Theory of the firm: Oligopoly
Introduction
An oligopoly is a market dominated by a few large ______________. The degree of
market concentration is very high (i.e. a large % of the market is taken up by the leading
firms). The firms sell either identical (cement) or differentiated products (motor
vehicles), and significant ____________ to entry into the industry exist.
Characteristics/assumptions of an oligopoly
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A few firms dominate the market (or a large number of firms in a market
dominated by only a few).
Each firm produces branded products
Likely to be significant entry barriers into the market in the long run which
allows firms to make abnormal profits.
Interdependence between competing firms. Businesses have to take into account
likely reactions of rivals to any change in price, output, marketing strategies and
location.
The significance of concentration ratios
A common indicator of concentration (or the degree of market share held by the
dominant firms) in an industry is the concentration ratio. Concentration ratios are
expressed in the form CRx where X represents the number of the largest firms. For
example, a CR4 would show the % of market share held by the four largest firms in an
industry.
Total concentration
100% means an extremely concentrated oligopoly. If for example CR1= 100%,
there is a monopoly.
Low concentration
0% to 50%. This category ranges from perfect competition to oligopoly.
Medium concentration
50% to 80%. An industry in this range is likely an oligopoly.
High concentration
80% to 100%. This category ranges from oligopoly to monopoly.
UK industries with the highest five-firm concentration ratios include the following:
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Sugar: 99%
Tobacco products: 99%
Gas distribution: 82%
Oils and fats: 88%
Confectionery: 81%
Interdependence and its impact on non-price competition
The key feature that is common in all oligopolies is that there is interdependence. As
there are a few firms that dominate the industry each firm needs to take careful notice of
each others’ actions. Interdependence can often result in collusion – either tacit or
formal.
Interdependence & collusion explained using Game theory
Game theory may be applied in situations in which decision makers must take into
account the reasoning of other decision makers. It has been used, for example, to
determine the optimum price at which to sell products or services, the best site for a
factory, and even the behaviour of certain species in the struggle for survival.
The ongoing interdependence between businesses can lead to implicit and explicit
COLLUSION between the major firms in the market. Collusion occurs when businesses
agree to act as if they were in a monopoly position.
Example: The prisoner’s dilemma
The prisoner's dilemma is the story of two criminals, Juan and Maria, who have been
arrested for a heinous crime and are being interrogated separately. Each knows that if
neither of them talks, the case against them is weak and they will be convicted and
punished for lesser charges. If this happens, each will get one year in prison. If both
confess, each will get 20 years in prison. If only one confesses and testifies against the
other, the one who did not cooperate with the police will get a life sentence and the one
who did cooperate will get parole (no prison sentence).
TASK 1: In your groups devise a table below that illustrates the various possibilities for
both prisoners.
TASK 2: Now choose how you as a group representing Juan or Maria are going to plead.
TASK 3: Individually complete the following exercise:
Two firms, A and B, are making sealed bids for a government contract to build a road
bridge across a river. Only two bids are possible, either a low price bid or a high price
bid. The high price bid will lead to a profit of $20 million, whereas a low price bid will
lead to a profit of $14 million. If the firms bid at the same price, they will be asked to
share the job and each will earn half the profits. If they submit different bids, the firm
offering to build at a lower price will get the job and all the profits.
Draw up a matrix like in the Prisoner’s Dilemma to show the possible outcomes under
competing and co-operating behaviour.
Collusion between firms
Firms may engage in formal collusion to maximize joint profits (see below) and to reduce
uncertainty. Collusion may take the form of agreeing on the price to charge, the market
share the firms are going to have and/or the advertising expenditure each firm is going to
undertake.
Controlling supply in a cartel
A cartel is a group of firms that decide to engage in a price fixing agreement. The aim
of this is to maximize joint profits and act as if the market was a pure monopoly. For
the cartel to work effectively the producers must control __________________ to
maintain an artificially high price.
In a cartel the firms produce separately but act as one firm in determining output and
price. In essence the firms act as a pure monopoly and will set an output (and subsequent
price) where ______________ (see diagram below). Firms will then agree to set price at
the profit maximizing level and market supply is allocated on the basis of a quota system.
Although the cartel as a whole is maximising profits, the individual firm's output quota is
unlikely to be at their profit maximising point. For a firm, expanding output and selling at
a price that undercuts the cartel price can achieve extra profits. Unfortunately if one firm
does this, it is in each firm's interests to do the same. (Game theory).
Collusion is easier to achieve when there is a relatively _______________ number of
firms in the market and a large number of customers, market demand is not too variable
and the individual firm's output can be easily monitored by the cartel members. There
should also be significant ______________________________ so that firms would not
be afraid that their arrangements would be disrupted by the entry of new firms.
The OPEC oil cartel -this is legal cartel between oil producing countries to control the
output (and thus price) for 45% of total world oil supplies. However, there have been
frequent tensions within the cartel - particularly when oil prices have been lower and
leading oil producers have seen a slump in their oil export revenues and tax receipts.
Why does price-fixing collusion often break down?
Some economists believe that price-fixing cartels are inherently unstable and that at some
point they inevitably come under pressure and finally break down. There are a number of
sources of potential instability for price fixing cartel arrangements.
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Falling ______________ creates tension between firms e.g. during an economic
downturn
The entry of non-cartel firms into the industry increases market ______________
and puts downward pressure on the cartel price
Exposure of illegal price fixing by the Government causes an arrangement to end
The most common reason, however, is that some firms try to capture a larger
share of the market by cheating on the agreement and selling more or reducing
price- there is too much incentive to produce at their own profit maximizing level.
Interdependence and non- collusive behaviour
Firms which do not formally collude still have to consider carefully other firms’ reactions
before changing their price or advertising strategy. The kinked demand curve below
illustrates how firms’ are concerned about how their competitors will react to changes in
price.
The kinked demand curve
An oligopolist faces a downward sloping demand curve but the ________________ may
depend on the reaction of rivals to changes in price and output. Assuming that firms are
attempting to maintain a high level of profits it may be the case that:
(a) Rivals will not follow a price increase by one firm - therefore demand will be
relatively _____________ and a rise in price would lead to a fall in the total revenue of
the firm
(b) Rivals are more likely to match a price fall by one firm to avoid a loss of market
share. If this happens demand will be more ________________ and a fall in price will
also lead to a fall in total revenue.
The kink in the demand curve at price P1 and output Q1 means that there is a
discontinuity in the firm's marginal revenue curve (why?- diagram?). If we assume that
the marginal cost curve is cutting the MR curve through the line of discontinuity then the
firm is maximising profits at this point.
In the diagram below, we see that a rise in marginal costs will not necessarily lead to
higher prices providing that the new MC curve (MC2) cuts the MR curve at the same
output. The kinked demand curve theory suggests that there will be price stickiness
in these markets and that firms will rely more on non-price competition to boost
sales, revenue and profits.
An increase in raw material prices causes an
upward shift in the firms’ marginal cost
curve (MC1 to MC2)
With a kinked demand curve (and
discontinuity in the MR curve) there may be
no change in the profit maximizing price and
output
The importance of non-price competition
The nature of interdependence in an oligopoly means that prices are often rigid –that is
they don’t vary much between competitors and over time. This can be explained above
with the theory of the kinked demand curve and the theory underpinning formal collusion
(price fixing).
Non-price competition focuses on other strategies other than price competition for
increasing market share. Firms may use non-price competition because they may have
agreed not to compete by means of price (collusion) or because they are afraid they will
lose out in a price war. Consider the highly competitive market for football boots. The
dominant players in this industry compete using:
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Branding
Celebrity product endorsement
Other marketing/promotion strategies
Innovative use of technology to develop new soles (or innovative use of
marketing to make you think that new soles have been developed)
Price competition
That said, price competition can happen in oligopolistic markets and price wars have
been known to break out particularly in the newspaper industry in the UK. Price wars
may be good for consumers in the short run but damaging in the long run- why?
Price leadership in an oligopoly
When a few firms have a dominant position in the market the oligopoly may experience
price leadership. The firms with lower market shares may simply follow the pricing
changes prompted by the dominant firms. We see examples of this with the major petrol
retailers.