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OLIGOPOLY
Chapter 11: Economics – IB Course
Companion
Blink & Dorton, 2007, p119-125
The Assumptions of Oligopoly
• Oligopoly is where a few firms dominate an
industry.
• The industry may have quiet a few firms or not
many, but the key factor is that a large
proportion of the industry’s output is shared
by just a small number of firms.
• What constitutes a small number varies, but a
common indicator of concentration in an
industry is known as the concentration ratio.
Concentration Ratios
• Concentration ratios are expressed in the form
of CRx where X represents the number of the
largest firms.
• For example: CR4 would show the percentage
of market share or output held by the largest
four firms in the industry.
• The higher the percentage, the more
concentrated is the market power of the four
largest firm.
Concentration Ratios
• While other concentration ratios such as CR8
are measured, it is the CR4 that is most
commonly used to make a link to a given
market structure.
CONCENTRATION RATIOS AND MARKET STRUCTURES
Case Study:
US Malt Beverages Industry
• In the US malt beverages industry, there are
160 firms and the CR4 is 90%.
• The four largest firms produce 90% of the
industry’s output and it is an industry with a
high concentration of market power among
the largest four companies
• The malt industry is clearly example of an
oligopoly.
TASK: Concentration Ratios
• Identify five industries in the United States or
China, that you think would be considered
oligopolies.
• What do you think the contraction ratio would
be for each industry?
Case Study:
US Frozen Fish & Seafood Industry
• In the frozen fish and seafood industry, there
are 600 firms and the CR4 is 19% suggested
low concentration.
• The frozen fish and seafood industry is in
monopolistic competition.
Type of Oligopolistic Industries
• Oligopolistic Industries may be very different
in nature.
• Some produce almost identical products. (Eg:
petrol, where the product is almost exactly
the same and only the names of the oil
companies are different
• Some produce highly differentiated products:
eg motor cars.
Barriers to Entry
• In most examples of oligopoly, there are
distinct barriers to entry, usually the large
scale production or the strong branding of the
dominant firms, but this is not always the
case.
• In some oligopolies there may be low barriers
to entry.
• This explained by contestable market theory.
Interdependence & Oligopolies
• The key feature that is common in all oligopolies is that
there is interdependence.
• Whereas in perfect competition and monopolistic
competition the firms are all too small relative to the
size of the market, to be able to influence the market,
in oligopoly there is small number of large firms
dominating the industry.
• As there are just a few firms, each needs to take careful
notice of each other’s actions.
• Interdependence tends to make firms want to collude
and so avoid surprises and unexpected outcomes.
Oligopolies & Collusion
• If oligopolies conclude and act as a monopoly,
then they maximize industry profits.
• However, there may also be tendency for firms
to want to compete vigorously with each
other in order to gain a greater market share.
Oligopolies and Price Issues
• Oligopolies tend to be characterised by price
rigidity.
• Prices in oligopoly tend to be change much
less than in more competitive markets.
• Even where there are production-cost
changes, oligopolistic firms often leave their
prices unchanged.
COLLUSIVE OLIGOPOLIES
Collusive Oligopoly exists when the
firms in an oligopolistic market
collude to charge the same prices for
their products, in effect acting as a
monopoly, and so divide up any
monopoly profits that may be made.
Two Types of Collusion
There are two main types of collusion:
• Formal Collusion
• Tacit Collusion
Formal Collusion
• Formal conclusion takes place when firms openly
agree on the price that they will all charge,
although sometimes it may be agreement on
market share or an marketing cartel. This type of
collusion is called cartel.
• Since this results in higher prices and less output
for consumers, this is usually deemed to be
against the interests of consumers.
• Collusion is generally banned by governments
and is against the law in the majority of countries
Anti Trust Authorities &
Formal Collusion
• If a country’s anti-trust authority finds that
firms have engaged in anti-competitive
behaviour such as price-fixing agreements,
then the firms will be penalised with fines or
other punishments.
Formal Collusion & Cartels
• Formal collusion between governments may
be permitted.
• The prime example is OPEC
• The Organization of Petroleum Exporting
Countries.
• OPEC is a cartel.
• It sets production quotas, which has a very
significant influence on the price of oil on
world markets.
Tacit Collusion
• Tacit collusion exists when a firms in oligopoly
charge the same prices without any formal
collusion.
• A firm may charge the same price as another
by looking at the prices of a dominant firm in
the industry, or at the prices of the main
competitors.
• It is not necessary for firms to communicate
with each other to charge the same price.
OLIGOPOLISTS ACTING
AS A MONOPOLIST
With both formal
and tacit collusion
the process is the
same. The firms
behave like a
monopolist (single
producer) charge
the monopoly price,
make monopoly
profits and share
then according to
market share.
Collusive Oligopoly & Price Rigidity
• Collusive oligopoly offers one explanation of
price rigidity in oligopoly.
• If firms are colluding, either formally or tacitly,
and they are making their share of long-run
monopoly profits, then they may try to keep
prices stable in order that the situation
continues.
NON COLLUSIVE OLIGOPOLY
• Non-collusive oligopoly exists when the firms
do not collude and so have to be very aware
of the reactions of other firms when making
pricing decisions.
• The behaviour of firms in an oligopoly is
strategic behaviour. They must develop
strategies that take into account all possible
actions of rivals
Extension: Game Theory
• To explain firms strategic behaviour,
economist often use `game theory`.
• While this is not the IB Diploma Economics
program, it may be covered in the Theory of
Knowledge as “The prisoner’s dilemma”.
The Kinked Demand Curve
• One way of attempting to explain the situation
in a non-collusive oligopoly is the kinked
demand curve devised in the 1930s by an
American Economist called Paul Sweezy
(1910-2004).
• Although the theory has been called into
question, it does provoke some interesting
thoughts and discussions concerning noncollusive oligopoly
THE KINKED DEMAND CURVE
The first assumption is that a firm
only knows one point on its demand
curve, - the one it holds at present.
This show is shown as point `a`. If
the firm raises its price, then it is
unlikely that its competitors would
raise theirs and so a lot of demand
would be lost to other firms. This
implies that demand would be
relatively elastic above point `a`,
since a small increase in price would
lead to large fall in the quantity
demanded.
If the firm were to lower its price then it is likely that competitors would follow.
Competitors would undercut the price of the first firm in order to regain any lost sales.
This implies that demand would be less elastic below point “a”, since a decrease in price
is unlikely to lead to a noticeable increase in quantity demanded. Due to these
expectations, the demand curve will be kinked around the point “a”. It will also possess
an MR curve that has the vertical section bc, since each part of the MC curve will be
twice as steeply sloping as the two parts of the demand curve.
Kinked Demand Curve & Price Rigidity
in Non-Collusive Oligopoly
The kinked demand curves offers an explanation
of why there tends to be price rigidity in noncollusive oligopoly. There are three reasons:
1. Firms are afraid to raise prices above the
current market price, because other firms will
not follow, and so they lose trade, sales and
probably profit.
2. Firms are afraid to lower their prices below the
current market price, because other firms will
follow, undercutting them an so creating a price
war that may harm all firms involved.
Kinked Demand Curve & Price Rigidity
in Non-Collusive Oligopoly
3. The shape of the MR curve means that if marginal costs
were to rise, then it is possible that MC would still
equal MR and so the firms, being profit maximisers
would not change their prices or outputs.
• Based on the kinked demand curve graph, if we
assume that the firm is operating on MC2 then they
are maximising profits by producing at Q and selling at
P.
• Marginal costs could rise as high as MC1 and the firm
would still be maximising profits by producing at Q and
charging P. Thus the market remains stable, even
though there have been significant price changes.
NON PRICE COMPETITION
• As firms in oligopoly tend not to compete in terms of price
the concept of non-price competition becomes important.
Types of Non Price Competition
• Brand names
• Packaging
• Special Features
• Advertising & Sales Promotion
• Personal Selling
• Publicity
• Sponsorship deals
• Special Distribution features
(eg: free delivery & after sales service)
Oligopoly and Advertising
• Oligopoly is characterized by very large
advertising and marketing expenditures as
firms try to develop brand loyalty and make
demand for their product less elastic.
• Some may argue that this represents a misuse
of scarce resources, but it could be argued
that competition among the large companies
results in greater choice for consumers.
The World’s Leading Oligopolies
• Rivalry among firms in oligopolies are well
known nationally and internationally:
• Eg: Coke / Pepsi and Adidas / Nike.
• However many of the branded consumer
goods that we purchase are produced in
oligopolies, which many consumer would not
be aware of, when shopping.
Unilever and Proctor & Gamble
• Unilever and Proctor & Gamble produce a vast
number of brands that compete with each
other in number of industries. For example:
home care products, personal hygiene, health
care and beauty products.
EXAMINATION QUESTIONS
Short Response Questions
1. Explain why prices tend to be quite
stable in a non-collusive oligopoly
(10 marks)
2. Explain why firms in oligopolies
engage in non price competition
(10 marks)
EXAMINATION QUESTIONS
Essay Questions
1a Distinguish between a collusive
and non-collusive oligopoly
(10 marks)
1b. Evaluate the view that governments
should maintain strong policies to
control collusive behaviour by
oligopolies (10 marks)