3.4.4 Oligopoly

• Market concentration:


  The degree to which the output of an industry is dominated by a few large firms.
• Concentration ratio:


  The market share of the largest firms in an industry. E.g. the 3 firm concentration ratio is calculated by adding up the market share of the largest 3 firms.

  If a market is described as 'concentrated' that means it has a high concentration ratio.
• Oligopoly:

  A market structure with the following characteristics:

  -A concentrated market dominated by a few (2-6) large firms.

  -Firms are interdependent (actions of one firm affect other firms in the industry).

  -Products are usually differentiated.

  -Barriers to entry are high.
• Collusive oligopoly:


  Firms co-operate with each other to increase profits. This could involve:

  -An agreement to increase prices

  -An agreement to restrict output (and therefore keep prices high)

  -An agreement for certain firms not to sell in certain geographical areas

  -An agreement to keep advertising spending low
• Formal collusion (AKA cartel or overt collusion):


  When firms make an agreement to co-operate.
• Tacit collusion:

  Collusion without a formal agreement. Firms collude by following unwritten rules, customs and practices.

  A form of tacit collusion is price leadership. This is when firms in an industry follow (copy) the pricing decisions of one dominant firm.
• How can game theory be used to explain collusive behaviour?


  -If firms collude they will both sell at a high price. This maximises their joint profits.

  -However, each firm has an incentive to break/cheat the collusive agreement by selling at a low price. This would increase Firm A's profits, and reduce the profits of Firm B (interdependence).

  -Firm B would then react by reducing their prices (price war) and both firms would end up with lower profit than their initial profit.
• Adv (+) and disadv (-) of collusive behaviour:

  (+) Increased profits

  (+) If barriers to entry are high, then it will be difficult for a new firm to enter the market and disrupt the agreement

  (+) If an industry is made up of a small number of established firms then there may be a high degree of trust between them making successful collusion more likely.

  (-) Collusion is illegal and can result in fines

  (-) A firm may break the agreement (as game theory predicts). This may result in a price war

  (-) High prices may attract new entrants to the market who may undercut existing firms.
• Competitive oligopoly:

  In a competitive oligopoly, firms don't collude. Instead, they compete through either price or non-price competition.
• Types of price competition:

  1) Price wars - A situation where several firms in the market lower prices to undercut each other in order to gain or defend market share. This tends to arise in markets where brand loyalty is weak, e.g. supermarkets.

  2) Predatory pricing - When an existing firm lowers prices to force a new entrant out of the market. If they are successful in forcing the new entrant to exit the market they can then put prices back up.

  3) Limit pricing - When firms set a low price to discourage new entrants from joining (barrier to entry).
• Types of non-price competition:

  Successful non-price competition reduces the closeness of substitutes and makes the product appear more unique. This reduces the PED of the product.

  -Advertising

  -Loyalty cards

  -Branding

  -Packaging
• Adv (+) and disadv (-) of an increase/decrease in market concentration

  ↑concentration -> ↓competition therefore closer to monopoly. (adv and disadv for monopoly)

  ↓concentration -> ↑competition. (adv and disadv of increase in competition)