Oligopoly

Oligopoly is a market structure dominated by a few large firms.

• High Barriers to Entry and Exit: Significant obstacles prevent new firms from easily entering the market (e.g., high start-up costs, economies of scale, legal barriers like patents, or sunk costs that cannot be recovered upon exit). This allows firms to earn supernormal profit in the long run.

• High Concentration Ratio: A small number of firms account for a large proportion of the market share (e.g., the top four or five firms dominate sales). This is a defining feature.

• Interdependence of Firms: Each firm’s output or price decisions significantly affect its rival firms, and firms must consider the likely reaction of competitors before making a move. This strategic interaction is central to oligopoly behaviour.

• Product Differentiation: Products are often differentiated (e.g., through branding, advertising, quality, or design) even if they are fundamentally similar (e.g., soft drinks, cars). Differentiation gives firms some power to set their price (they are price makers).

This graph represents the Kinked Demand Curve model for an individual firm in a non-collusive oligopoly. It is used to explain the concept of price rigidity or price stability often observed in oligopolistic markets.

The model is based on two key assumptions about the likely reactions of competitors:

1. Price Increases (Above P*):

2. • Curve Segment: The demand curve is elastic (represented by the flatter segment D cop - competitors ignore price increases).

   • Competitor Reaction: If one firm raises its price above P*, its rivals are assumed to ignore the increase. They will not follow the price rise, as this allows them to capture market share from the firm that raised its price.

   • Outcome for the Firm: The firm will lose a significant number of customers to its rivals. The percentage drop in quantity demanded will be greater than the percentage rise in price (PED > 1), leading to a fall in Total Revenue (TR). This makes a price increase unprofitable.

4. Price Decreases (Below P*):

5. • Curve Segment: The demand curve is inelastic (represented by the steeper segment dd - competitors follow price decreases).

   • Competitor Reaction: If one firm lowers its price below P*, its rivals are assumed to follow suit immediately to prevent losing their own market share. A price war is triggered.

   • Outcome for the Firm: While the firm's quantity demanded will increase slightly, the percentage rise in quantity demanded will be less than the percentage fall in price (PED < 1). The firm gains very little market share, and because the price is lower, the firm's Total Revenue (TR) will also fall. This makes a price decrease unprofitable.

Calculation of n-Firm Concentration Ratios and their Significance

The n-firm concentration ratio measures the combined market share of the largest 'n' firms in an industry.

• Calculation:

n-Firm Concentration Ratio = Sum of Market Share of Largest n Firms

Market share is typically measured by sales, turnover, output, or employment. It is expressed as a percentage or a decimal.

Example: If the top four firms in an industry have market shares of 30%, 25%, 15%, and 10%, the 4-firm concentration ratio is $30 + 25 + 15 + 10 = 80%.

Significance:

• Indicates Market Structure: A high concentration ratio (e.g., a 5-firm ratio over 60%) suggests an oligopoly or, in the extreme case of 100%, a monopoly. A low ratio suggests a more competitive market structure like monopolistic or perfect competition.

• Measure of Market Power: A higher ratio implies greater market concentration and, potentially, greater market power for the dominant firms, allowing them to influence price or output.

• Regulatory Scrutiny: Regulatory bodies (like the Competition and Markets Authority) use concentration ratios to identify industries that may require closer investigation for potential anti-competitive behaviour (such as collusion).

Reasons for Collusive and Non-Collusive Behaviour

Due to interdependence, firms in an oligopoly can either collude (cooperate) or compete (non-collusive behaviour).

Reasons for Collusive Behaviour (Cooperation)

• Increased Profits: By acting together, firms can effectively behave as a monopoly, restricting output and raising prices to maximise joint profits (supernormal profits).

• Avoid Uncertainty/Risk: Collusion reduces the risk associated with unpredictable competitor actions, especially the danger of destructive price wars.

• Few Firms/High Concentration: The fewer the firms, the easier it is to organise, monitor, and enforce a collusive agreement.

• Similar Costs/Demand: If firms have similar cost structures and face similar demand conditions, it's easier to agree on a price.

• High Barriers to Entry: Prevents new firms from entering and disrupting the collusive agreement, making long-run supernormal profits more secure.

Reasons for Non-Collusive Behaviour (Competition)

• Legal Penalties (Anti-Trust Laws): Laws against collusion (cartels) are severe, providing a strong disincentive.

• Incentive to Cheat (Prisoner's Dilemma): Individual firms have a strong incentive to secretly 'cheat' on a collusive agreement by slightly lowering prices to gain a larger market share, potentially breaking the agreement.

• Numerous Firms/Low Concentration: More firms make agreements harder to coordinate and police.

• Non-Homogenous Products: Product differentiation makes it difficult to agree on a single price.

• Significant Differences in Costs/Objectives: Firms with varying cost structures (e.g., due to different economies of scale) or differing business objectives (e.g., profit maximisation vs. sales maximisation) find it difficult to agree on a common price or output strategy.

• Recession: During a recession, firms may compete fiercely on price to maintain sales volume.

Overt and Tacit Collusion; Cartels and Price Leadership

Overt Collusion

• Occurs when firms explicitly agree to limit competition, such as fixing prices or output levels. It is usually illegal.

• Cartel: The most formal and restrictive type of overt collusion. It is a formal agreement among firms to coordinate production and price decisions to act as a collective monopoly. The most well-known example is OPEC (Organization of the Petroleum Exporting Countries).

Tacit Collusion

• Occurs when firms coordinate their behaviour without explicit communication or formal agreement. They simply observe each other's actions and follow suit. It is often much harder for regulators to prove.

• Price Leadership: A common form of tacit collusion where one dominant firm (the price leader, often the largest or most respected) sets the price, and other firms in the industry implicitly agree to follow that price. This results in price rigidity in the market.

The Prisoner's Dilemma

Game Theory is the study of strategic decision-making in situations where the outcome for one agent depends on the actions of other agents. It's used to model the interdependence of firms in an oligopoly.

The Prisoner's Dilemma (Simple Two-Firm/Two-Outcome Model)

This scenario illustrates why two firms may not cooperate, even if cooperation would lead to a better outcome for both.

Context: Two oligopolistic firms, Firm A and Firm B, must decide whether to set a High Price (collude/cooperate) or a Low Price (compete/cheat). The outcome (payoff) is measured in profits.

Analysis:

• Individual Rationality: Each firm's dominant strategy is to choose a Low Price.

  • For Firm A: If B chooses High Price, A is better off choosing Low Price (£15m vs .£10m). If B chooses Low Price, A is still better off choosing Low Price (£7m vs. £5m).

  • For Firm B: The logic is symmetrical.

• Nash Equilibrium: The outcome where both firms choose Low Price (A: 7, B: 7) is the Nash Equilibrium (the stable outcome where neither firm has an incentive to unilaterally change their strategy, given the other firm's choice).

• The Dilemma: Both firms acting in their individual best interest (choosing Low Price) leads to an outcome (£7m each) that is worse than if they had cooperated and chosen High Price (£10m each). This demonstrates the inherent instability of collusion.

Types of Price Competition

Firms in an oligopoly may occasionally engage in price competition despite the risks.

• Price Wars: A cycle of competitive price cutting, where firms continuously lower prices to undercut rivals and gain market share. This typically leads to lower profits for all firms involved.

• Predatory Pricing: Setting prices below average variable cost (AVC) with the sole intention of driving competitors out of the market. Once rivals are eliminated, the firm can raise its prices and exploit its monopoly power. This practice is illegal in many jurisdictions.

• Limit Pricing: Setting the price low enough to deter the entry of new firms (potential competitors) into the market. This is often done by setting the price at or just above the new entrant's average cost (AC), making the prospect of entry unprofitable. Incumbent firms can maintain this price because of their existing economies of scale and lower cost structures.

Types of Non-Price Competition

Due to the risks of price competition (price wars), oligopolies often compete fiercely using non-price strategies, aiming to increase brand loyalty and differentiate their product.

• Product Differentiation: Enhancing the product to make it stand out from rivals, through:

  • Quality and Design: Improving the durability, performance, or aesthetic appeal of the product.

  • Branding and Packaging: Creating a strong, recognisable, and trusted brand identity.

• Advertising and Marketing: High spending on campaigns to increase product awareness, persuade consumers, and build brand loyalty, making demand for the firm's product more inelastic.

• Innovation and Research & Development (R&D): Developing new products, features, or technologies (e.g., in pharmaceuticals or technology sectors) to gain a competitive edge.

• Sales Promotion: Offering special deals, loyalty schemes, coupons, or competitions to attract and retain customers (e.g., supermarket loyalty cards).

• Customer Service: Providing excellent after-sales care, extended warranties, and technical support.

• Distribution Channels: Offering convenient or exclusive ways for consumers to access the product (e.g., exclusive retail partnerships, next-day delivery).