Download Oligopoly

Structure
monopoly
oligopoly
monopolistic
competition
perfect
competition
Examples
Local, national or
international e.g.
rail franchise,
Microsoft
Mobile phones,
food retailing.
Many firms,
slightly
differentiated
product e.g. driving
schools, coach hire
Unlikely to exist in
practice (some
commodity markets
exhibit key
characteristics)
No. of sellers
Single supplier
A ‘few’ large firms
Many small firms
Many small firms
Product
differentiation
Single product
Common as prices
tend to be stable.
Characterized by
non price
competition
Yes
No. Product
identical
‘homogenous’
Price-taker or
price/maker
Price maker
Elements of both
Small influence
over price
Price taker
Barriers to entry
Many natural
and/or artificial
As for monopoly.
Brand loyalty very
important
None
None
Long run
supernormal profit
Yes
Yes
No
No
Economic
consequences
Allocative/
productive
inefficiency
Allocative/
productive
efficiency
Oligopoly
Imperfect competition
The vast majority of firms do compete with other
firms, yet are not price takers. They have some degree
of market power. Most markets, therefore, lie between
the two extremes of perfect competition and monopoly.
There are two types of imperfect competition:
Monopolistic Competition and Oligopoly.
Features of Oligopoly
• A few firms dominate the industry
• Products may be homogeneous or differentiated
• There are barriers to entry and exit from the industry,
the size and effectiveness of the barriers differ
considerably from one industry to another.
• There is interdependence of firms. Firms are mutually
dependent, as each firm is affected by its rivals’ actions
• Due to interdependence, there is no one single generally
accepted theory of oligopoly. Firms may react
differently or unpredictably.
Examples of Oligopoly?
Pepsi and Mirinda and 7up= Pepsico.
Sprite and coca cola= Coca Cola,
Oligopoly behaviour
1. Interdependence
the quantity sold by any one producer
depends on that producer’s price and
the prices and quantities sold by the
other producers.
2.Strategic behaviour
Each firm must take into account the
effects of its own actions on the
actions of other firms
There are two conflicting policies a firm in an
oligopolistic industry may adopt.
Competition – Firms may be tempted to compete with the
other firms to gain market share and a larger slice of
industry profits in the longer term. Firms compete using
price, output or non price competition
Collusion – Interdependence may encourage firms to club
together and act as if they were collectively a monopoly.
Formal : open agreement on price and output strategy
(cartel)
Tacit : ‘unwritten’ agreement not to compete (e.g. on
price, advertising)
We need to deal with the two possibilities,
collusive oligopoly and non-collusive oligopoly.
Collusive oligopoly
Firms may engage in collusion (formally or
informally), by agreeing prices, market share,
advertising expenditure, product development,
no poaching agreements etc.
Restricting the levels of competition protects
industry profits from being reduced
A Cartel – Is a formal collusive agreement. Cartel
members collude to act as if it (the cartel) were a
monopoly, by acting like a single firm to maximise
profits.
Collusive oligopoly
In reality, formal collusive agreements are often made
illegal through legislation to promote competition.
The competition commission, in the UK, enforces rules
and regulations laid down in UK and EU law.
Therefore, it is much more likely that collusion
would be informal (which can be very difficult
to prove). Informal collusion could be clearly an
attempt to act anti-competitively, which would
be breaking the law. Building firms informally
agreeing contracts could be a clear example.
Price Fixing in the news
• The Office of Fair Trading (OFT), accused
British Airways (BA) of fixing the price of
fuel surcharges with Virgin on long-haul
flights between 2004 and 2006. The case
was the first criminal prosecution the OFT
had pursued under powers awarded to the
watchdog in 2003. One current and three
former British Airways executives could
have faced up to five years in prison.
Price Fixing in the news
• Supermarkets Sainsbury's and Asda are
among companies that have agreed to
pay the Treasury near-record fines of
more than £116m after admitting that
they fixed the price of milk, cheese and
butter in a scandal estimated to have
cost consumers about £270m
• Dec 2007
Collusive oligopoly
Firms are more likely to undertake tacit collusion. Firms
tacitly ‘agree’ to avoid price cutting, excessive
advertising or other forms of competition.
There a number of ways firms can tacitly collude to
set prices in an industry for example:
• Dominant firm price leadership- largest firm sets the
benchmark
• Barometric firm price leadership- the most reliable
firm sets the benchmark
Price
Collusive Oligopoly
A collusive oligopolistic industry in the long run will
act as if it were a monopoly.
MC
(industry)
P
AC
(industry)
Abnormal Profit
TR>TC
Total Cost
(TC=ACxQ)
0
MR
Q
AR = D
(industry)
Quantity
Oligopoly
Even if collusion exists, there is a strong
temptation to ‘cheat’ by cutting prices or selling
more than the allocated quota.
Economists use simple game theory to study
alternative strategies of firms, based on
possible actions of their rivals.
The kinked demand curve is a product of kinked
demand theory developed in 1939 (P. Sweezy). The
model seeks to explain why, even when there is no
collusion at all, prices can remain stable.
The interdependence of firms in an oligopoly is
important to consider here.
The kinked demand curve under
non- collusive oligopoly.
P
An oligopolist can observe
current price and output,
P0
but must try to anticipate
rival reactions to any
price change.
Q0
Q
The kinked demand curve
The firm may expect rivals
to respond if it reduces
its price,
Price
so demand in response
to a price reduction is likely
to be relatively inelastic
P0
D
The demand curve will
be steep below P0.
Quantity
The kinked demand curve
…but for a price increase
rivals are less likely to
react,
P
P0
so demand may be
relatively elastic
above P0
D
so the firm perceives
that it faces a kinked
demand curve.
Quantity
The kinked demand curve
Given this perception, the
firm sees that revenue will
fall whether price is increased
or decreased,
so the best strategy is to keep
price at P0.
Prices are stable (‘sticky’)
Price
P0
D
Q0
Quantity
Homework
• Monday- questions on price and nonprice competition (handout last Monday)
• Investigate real- life examples of
collusion eg. national bus companies in
the UK, look for news articles on price
fixing as a starting point
• Bring in news article to discuss on
Monday
Non collusive oligopoly
The kinked demand theory is based on two
asymmetrical assumptions:
1. If an oligopolist cuts its price, its rivals will be forced
to follow suit, to maintain market share and not lose
customers to the price cutting firm.
2. If an oligopolist raises its price, its rivals will not
follow suit, as they will gain market share from the
first firm.
The market price remains relatively stable. Profits
are maximised where MC=MR, so prices remain
stable even with a considerable change in costs.
Price
Non collusive Oligopoly
Cost and revenue curves for a firm in a
non-collusive oligopoly
MC2 (firm)
MC1 (firm)
P1
D=AR
(firm)
0
Q1
MR
Quantity
Notes on Model
• Profit is maximised where MC= MR thus if the
MC curve lies anywhere between MC1 and MC2,
the profit maximising level of output is still P1
and Q1. Thus prices remain stable even with a
considerable change in costs
• Model does not explain how prices are set in
the first place
• Model predicts that prices will be raised only
after MC has risen above MC2
Oligopolistic Industries
In the real world, there are a number of industries that
exhibit the key characteristics of oligopoly. Petrol,
Cars, chemicals, Soap Powder, Soft drinks, long haul air
passenger industry, top independent schools?
It is important to remember, in the real world,
industries may not exactly fit the theoretical market
structure characteristics.
Though the market characteristics are important, the
behaviour of firms and the level of competition are of
most interest, especially when considering oligopoly.
Game theory
The behaviour of a firm under non- collusive oligopoly will depend on how
it thinks its rivals will react to its policies
When considering whether to cut prices in order to gain market share, a
firm will ask itself 2 key questions
1. How much can it get away with without inciting retaliation
2. If it’s rivals do retaliate and a price war ensues, whether it will be
able to ‘see off’ some or all of its rivals while surviving itself.
It is not unreasonable to compare rival firms in an oligopoly to the
players in a game.
They will need to choose the appropriate strategy with respect to price,
advertising and product development.
The firm’s choice of strategy will depend both on how it thinks its rivals
will react and on how willing it is to take risks.
Game theory is a mathematical method of decision making in which
alternative strategies are analysed to determine the optimal course of
action for the interested party, depending on assumptions about rivals
behaviour.
http://www.youtube.com/watch?v=uAJDD1_Oexo
Single Move Games
• The simplest type of ‘game’
• One ‘move’ by each firm
• For example 2 firms bidding for a contract
which will be awarded to the lowest bidder
• Many single move games have predictable
outcomes, no matter what assumptions
each firm makes about its rivals’
behaviour.
• Such games are known as dominant
strategy games.
Simple Dominant Game
Strategy
2 firms with identical costs,
products and demand
Firm A is considering cutting its
price to £3, Firm B could cut or
leave at £4
£4
FIRM B
£3
FIRM A
£4
£3
£5m
£6m* ,
£5m
£2.5m
£2.5m
£6m*
,
£4m* ,
£4m*
Simple Dominant- Strategy Game
• Cautious approach- think that the worst could happen
• if A kept at £4- B could cut to £3, As profits would
fall. If A cut to £3 and B cut, profits would fall, but
by less.
• So if A is cautious it will cut its price
• (Note if B is cautious too it will also cut its price)
• Policy of adopting safer strategy is known as maximin
• i.e. The firm will opt for the alternative that will
maximise its minimum profit possible
• An alternative is the optimistic approach and assume
your rivals react in the way most favourable to you
• The firm will go for the strategy that yields the
highest possible profit.
• In As case this means cutting its price assuming B will
leave its price unchanged
• If A is correct it will achieve the maximum possible
profit of £6m.
• This approach is known as maximax
• Same argument applies to firm B. Its maximax
strategy is to cut and hopefully maximise profits
• In this ‘game’ both approaches, maximax and maximin,
lead to the same strategy (cutting price) thus this is
known as a dominant strategy game
• The equilibrium outcome of a game
where there is no collusion between
players is known as Nash Equilibrium
• Collusion would have benefited both
players in this game, yet both would
have been tempted to cheat and cut
prices- this is known as the prisoners’
dilemma
The Prisoners’ dilemma
• Handout
Oligopoly:
Outcome under
collusion or
competition
Collusion or competition ?
Both firms comply (collude without cheating)
Monopoly outcome (Pm, Qm)
Both firms cheat
Perfectly competitive outcome (Ppc, Qpc)
One firm cheats
Output : <Qpc , >Qm
Price : <Pm , >Ppc
SNP : < M , >PC
Price,
Costs,
Revenue
Pm
Ppc
AC = MC
MR
AR = D
Qm
Qpc
• More complex games can be devised
with more firms and many alternative
prices, differentiated products and
various forms of non- price competition
• Multiple move games can also be created
• For more info see an undergraduate
Economics textbook such as Sloman,
Lipsey and Chrystal (both in the library)
Handout
• Game Theory
What determines market structure?
The minimum efficient scale (MES) is the output at which a firm’s long-run
average cost curve stops falling.
The size of the MES relative to market demand has a strong influence on
market structure
•
•
•
LAC1 offers negligible economies of scale relative to market demand, and it is unlikely that
any individual firm will be able to have much influence. This is likely to end up as perfect
competition.
In contrast, LAC3 looks likely to be a natural monopoly, as the largest firm is always likely to
dominate.
LAC2 is an intermediate case, which will probably end up as an oligopoly.
C
LAC2
LAC3
LAC1
D
Output