Characteristics of oligopoly
Few large dominant firms
There are a small number of dominant firms within the market and therefore the market is likely to have a high concentration ratio.
High barriers to entry and exit
There are high barriers to entry and exit within oligopolistic industries. This is often due to high startup costs which can be seen in oligopolistic industries such as the airline industry. For example, it costs hundreds of millions of pounds to buy several airplanes and therefore this is a massive barrier to entry for firms trying to enter the market. In addition to this, there is a high level of sunk costs for firms if they were to leave the market, thus acting as a barrier to exit. For example, in the smartphone industry lots of money is spent on advertising, product development and market research. When a phone company exits the market, these cost cannot be recovered. Therefore, phone companies tend to stay in the market for as long as possible which would be in contrast to a company in an industry with lower sunk costs.
High concentration ratio
There are several types of concentration ratio depending upon the number of firms included within the calculation. For example. A 4-firm concentration ratio takes the combined market share of the 4 biggest firms within the industry which is then expressed in relation to the overall market share. Therefore it can be concluded that a higher concentration ratio reflects lower levels of competition and a lower concentration ratio reflects higher levels of competition. A 5-firm concentration ratio would a similar calculation but instead would include the top 5 firms and 4-firm concertation ratio would be a similar calculation but would include only the top 4 firms etc etc. Oligopolistic industries such as the airline industry have high concentration ratios as they are dominated by only a small number of firms.
Interdependence of firms
Firms changing their prices within an oligopoly market structure need to consider the reaction of competitors. For example, firms within the market often lower their prices as soon as another firm does and therefore the overall revenue gained by firms within the market fall. As a result of this interdependence, prices within the market are often very rigid.
As there is product differentiation within the oligopoly market structure, firms have the ability to set prices. Therefore both average revenue and marginal revenue are downwards sloping on the oligopoly diagram.
Firms operating within an oligopoly market structure tend to compete through non-price mediums such as advertising. This can be seen in the mobile phone industry by big companies such as Samsung and Apple. Although both phones may be more expensive than similar alternatives, the strong brand they’ve created gives them a competitive advantage.
Firm’s profits maximize
Firms operate at the point where marginal cost is equal to marginal revenue.
Kinked demand curve
Firm’s within an oligopoly are profit maximizers and therefore produce at the point where marginal cost is equal to marginal revenue. This gives a price level of P1 and a quantity of Q1. The kink in the demand curve shows the price rigidity and interconnectedness of firms within an oligopoly market structure. Above the price level of P1 the demand/average revenue curve turns more elastic. This means that if firms were to increase their prices above P1, the change in quantity demand would be greater than the change in price level. Therefore, the firm’s total revenue and profit would decrease. On the other hand, the demand/average revenue curve becomes slightly inelastic below the price level P1. This is due to the interconnectedness of firms within oligopolistic markets, meaning that if one firm reduces their prices, so will all of the other firms within the market. Therefore, demand is relatively inelastic below P1 as they would gain no price advantage as competitors would also drop their prices (the percentage change in quantity will be less than proportional to the change in price). This means by doing so all firms suffer a decrease in total revenue and profit As a result of this, the market price tends to be very rigid and instead, firms compete through non price means such as advertisement.
Another key characteristic of the kinked demand diagram is the discontinuity that occurs in the marginal revenue curve. As a result of this discontinuity, firms will still keep a price of P1 regardless of a marginal cost increase given that it is within the vertical discontinuity. This is shown on the diagram where marginal cost increases from MC1 to MC2 whilst firms still operate at a price level of P1. Again this shows the price rigidity of oligopolistic markets as well as the disincentive for firms to raise or lower their prices given the elasticity changes before and after the kink in AR.
Calculation of n-firm concentration ratios
4-firm concentration ratio example:
Find the top 4 biggest firms
Firm A – 20%
Firm B – 14%
Firm C – 6%
Firm D – 15%
Firm E – 4%
Firm F – 16%
Firm G – 3%
Add the market share of the four firms together
Firm F – 16%
Firm D -15%
Firm B – 14%
Firm A – 20%
4-firm concentration ratio = 65%
This figure tells us that the top 4 firms within the industry make up 65% of the total market share. A 4-firm concentration ratio of around 60% usually indicates that the industry is oligopolistic. A 4-firm concentration ratio of 0-50% usually indicates a perfectly competitive market. If a single firm has a concentration ratio of 100% then this is considered a pure monopoly. However, in the UK any single firm that has a market share of 25% or more is considered a monopoly.
Simple game theory
Game theory is used to demonstrate the interdependence of firms and price rigidity within an oligopoly market structure. It does this by showing a firm’s decision given the expected reaction of a competitor.
For example, firm A and firm B both have a choice whether to increase their prices, or decrease them. The figures in the box represent the profit that each firm will make given their choice. Firm B’s profit is represented by the value on the right hand side, whereas firm A’s decision is on the left hand side.
If firm B decided to raise its prices and firm A reacts by raising their prices also, then both firms would make £20 million profit.
If firm B decided to raise its price and firm A reacted by lowering their price, firm B would make £10 million, whereas Firm A would make £24 million.
On the other hand, if firm A were to raise their price and Firm B where to lower their price then Firm A would make £10 million and firm B would make £24 million.
Furthermore, if Firm A were to lower their price and Firm B were to also lower their price, both firm’s would make £15 million.
Given the fact that the reaction to either firm increasing their price would be the competitor lowering their price, the best outcome for both of them given their expected reactions would be £15 million each. This is known as the nash equilibrium. Although £15 million is the best outcome for them both given their expected reactions, the most efficient outcome for both firms would be for both of them to raise their prices. By doing so they could both earn £20 million each. However, for this to occur there needs to be collusion from both firms in order to stop the competitor from lowering their prices given the firm’s decision to raise their price. Collusion often results in monopoly outcomes for consumers as they can now charge whatever they want without having to worry about competitors offering lower prices. Therefore, overt collusion is illegal. Although this is the case, tacit collusion is still legal. Both of these forms of collusion are explained below.
Types of collusion
This is known as informal collusion and often originates from price leadership. If there is a dominant firm within the market then other firms will follow their prices. This is because the dominant firm benefits from large economies of scale and therefore cannot be beaten price wise by the smaller firms. Therefore, all the smaller firms follow the prices that the price leader sets.
This occurs when firms within the market get together in order to formally set the market price for a good/service. As a result of this, firms are able to set prices similar to those within a monopoly market structure and therefore make large amounts of profit. Due to the extortionate prices and uncompetitive outcomes (poor quality goods, poor customer service etc) that this leads to, overt collusion is banned within the UK as well as in many other countries.
Reasons for collusive behavior
Small number of firms
If there are only a small number of firms within the market, it is easy for firms to get together with the intention to collude.
If firms within the market have similar costs then it is less likely that one firm will have an advantage over another firm. Therefore, all firms within the market have more incentive to collude than to try and get ahead of competitors through means such as price wars. In addition to this, it is much easier for firms to agree on the fixed price that is to be set. This is because firms within the market have very similar profit margins.
High entry barriers
If there are high barriers to entry within a market then firms do not have to worry about firms entering the market in the long run due to the large amounts of supernormal profit that they make. As potential new entrants in to the market will be put off by the high entry barriers, firms are able to keep making supernormal profits within the long run. Therefore, there is more incentive to collude knowing that they will be able to maintain the supernormal profit made through collusion in the long run.
Ineffective competition policy
If the competition policy is ineffective and less stringent, then firms within the market are more likely to get away with collusion. Therefore, there is more incentive for firms to collude.
Firms are less likely to cheat on a collusive deal if consumer loyalty is high. This is because regardless of the lower price level offered by the competitor that broke the deal, customers will continue to shop at their existing firm. This means that little revenue will be made by the firm through undercutting the fixed price agreed upon. Therefore any collusive deals made are more likely to stay intact.
Reasons for non-collusive behavior
Large number of firms
When there are a large number of firms within the market it can be difficult to organize collusion.
Low barriers to entry
Market structures that have low barriers to entry usually don’t make supernormal profits in the long run due to the fact that other firms see these supernormal profits and enter the market, removing supernormal profit in the long run. This is the same reason why firms that are in markets with low barriers to entry are less likely to collude. The large amounts supernormal profit that would be made by firms through collusion will be removed in the long run as more firms enter the market.
If one competitor has a large cost advantage then there is no need for them to collude. This is because they… Read more