oligopolistic firms. It illustrates that cooperation, rather competition, between two
"players" can lead to an outcome that is more beneficial to both players.
The moves and counter moves among oligopoly firms can be analyzed with game
theory, developed by John Nash, a Nobel Prize winning economist and
mathematician.
The standard game theory analysis is based on alternative outcomes that arise given
a choice that each of two players face. The key is that the choice made by each
player affects the outcome of both players.
Game theory illustrates the key problem of interdependent decision-making
found in oligopoly. Competition among the few can lead to inefficiency and
competitive actions that waste resources without generating corresponding benefits.
12. Explain how game theory (the simple prisoner’s dilemma) can
illustrate strategic interdependence and the options available to
oligopolies.
The Prisoner’s Dilemma
The Prisoner's Dilemma is a simple game which illustrates the choices facing oligopolies. As
you read the scenarios, you can play the part of one of the prisoners.
The scenario:
 Robin and Tom are prisoners:
 They have been arrested for a petty crime, of which there is good evidence of their
guilt – if found guilty they will receive a 2 year sentence.
 During the interview the police officer becomes suspicious that the two prisoners are
also guilty of a serious crime, but is not sure he has any evidence.
 Robin and Tom are placed in separate rooms and cannot communicate with each other.
The police officer tries to get them to confess to the serious crime by offering them
some options, with possible pay-offs.
The options:
 Each is told that if they both confess to the serious crime they will receive a sentence of
3 years. However, each is also told that if he confesses and his partner does not, then
he will get a light sentence of 1 year, and his partner will get 10 years. They know that
if they both deny the serious offence they are certain to be found guilty of the lesser
offence, and will get a 2 year sentence.
12. Explain how game theory (the simple prisoner’s dilemma) can
illustrate strategic interdependence and the options available to
oligopolies.
The dilemma is that their own 'payoff' is wholly dependent on the
behavior of the other prisoner.
To avoid the worse-case scenario (10
years), the safest option is to confess
and get 3 years.
If collusion is possible they can both
agree to deny (and get 2 years), but
there is a very strong incentive to cheat
because, if one denies and the other
confesses, the best outcome of all is
possible - that is 1 year.
Fearing that the other may cheat, the
safest option is to confess.
12. Explain how game theory (the simple prisoner’s dilemma) can
illustrate strategic interdependence and the options available to
oligopolies.
Types of strategy:
 Dominant strategy
A dominant strategy is the best outcome irrespective of what
the other player chooses, in this case it is for each player to
confess.
 (Non-dominate strategy)
 Nash equilibrium Nash equilibrium, named after Nobel
winning economist, John Nash, is a solution to a game
involving two or more players who want the best outcome
for themselves and must take the actions of others into
account.
John Nash
Nash equilibrium is just such an
idea, and was a fundamental
contribution to the nascent
mathematical theory of noncooperative games - situations
where one player's fortunes
depend on the actions of others,
and everybody tries to do as well
for themselves as possible.
Nash's definition of equilibrium was
definitely loose enough:
"A configuration of strategies,
such that no player acting on his
own can change his strategy to
achieve a better outcome for
himself."
12. Explain how game theory (the simple prisoner’s dilemma) can
illustrate strategic interdependence and the options available to
oligopolies.
Implications
Game Theory provides many insights into the behavior of oligopolists.
For example, it indicates that generating rules for behavior may take
some of the risks out of competition, such as:
 Employing a simple cost-plus pricing method which is shared by
all participants. This would work well in situations where oligopolists
share similar or identical costs, such as with petrol retailing.
 Implicitly agreeing a 'price leader' with other firms as followers.
In the Airline example, firm A may lead and raise price, with B
passively following suit. In this case, both would generate revenues
of £120.
 Supermarkets implicitly agreeing some lines where price cutting will
take place, such as bread or baked beans, but keeping price
constant for most lines.
 Generally keeping prices stable (sticky) to avoid price retaliation.
12. Explain how game theory (the simple prisoner’s dilemma) can
illustrate strategic interdependence and the options available to
oligopolies.
Coke
Pepsi
Advertise
Don’t Advertise
Advertise
$110,
$75,
Don’t Advertise
$160
$150
$75,
$100,
$125
$125
12. Explain how game theory (the simple prisoner’s dilemma) can illustrate
strategic interdependence and the options available to oligopolies.
How to win at rock-paper-scissors
13. Explain the term “collusion”, give examples, and
state that it is usually (in most countries) illegal.
COLLUSION:
A usually secret agreement among competing firms in an
industry (primarily oligopoly) to dominate the market,
control the market price, and otherwise act like a
monopoly. The reason for the secrecy is that such behavior
is illegal in the United States under antitrust laws.
Collusion can take one of two forms. Explicit collusion
occurs when two or more firms in the same industry formally
agree to control the market. Implicit collusion occurs when
two or more firms in the same industry control the market
through informal, interdependent actions.
Collusion is one of two ways oligopoly firms cooperate
to avoid competition. The other is through mergers.
13. Explain the term “collusion”, give examples, and
state that it is usually (in most countries) illegal.
Whether explicit or implicit, collusion is often difficult to
detect. Firms that engage in explicit collusion are
usually shrewd enough to avoid documenting this illegal
activity. These firms seldom leave a paper trail that
could provide evidence for government prosecution.
With no formal agreement, implicit collusion is even
more difficult because. In fact, implicit collusion is just
a notch away from normal, interdependent oligopolistic
behavior. The firms might be colluding or they might be
competing.
13. Explain the term “collusion”, give examples, and
state that it is usually (in most countries) illegal.
Collusive oligopolies
If colluding, participants act like a monopoly and can enjoy the benefits of higher profits
over the long term.
Types of collusion:
 Overt
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
Covert
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
Overt collusion occurs when there is no attempt to hide agreements, such as the when firms
form trade associations like the Association of Petrol Retailers.
Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid
detection by regulators, such as when fixing prices.
Tacit

Tacit collusion arises when firms act together, called acting in concert, but where there is no
formal or even informal agreement. For example, it may be accepted that a particular firm is
the price leader in an industry, and other firms simply follow the lead of this firm. All firms
may ‘understand’ this, but no agreement or record exists to prove it. If firms do collude, and
their behavior can be proven to result in reduced competition, they are likely to be subject to
regulation. In many cases, tacit collusion is difficult or impossible to prove, though regulators
are becoming increasingly sophisticated in developing new methods of detection.
14. Explain the term “cartel”.
CARTEL:
A formal agreement between businesses in the same
industry, usually on an international scale, to gain
market control, raise the market price, and otherwise
act like a monopoly. The most famous international
cartel is the Organization of Petroleum Exporting
Countries (OPEC), which seeks to exert control over the
world oil market.
Other cartels have existed, or still exist, in the global
markets for uranium, diamonds, long distance telephone
services, and airlines.
14. Explain the term “cartel”.
Game theory also predicts that:
 There is a tendency for cartels to form because co-operation is likely
to be highly rewarding. Co-operation reduces the uncertainty
associated with the mutual interdependence of rivals in an oligopolistic
market. While cartels are ‘unlawful’ in most countries, they may still
operate, with members concealing their unlawful behavior.
 Cartels are designed to protect the interests of members, and the
interests of consumers may suffer because of:
 Higher prices or hidden prices, such as the hidden charges in credit
card transactions
 Lower output
 Restricted choice or other limiting conditions associated with the
transaction
 A classic game called the Prisoner's Dilemma is often used to
demonstrate the interdependence of oligopolists.
15. Explain that the primary goal of a cartel is to limit competition between
member firms and to maximize joint profits as if the firms were collectively
a monopoly.
Cartel
One of the most noted examples of explicit collusion is a cartel.
While the term cartel can be used to mean any type of explicit
collusion, it is often reserved for international agreements, such
as the Organization of Petroleum Exporting Countries (better
know as OPEC).
Acting Like Monopoly
In general, collusion among oligopolistic firms means that
two or more firms decide to act like a monopoly. Rather than
maximizing profit for each individual firm, the firms maximize
total industry profit just as if a monopoly controlled the industry.
Motivation behind collusion is relatively straightforward. Total
profit is greater when firms collude than when they compete.
Cooperating firms can agree to charge a higher price and
produce less output--just like a monopoly.
15. Explain that the primary goal of a cartel is to limit competition between
member firms and to maximize joint profits as if the firms were collectively
a monopoly.
A side benefit for the colluding firms is that noncolluding firms can be driven from the market.
For example, the top two soft drink firms that control a
sizeable share of the hypothetical Shady Valley soft drink
market might decide to do a little colluding.
While their ultimate goal is to raise the price, they might
first agree to lower the price. By so doing, they can force
other smaller firms out of the market.
Once these other firms have left, then their market control
increases, making their collusion more effective.
They can then raise the price and more effectively act like a
monopoly, without concern that the smaller firms will
undercut their collusion price.
16. Explain the incentive of cartel members to
cheat.
A Little Cheating
A major problem with collusion, whether explicit, implicit, or a
highly-structured cartel, is the incentive for each firm to cheat on
the agreement.
Collusion works only if all firms in the industry maintain the
same price. And this is often accomplished by restricting the
quantity supplied by each firm. If all firms keep prices high, then all
firms enjoy higher profits.
However, if one firm reduces its price and produces more AS LONG
AS THE OTHER FIRMS KEEP PRICES HIGH AND REDUCE
OUTPUT, then it can boost its market share and profit.
Each firm has this same incentive to cheat. And if one cheats, then
others have less incentive to continue with the collusive arrangement
and more incentive to cheat. Collusive arrangements, as such,
tend to break down.
17. Analyze the conditions that make cartel
structures difficult to maintain.
Competition and Cooperation
Collusive behavior and the tendency to cheat on a
collusive agreement illustrate the constant tug-and-pull
between competition and cooperation in oligopoly.
Because firms grow weary of competition and see the
benefits of cooperation they tend to pursue collusion.
However, the competitive forces never leave, inducing firms
to cheat on any collusive agreement.
Then, if collusion falls apart, and competition dominates the
market, the pressure to collude anew is always present.
Even without government antitrust action, the "natural"
course of events for an oligopolistic industry is to ebb
and flow between competition and collusion.
17. Analyze the conditions that make cartel
structures difficult to maintain.
Most cartel arrangements experience difficulties and tensions and some cartels collapse completely.
Several factors can create problems within a collusive agreement between suppliers:

Enforcement problems: The cartel aims to restrict production to maximize total profits of members.
But each individual seller finds it profitable to expand production. It may become difficult for the
cartel to enforce its output quotas and there may be disputes about how to share out the profits.
Other firms – not members of the cartel – may opt to take a free ride by producing close to but
just under the cartel price.

Falling market demand creates excess capacity in the industry and puts pressure on individual
firms to discount prices to maintain their revenue. There are good recent examples of this in
commodity markets including the collapse of the coffee export cartel.

The successful entry of non-cartel firms into the industry undermines a cartel’s control of the
market – e.g. the emergence of online retailers in the book industry in the mid 1990s led ultimately
to the end of the Net Book Agreement in 1995. Rapid technological change can often undermine a
cartel e.g. a new entrant with an innovative and success alternative business model.

The exposure of illegal price-fixing by market regulators such as UK Office of Fair Trading and
the European Competition Commission. The Office of Fair Trading can fine a company up to 10 per
cent of its global turnover in a particular sector if it is found to be part of a cartel.

The exposure of price-fixing by whistle-blowing firms – these are firms previously engaged in a
cartel that decides to withdraw from it and pass on information to the competition authorities.
Twenty-five whistleblowers exchanged information for reduced fines or immunity from prosecution
by the Office of Fair Trading in 2010
18. Describe the term “tacit collusion”, including
reference to price leadership by a dominant firm.
Price leadership refers to a situation where prices and price changes established
by a dominant firm, or a firm are usually accepted by others and which other
firms in the industry adopt and follow.
When price leadership is adopted to facilitate tacit (or silent) collusion, the
price leader will generally tend to set a price high enough that the least costefficient firm in the market may earn some return above the competitive level.
We see examples of this with the major mortgage lenders and petrol retailers
where many suppliers follow the pricing strategies of leading firms. If most firms
in a market are moving prices in the same direction, it can take some time for
relative price differences to emerge which might cause consumers to switch their
demand.
Firms who market to consumers that they are “never knowingly undersold” or
who claim to be monitoring and matching the cheapest price in a given
geographical area are essentially engaged in tacit collusion.
Tacit collusion occurs where firms undertake actions that are likely to
minimize a competitive response, e.g. avoiding price cutting or not attacking
each other’s market
19. Explain that the behavior of firms in a non-collusive oligopoly is
strategic in order to take account of possible actions by rivals.
Competitive oligopolies

When competing, oligopolists prefer non-price competition in order to avoid price wars. A price
reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but
the danger is that rivals will simply reduce their prices in response.

This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more
beneficial strategy may be to undertake non-price competition.
Pricing strategies of oligopolies
Oligopolies may pursue the following pricing strategies:

Oligopolists may use predatory pricing to force rivals out of the market. This means keeping
price artificially low, and often below the full cost of production.

They may also operate a limit-pricing strategy to deter entrants, which is also called entry
forestalling price.

Oligopolists may collude with rivals and raise price together, but this may attract new entrants.

Cost-plus pricing is a straightforward pricing method, where a firm sets a price by calculating
average production costs and then adding a fixed mark-up to achieve a desired profit level.
Cost-plus pricing is also called rule of thumb pricing.

There are different versions of cost-pus pricing, including full cost pricing, where all costs - that is,
fixed and variable costs - are calculated, plus a mark up for profits, and contribution pricing,
where only variable costs are calculated with precision and the mark-up is a contribution to both
fixed costs and profits.
20. Explain, using a diagram, the existence of price
rigidities, with reference to the kinked demand curve.
The Kinked Demand curve gives an
explanation to underlying reason
why an oligopolistic market
experiences price rigidity.
Lets assume that a firm is selling at
price P.
The firm as three options:
(1) If the firm increase the Price: If
the firm increase the price above its
present price P, it is more likely that
other firms will not increase their
prices. The firm will end up losing
customer to other firms. The firm will
lose relatively large demand as
compared to the price increase. Thus,
a firm will face a relatively elastic
demand curve above the point 'a'.
20. Explain, using a diagram, the existence of price
rigidities, with reference to the kinked demand curve.
(2) If the firm lowers the Price: If the
firm lowers the price, it will start a price
war and other firms will lower their
prices too. It is more likely that the
competitors will set their prices even
lower than the firm. The firm will not
see much increase in its demand even
with a relatively high price cut. Thus, the
firm will face less elastic demand below
the point 'a'.
(3) It should therefore not change the
price and should continue to sell at
price 'P'.
If we combine both the demand curves
we will get a demand curve kinked at
point 'a'.
The MR curve will be twice as steeply
sloping.
20. Explain, using a diagram, the existence of price
rigidities, with reference to the kinked demand curve.
Kinked demand curve explains the price inflexibility
of oligopolistic firms that do not collude.
If the firm lowers its prices the competitors will lower
their prices even further and the firm will lose demand
and if the firm increase its price, the competitors will not
follow by increasing their prices and thus the firm will
again lose demand. Therefore, the best strategy is to
stick to the existing price level.
In order to avoid a price war firms will compete on
other factors rather than price. This is known as nonprice competition.
20. Explain, using a diagram, the existence of price
rigidities, with reference to the kinked demand curve.
Price stickiness
Even when there is a large rise in marginal cost,
price tends to stick close to its original, given the
high price elasticity of demand for any price rise.
At price P, and output Q, revenue will be
maximized.
If marginal revenue and marginal costs are
added it is possible to show that profits will also
be maximized at price P.
Profits will always be maximized when MC = MR,
and so long as MC cuts MR in its vertical portion,
then profit maximization is still at P.
Furthermore, if MC changes in the vertical portion
of the MR curve, price still sticks at P.
Even when MC moves out of the vertical portion,
the effect on price is minimal, and consumers will
not gain the benefit of any cost reduction.
21. Explain why non-price competition is common in
oligopolistic markets, with reference to the risk of price wars.
Non-price competition is a marketing strategy "in which one firm tries to
distinguish its product or service from competing products on the basis
of attributes like design and workmanship".
The firm can also distinguish its product offering through quality of
service, extensive distribution, customer focus, or any sustainable
competitive advantage other than price.
It can be contrasted with price competition, which is where a company
tries to distinguish its product or service from competing products on the
basis of low price.
Firms will engage in non-price competition, in spite of the additional
costs involved, because it is usually more profitable than selling for a
lower price, and avoids the risk of a price war.
Although any company can use a non-price competition strategy, it is
most common among oligopolies and monopolistic competition, because
firms can be extremely competitive.
21. Explain why non-price competition is common in
oligopolistic markets, with reference to the risk of price wars.
Price war is "commercial competition characterized by the
repeated cutting of prices below those of competitors". One
competitor will lower its price, then others will lower their prices to
match. If one of them reduces their price again, a new round of
reductions starts. In the short term, price wars are good for buyers,
who can take advantage of lower prices. Often they are not good
for the companies involved because the lower prices reduce profit
margins and can threaten their survival.
In the medium to long term, price wars can be good for the
dominant firms in the industry. Typically, the smaller, more marginal,
firms cannot compete and must close. The remaining firms absorb
the market share of those that have closed. The real losers then,
are the marginal firms and their investors. In the long term, the
consumer may lose too. With fewer firms in the industry, prices tend
to increase, sometimes higher than before the price war started.
22. Describe, using examples, types of non-price
competition.
Non-price competition typically involves promotional
expenditures (such as advertising, selling staff, the
locations convenience, sales promotions, coupons, special
orders, or free gifts), marketing research, new product
development, and brand management costs.
22. Describe, using examples, types of non-price
competition.
Advantages & Disadvantages of Non-price Competition
Quality
If consumers must choose between two products of the same price but they can see that one
is of a higher quality, they generally pick the product of higher quality. In this way, if a firm
can figure out how to produce an item at a cost comparable to what its competitor charges
but make it of higher quality, that firm may be able to steal the market from its competitor.
However, a problem with this approach is that it may take some time for consumers to
realize any difference in quality.
Perception and Branding
In some cases, little possibility of quality differentiation exists between two products. For
instance, in the United States, blue jeans have little actual quality variability from one
producer to another. For this reason, a number of producers compete by manufacturing a
perception of high quality with their brands. This allows some companies to charge higher
prices for seemingly identical products because consumers see value in the brand itself.
However, the long-term sustainability of such an approach may be difficult because, as such
brand advantages arise through consumer trends, consumer trends may also lead to their
demise. For instance, if consumers no longer see a clothing brand as fashionable, the
manufacturer may not be able to continue charging high prices for its products.
22. Describe, using examples, types of non-price
competition.
Product Design
In some cases, firms may compete by changing the design of their products to make them more
appealing without significantly changing production costs or quality levels. Such a strategy can prove
effective at stealing business from competitors, but it can also backfire, because it can cause the
company to alienate its existing consumers, who may be knowingly choosing the existing design over
other products with different designs specifically because it appeals to their tastes.
Product Differentiation
Not all consumers are the same. Markets consist of men and women from diverse age, ethnic and
economic groups. Such groups tend to gravitate toward particular products as a bloc. For this reason,
firms should not expect a single product to appeal to every consumer in a market. By offering a range
of similar products geared toward different market sectors, firms can expand their market base.
However, such product differentiation can result in significantly higher overhead costs for production.
Sales Structure
When two firms are competing with similar products, one may be able to enjoy more market share and
a deeper level of penetration due to a more effective and aggressive sales structure. By engaging in
direct sales, firms can appeal to prospective buyers who otherwise would not feel compelled to buy
due to advertising or other kinds of marketing. Multilevel marketing is one way in which firms rapidly
build their consumer base. However, by turning buyers into sellers as well, such schemes may require
significantly higher prices.
Contestable Markets
A contestable market occurs when
there is freedom of entry and exit
into the market. Thus in a
contestable market, there will be
low sunk costs.(Costs which can’t be
recovered when leaving the market)
The contestable market theory
assumes that even in a monopoly or
oligopoly, the existing companies
will behave competitively when
there is a lack of barriers, such as
government regulation and high
entry costs, to prevent new
companies from entering the market.
Price discrimination
23. Describe price discrimination as the practice of charging different
prices to different consumer groups for the same product, where the price
difference is not justified by differences in cost.
Price discrimination or price differentiation exists when
sales of identical goods or services are transacted at
different prices from the same provider.
Price discrimination can only be a feature of monopolistic
and oligopolistic markets, where market power can be
exercised. Otherwise, the moment the seller tries to sell the
same good at different prices, the buyer at the lower price
can arbitrage by selling to the consumer buying at the
higher price but with a tiny discount.
As long as a firm faces a downward-sloping demand curve
and thus has some degree of monopoly power, it may be
able to engage in price discrimination.
24. Explain that price discrimination may only take place if all of the following conditions exist: the firm
must possess some degree of market power; there must be groups of consumers with differing price
elasticity’s of demand for the product; the firm must be able to separate groups to ensure that no resale of
the product occurs.
Conditions necessary for Price Discrimination
• The firm must have some degree of monopoly
power—it must be a price setter.
• The market must be capable of being fairly easily
segmented—separated so that customers with different
elasticity's of demand can be identified and treated
differently.
• The various market segments must be isolated in
some way from one another to prevent customers who
are offered a lower price from selling to customers who
are charged a higher price.
24. Explain that price discrimination may only take place if all of the following conditions exist: the firm
must possess some degree of market power; there must be groups of consumers with differing price
elasticity’s of demand for the product; the firm must be able to separate groups to ensure that no resale of
the product occurs.
To be a successful price discriminator a seller must satisfy three things:
Market Control: First and foremost, a seller must be able to control the price. Monopoly is
quite adept at price discrimination because it is a price maker, it can set the price of the
good. Oligopoly and monopolistic competition can undertake price discrimination to the
extent that they are able to control the price. Perfect competition, with no market control,
does not do well in the price discrimination arena.
Different Buyers: The second condition is that a seller must be able to identify different
groups of buyers, and each group must have a different price elasticity of demand. The
different price elasticity means that buyers are willing and able to pay different prices for
the same good. If buyers have the same elasticity and are willing to pay the same price,
then price discrimination is pointless. The price charged to each group is the same in this
case.
Segmented Buyers: Lastly, price discrimination requires that each group of buyers be
segmented and sealed into distinct markets. Segmentation means that the buyers in one
market cannot resell the good to the buyers in another market. Price discriminate is not
effective if trade among groups is possible. Those buyers charged a higher price cannot
purchase the good from those paying the lower price instead of from the seller.
25. Draw a diagram to illustrate how a firm maximizes profit in third degree
price discrimination, explaining why the higher price is set in the market
with the relatively more inelastic demand.
First-degree discrimination,
alternatively known as perfect
price discrimination, occurs
when a firm charges a
different price for every unit
consumed.
The firm is able to charge the
maximum possible price for
each unit which enables the
firm to capture all available
consumer surplus for itself.
In practice, first-degree
discrimination is rare.
25. Draw a diagram to illustrate how a firm maximizes profit in third degree
price discrimination, explaining why the higher price is set in the market
with the relatively more inelastic demand.
Second-degree price
discrimination means
charging a different price for
different quantities, such as
quantity discounts for bulk
purchases.
Suppliers do not know who is
going to fall into which buying
group (purchasing a lot of a
little of a product) – force the
buyers to self select into the
pricing arrangement that is
best for them.
25. Draw a diagram to illustrate how a firm maximizes profit in third degree
price discrimination, explaining why the higher price is set in the market
with the relatively more inelastic demand.
Third-degree price discrimination means charging a different price to
different consumer groups.
For example, airline travelers can be subdivided into commuter and casual
travelers, and cinema goers can be subdivide into adults and children.
Splitting the market into peak and off peak use is very common and occurs
with gas, electricity, and telephone supply, as well as gym membership and
parking charges. Third-degree discrimination is the commonest type.
Discrimination is only worth undertaking if the profit from separating the
markets is greater than from keeping the markets combined, and this will
depend upon the elasticity's of demand in the sub-markets.
Consumers in the inelastic sub-market will be charged the higher price,
and those in the elastic sub-market will be charged the lower price.
25. Draw a diagram to illustrate how a firm maximizes profit in third degree
price discrimination, explaining why the higher price is set in the market
with the relatively more inelastic demand.
Diagram for price discrimination
If we assume marginal cost (MC) is constant across all markets, whether or
not the market is divided, it will equal average total cost (ATC). Profit
maximization will occur at the price and output where MC = MR. If the
market can be separated, the price and output in the inelastic sub-market
will be P and Q and P1 and Q1 in the elastic sub-market.
Price Discrimination – An Evaluation
Advantages to the Firm
 Enables producers to gain a higher level of revenue
 Enables producers to produce more and gain from economies of scale.
 Profits gained in inelastic market segment can be used to drive away
competition in more elastic market segment
Advantages to the Consumers
 Poorer consumers may be able to consume products.
 Allows people to purchase a product at a lower price than they would
have had to pay if the producer had not been able to secure higher
prices from others.
 Increased output provides opportunity for more consumers to use the
product.
 Economies of scale: If total output increases significantly, this may result
in lower average cost and thus lower prices for consumers.
Price Discrimination – An Evaluation
Disadvantages of Price Discrimination
 Any consumer surplus that existed before the price
discrimination will be lost.
 Some consumers will pay more than the price that
would have been charged in a single, non
discriminated market.
 If a firm succeeds in driving rival firms out from the
market, it can use its increased monopoly power to
increase prices and exploit the consumers.