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Oligopoly By Chris and Harrison (Ford?) What is an Oligopoly? Oligopolies may be identified using concentration ratios, which measure the proportion of total market share controlled by a given number of firms. When there is a high concentration ratio in an industry, economists tend to identify the industry as an oligopoly. In normal people words: When a small number of companies own a large section of the industry. Key Characteristics • Interdependence Firms working in such close proximity to each other have to take action against their competitors actions and their potential actions • Strategy 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. Key Characteristics Cont. • Barriers to entry • Natural Economies of scale Ownership/Control of a scarce resource High set-up costs High R&D costs • Artificial Limit/Predatory pricing Advertising in an Oligopoly Oligopolistic firms can gain maximum from advertisement by increasing its market share as well as increasing total market demand. To achieve this, they need to establish the superiority of their products over those of their competitors, and in doing so they must also counter the impact of advertisement of the competitors. Advertising may or may not result in improved consumer benefits and efficiency. When advertising results in increased sales and in turn increased production, it may lead to economy of scale. But advertising itself involves some cost. Advertising improves efficiency only when savings from economy of scale exceeds the cost of advertising. Advertisements • Pros Product placements from companies to advertise their products help fund the projects they are promoted in, like movies or scholarships • Cons Advertising is a sunk cost - the more that is spent by incumbent firms the greater the deterrent to new entrants. Collusion • Overt 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 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. 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. Pricing Strategies cont. • 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. • Pricing Strategies cont. Kinked demand curve The reaction of rivals to a price change depends on whether price is raised or lowered. The elasticity of demand, and hence the gradient of the demand curve, will be also be different. The demand curve will be kinked, at the current price. 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.