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1.5.5 Collusive and Non-collusive Oligopoly Write down five things you know about an oligopoly. Compare your five points with a colleague in the class. Add all the points to a spider diagram on the board. How many different points can you make working as a class? AQA 1.5: P ERFECT C OMPETITION , I MPERFECTLY C OMPETITIVE M ARKETS AND M ONOPOLY 1.5.5 W HAT YOU NEED TO KNOW The main characteristics of oligopolistic markets Oligopolistic markets can be very different in relation to, for example, the number of firms, the degree of product differentiation and ease of entry Oligopoly can be defined in terms of market structure or in terms of market conduct (behaviour) Concentration ratios and how to calculate a concentration ratio The difference between collusive and non-collusive oligopoly The difference between cooperation and collusion The kinked demand curve model The reasons for non-price competition, the operation of cartels, price leadership, price agreements, price wars and barriers to entry 1.5.5 W HAT YOU NEED TO KNOW ( CONTINUED ) The factors which influence prices, output, investment, expenditure on research and advertising in oligopolistic industries The significance of interdependence and uncertainty in oligopoly The advantages and disadvantages of oligopoly Students should be aware of the various factors which affect the behaviour and performance of firms in a variety of real world markets The factors include different barriers to entry and the degree of concentration and product differentiation The kinked demand curve model should be used as an illustration of the interdependence between firms and not taught as if it is the only model of oligopoly Students should recognise that collusion may allow oligopolists to act as a monopolist and maximise their joint profits I N PAIRS UNPICK AND DISCUSS THE MEANING OF THIS QUOTE “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.” Adam Smith An Inquiry into the Nature and Causes of the Wealth of Nations T HE MAIN CHARACTERISTICS OF OLIGOPOLISTIC MARKETS An oligopoly exists where there are only a few firms in the market. Like monopolies and duopolies, oligopolies can exploit consumers by charging high prices Barriers to entry exist in oligopolistic markets, particularly through advertising. This means ease of entry to the market is far more difficult for smaller firms Oligopolies tend to compete on non-price competition such as promotion and there may also be an element of collusion It is important for oligopolists to take into account the reaction of competitors when making decisions regarding pricing. For example, if one firm cuts price, then others are likely to follow suit, resulting in a lower income for the market as a whole Therefore, oligopolists are unlikely to lower price as a long term strategy T HE MAIN CHARACTERISTICS OF OLIGOPOLISTIC MARKETS To what extent do you think the rebranding of Coke Zero was necessary? Is this an oligopolistic market? Oligopolies exhibit the following characteristics: Do not tend to compete on price in the long run. However, oligopolists might compete on price as a tactic (short run) Tend to spend heavily on new product development Branding is crucial to and expensive marketing budgets are available Firms must ensure that their products are accessible if they are going to be successful P RODUCT DIFFERENTIATION Oligopolists try to make their product different to the competition by adapting the actual product in some way or by distinguishing the product through advertising and branding A business might have a product range selling a variety of goods or services to meet consumer needs With high competition in most markets it is important that a business tries to differentiate itself from the competition in order to sell A Unique Selling Point (USP) is something that distinguishes a firm’s product from those of its competitors and can allow a firm to charge a premium price Market structure details the characteristics of a market. M ARKET STRUCTURE V MARKET CONDUCT ( BEHAVIOUR ) The key characteristics of oligopoly are: A 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 i.e. the actions of one firm will impact on other firms in the industry Market conduct or behaviour refers to the policies that a firm uses to market its products. M ARKET STRUCTURE V MARKET CONDUCT ( BEHAVIOUR ) 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 suggests that oligopolists face uncertainty as they do not know how other firms will react to their market behaviour C ONCENTRATION The concentration ratio (CR) tells us the number of firms that dominate the market What is the concentration ratio in the football kit market? RATIO For 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 ratio of CR1 = 100% the industry is a monopoly If CR8 = 0% the industry is perfectly competitive T EAM C HALLENGE C AN YOU PLAC E THE IND UST RI E S UND ER THE C ORREC T HEAD I N G IN THE TABLE ? UK industries with the highest five-firm concentration ratios (10 industries) UK industries with the lowest five-firm concentration ratios (8 industries) Pesticides Man-made fibres Furniture Gas distribution Sugar Oils and fats Soft drinks and mineral waters Tobacco products Structural metal products General purpose machinery Plastic products Wood and wood products Confectionery Weapons and ammunition Construction Coal extraction Wholesale distributions Metal forging, pressing etc. FACTORS INFLUENCING PRICE AND OUTPUT IN OLIGOPOLY SFO investigates price rigging in foreign exchange market. Price and output is influenced by a variety of factors in oligopoly: Collusive pricing occurs when firms agree to set higher prices and act as a monopolist. This will restrict output Predatory pricing occurs when a firm attempts to force competition out of the market by setting low prices. This might be below average cost in the short run and is likely to see increased output as demand is higher Limit-pricing occurs when a firm operates below the profit maximising output of MC = MR. The firm will still make a profit but potential entrants will be deterred from entering the market as lower price means that entry is not profitable Cost plus pricing occurs when a firm sets price based on its average cost at a particular output level. It adds a mark-up to its average cost where it is producing at its minimum efficient scale I NVESTMENT AND EXPENDITURE ON RESEARCH Heavy investment is undertaken in oligopolies Firms will have high levels of capital investment This entails expenditure on fixed assets such as land, factories, buildings and machinery This will lead to a stream of income for the firm in the future Investment and research and development (R & D) are significant features of oligopoly, creating barriers to entry and reducing the threat of potential entrants High set-up costs will deter entry into the market A DVERTISING A sunk cost is one that the firm can not recover if it were to exit the market. How effective are loyalty cards? AND MARKETING POLICIES Advertising is an example of a sunk cost and deters new entrants Firms will spend heavily trying to establish brand loyalty and repeat custom This may take the form of loyalty schemes where incentives e.g. loyalty cards are offered to buy from the firm Marketing policy is how the firm differentiates itself from the competition By investing in new product development the firm can increase demand and maintain brand loyalty C OLLUSION Collusion occurs when firms in an oligopolistic market agree to act as one firm in order to benefit from elements of monopoly. Non-collusive oligopoly occurs when firms do not collude when undertaking decision-making. IN OLIGOPOLY Firms in oligopolistic markets will benefit from colluding with one another This will allow them to operate closer to conditions of monopoly In most parts of the world e.g. the EU and the US this is deemed to be illegal as it operates to the detriment of consumers by restricting output and raising price This would lead to profit maximisation Firms often collude to segment the market geographically This gives each firm monopoly power in their own geographical area as they agree not to compete with one another C OOPERATION IN OLIGOPOLY Firms in oligopolistic markets might cooperate if it is to be seen in the interest of the public For example, firms might join together to innovate new production processes These might benefit society as a whole as efficiency for the industry might improve This will lead to lower production costs that can benefit the consumer This can be distinguished from collusive practices that impact negatively on price for the consumer C OLLUSION IN OLIGOPOLY – ACTING LIKE A MONOPOLY Price By colluding and acting like monopolists firms can make supernormal profits where AR is greater than AC. MC P AC AR = D Q MR Output N ON - COLLUSIVE OLIGOPOLY Assume a CR4 = 80% in the market Firm A looks to raise price. Firms B, C and D do not follow suit as they realise that they will gain market share from firm A, who will see a large drop in sales. Its demand curve above price P is therefore price elastic If firm B lowers price then most consumers will switch to them. Firms A, C and D will have to lower price in order to retain market share. The demand curve below price P is therefore price inelastic This suggests that under conditions of oligopoly firms are unlikely to raise or lower price i.e. there is price rigidity N ON - COLLUSIVE OLIGOPOLY: THE KINKED DEMAND CURVE Oligopolistic markets often display price rigidity where prices tend to be stuck for a period of time despite changes in demand and supply in the market. Price elasticity of demand differs when prices rise or fall. This is shown by a kink in the demand curve. The kinked demand curve explains why price rigidity or price stickiness occurs in oligopoly Price Price elastic P Price inelastic Above P price will be price elastic and below P price inelastic. Q Output T HE Firms try to profit maximise where MC = MR. KINKED DEMAND CURVE Price MC2 This occurs at all output levels between the MC curves MC1 and MC2 or between points a and b. MC1 P There is a discontinuous MR curve and the firm will continue to set price at P where MC = MR. a b AR = D MR Q Output R EASONS FOR NON - PRICE COMPETITION Non-price competition occurs when a firm distinguishes or differentiates its product from that of its competitors This can take many forms including promotion, quality, customer service and branding It is common in oligopoly as competing on price is likely to lead to lower profits for the oligopolist This will reduce the likelihood of price wars The additional costs of non-price competition are likely to be less than the cost of engaging in a price war T HE The cost of price fixing. OPERATION OF CARTELS A cartel is a formal agreement between firms to collude in the operation of the market This will normally take the form of price fixing It may involve fixing output levels Cartels allow member firms to operate closer to conditions of monopoly They are therefore seen to be against the interest of the consumer and are mostly deemed to be illegal Some cartels might be allowed if the scale of operations and joint cooperation is seen to be in the public interest P RIC E LEAD E R S H IP, PRIC E AGRE E M E NT S , PRIC E WARS AND BARR I E R S TO ENTRY Apple denies iPhone price-fixing. Price leadership is common in oligopoly. The dominant firm sets price and other firms follow suit, normally over a period of time. This is likely to see higher prices and lower output Price agreements may be: Explicit, where the firms overtly agree to set price Implicit, where there is 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 rather than in collusion Barriers to entry are obstacles preventing firms entering the market such as R&D costs. These are an important reason for the existence of oligopolistic markets I NTERDEPENDENCE AND UNCERTAINTY Firms in oligopolistic markets are interdependent This means that the actions of one firm will impact on other firms in the industry Interdependence creates uncertainty as firms are unsure of how competitors will react to their policies and whether they will be proactive in the market This means that interdependence and uncertainty are linked Firms will try to anticipate the tactics and strategies of other firms in the market I NTERDEPENDENCE IN OLIGOPOLY: T HE KINKED DEMAND CURVE A firm is unwilling to raise price unilaterally as other firms might not follow suit. This would see a fall in market share and lower profit as the demand curve is price elastic above price P. A rise in price will lead to a fall in total revenue (TR). If the firm were to lower price all other firms would have to follow suit to maintain market share. Below P demand is price inelastic. Lower prices will lead to a fall in TR. The kinked demand curve can be used to explain interdependence in oligopoly Price Price elastic P Price inelastic Q Output A DVANTAGES OF OLIGOPOLY Oligopolists are continually innovating in order to create a competitive advantage over other firms in the market This is enable because oligopolists have the ability to reinvest their supernormal profit This leads to dynamic efficiency in terms of new production processes and new product development that creates improved products and greater choice for consumers This leads to benefits for all firms, not just those in the oligopolistic industry e.g. many businesses have benefited from the development of app technology At times, oligopolistic markets are highly competitive, reducing costs and therefore lower prices and creating better quality for consumers D ISADVANTAGES OF OLIGOPOLY Oligopolistic markets reduce choice for the consumer as there is a high concentration ratio of firms At times, oligopolists will act like monopolists, reducing output and increasing prices. This leads to a misallocation of resources and allocative inefficiency which impacts negatively on society Oligopolists create barriers to entry that reduce competition In particular, advertising is used to manipulate consumers. This leads to irrational decision making that do not maximise consumer satisfaction or utility Oligopolists exhibit productive inefficiency as they do not operate on the lowest point of their LRAC curve G AME THEORY ( THE FOLLOWING SLIDES ARE NOT A REQUIREMENT OF THE COURSE BUT CAN AID THE UNDERSTANDING OF INTERDEPENDENCE ) A payoff matrix shows the outcome of all strategies undertaken by a firm in relationship to strategies undertaken by all firms in the industry. This can be very complex so we often simplify it to show the relationship between two firms in an industry i.e. a duopoly. Game theory is the study of strategies undertaken by firms that operate in interdependent markets It looks at how firms will behave: Reactively, by responding to competitors’ actions Proactively, by initiating actions before competitors do Complex mathematical models are used to look at how firms are interdependent of each other in a variety of markets The strategies that a firm undertakes in response to a competitor can be shown using a payoff matrix Game theory will see firms attempt to profit maximise based on information available regarding the competition G AME THEORY Games will have players or economic agents e.g. firms Each firm will have different strategies available to it Each game will have payoffs. These are the outcomes that will occur based on the strategies undertaken by each firm The dominant strategy is that strategy that a firm will undertake to maximise their own interests, regardless of the other players The Prisoner’s Dilemma is used to illustrate the idea of game theory T HE P RISONER ’ S D ILEMMA Two prisoners (players), A and B have been arrested for bank robbery and interrogated separately. Police have evidence of minor crimes for both prisoners. However, they are looking to pin a major crime on one or both of the prisoners. Both players have evidence on each other that they took part in the major crime. The police are willing to be more lenient if the prisoners provide them with this evidence and betray their partner in crime. Each player has a strategy – betray or don’t betray. There is a payoff for each strategy undertaken. This is shown in the table e.g. if A and B both betray they each get 5 years in prison. Betray B Don’t betray 5 years Betray 5 years 15 years 1 year A 1 year Don’t betray 15 years 3 years 3 years The dominant strategy is the best strategy undertaken by a player regardless of the strategy undertaken by the other players. What is the best strategy for A dependent on what he thinks B will do? T HE P RISONER ’ S D ILEMMA The Nash Equilibrium occurs when each firm or player in the game maximises the benefit from their own strategy taking into account the strategies of all other firms in the industry. The police have told both prisoners of the likely outcomes as to what will happen if they implicate their partner or not. They will be lenient to the prisoner if they betray their partner. The outcomes are shown in the Prisoner’s Dilemma Matrix Prisoner A considers his two options: Option A B betrays me and I don’t betray – I get 15 years B betrays me and I betray him – I get 5 years Therefore, A should betray B to get less time Option B B doesn’t betray me and I don’t betray – I get 3 years B doesn’t betray me and I betray him – I get 1 year Therefore, A should betray B to get less time The dominant strategy of A is to betray B, the same goes for B Therefore, without cooperation and based on self interest they will both go to prison for 5 years This is an example of a Nash Equilibrium as, given the strategy of the other players, a firm cannot benefit by changing their own strategy T HE P RISONER ’ S D ILEMMA What would happen if the prisoners colluded to minimise the amount of time that the two together would spend in prison If the prisoners were able to cooperate and trusted each other then the best outcome would be for neither of them to betray each other This would mean that they had a total of 6 years in prison as opposed to 10, 16 or 16 years Therefore, collusion or cooperation between the prisoners (or players in a market) will maximise the benefits to all players We can use game theory to illustrate whether firms should collude or compete in a market T HE P RISONER ’ S D ILEMMA – NO DOMINANT STRATEGY We can apply the Prisoner’s Dilemma to firms in the real world and look at the strategies that they should undertake. With no dominant strategy the firm will have to take into account the actions of competitors. The matrix shows the sales revenue of firms dependent on their pricing strategy. Maintain P B Lower P £110 Maintain P £100 £70 £80 A £110 Lower P £90 £100 £120 If B maintains P then A should maintain P as £100 is greater than £90. If B lowers P then A should lower P as £120 is greater than £80 A does not have a dominant strategy. It depends on the actions of B. T HE P RISONER ’ S D ILEMMA – DOMINANT STRATEGY With a dominant strategy the firm does not have to take into account the actions of competitors. Maintain P B Lower P £110 Maintain P £100 £70 £80 A £110 Lower P £90 £100 £120 If A maintains P then B should maintain P as £110 is greater than £70. If A lowers P then B should maintain P as £110 is greater than £100 B has a dominant strategy of maintaining P. It does not depend on the actions of A. C OLLUSION With a dominant strategy the firm does not have to take into account the actions of competitors. The best strategy for B would be to maintain price regardless of what A does. By maintaining price revenue would be £110. If A knows that this will be B’s strategy then it will maintain price too as £100 is greater than £90. Total revenue for the industry will be £210. Maintain P B Lower P £110 Maintain P £100 IN OLIGOPOLY £70 £80 A £110 Lower P £90 £100 £120 However, if both firms were to lower price the total revenue for the industry would be £220. If both firms were to collude they could share revenues e.g. A gets £105, B gets £115 and both are better off. P RACTICAL EXPERIMENT Devise a scenario that could be used to test the concept of game theory, this will work best if there is a genuine reward or risk Invite pairs of students, who do not study Economics, to take part in the game Repeat with different students allowing them time to discuss before making their choices Record the outcomes Record the outcomes Use your results to explain the concepts of interdependence and uncertainty S HOW OFF YOUR KNOWLEDGE Read the article “UK banks face full CMA competition probe” Annotate all of the economics theory contained within the article How would you describe the UK banking industry?
