Wednesday, 15 December 2010

Oligopolies - Notes from A Level Economics textbook

Notes taken from ‘Economics-A Level’ by Alain Anderton. Chapters 52-54
By Komilla Chadha
The importance of oligopoly 
  • Most markets are oligopolistically competitive which means they are dominated by a few suppliers.
  • Even though this is arguably the most important economic market structure there is no one theory which is used to explain in. In this post I hope to explain some of these theories.
Market Structure
  • There are some key aspects to oligopolies and we will look at them now.
  • The first is that the industry is highly concentrated. What this means is that regardless of how many firms exist in an industry there are a few top e.g. in a market where there are 100 firms if for arguments sake the top three firms have 80% market share then it is clear that the market is highly concentrated.
  • Firms must be interdependent. This means that the activity of one firm must affect the others e.g. if ASDA decides to sell more cookies at lower price then this will affect Tesco because ASDA is gaining Tesco’s market share.
  • It is also assumed that there are barriers to entry in this market for if they weren’t then the market would not be highly concentrated.
Market Conduct
It is important when we examine different market structures we identify their market conduct as this usually defines them.
  • Firms in oligopolies compete through non-price competition (we will see later why they don’t compete on price competition). Non-price competition focuses on utilizing the Marketing Mix (promotion, place, product and price - obviously not price in this case) as well creating some form a brand and brand loyalty because branded products sell faster than non-branded products.
  • Price rigidity - Prices in the oligopoly market structure are seen to change far less than any other market even though underlying costs of production may be changing.
  • L-shaped average cost curve - Over a longer period firms in oligopoly experience efficient scale of production. This is why they are described as having an L-shape rather than an U-shape.
  • Collusion - Firms in oligopolies appear to collude very often and this will be looked at in more detail in the next section.
Collusive and non-collusive oligopoly 
  • When oligopolistic firms compete against themselves they are called non-collusive or competitive oligopolies.
  • Collusion, though, is normal because there are strong incentives to collude.
  • By colluding firms can act like a monopoly and maximise profits.
  • By colluding they form a cartel (an organisation of producers which exists to further the interests of its members, often by restricting output through the imposition of quotas, leading to a rise in price). 
  • A formal collusion is where firms make an agreement to restrict competition, reduce output, raise prices and keep competitors out of the market. 
  • For this to form there are a few conditions that are required.
  • The first is that there has to only be a few firms so that it is easy to organise. 
  • Cheating must be prevented. So there must be trust that none of the firms involved will whistle-blow because then the other firms will have hefty fines to pay (remember BA and Virgin example). Also, another form of cheating is using the supernormal profits to expand and charge a lower price. By doing this is firm cheating gains the market share of the other firm as well as starting a price war off. Price wars are not good because in the long-run all firms are left with not as much supernormal profit as they could have.
  • Potential competition needs to be eradicated as firms are attracted by the abnormal profits. To this firms will need to arrange ways to create barriers to entry. 
  • Formal collusions are illegal in the EU, UK, USA and many other countries unless they are in the public’s interest. However, covert collusions to take place because they are hard to prove. There is one famous example of a formal cartel which is OPEC. OPEC is an organisation of oil producing firms and countries which sets prices and production quotas in order to prevent the oil from running out fast.
  • Tacit collusion is when firms collude without speaking or organising. For example if Tesco price their bread at £1.88 ASDA will too. This is legal and is part of an oligopolies market conduct. 
The kinked demand curve theory of oligopoly 
The kinked demand theory essentially shows that if a competitor in an oligopoly raises price a firm will keep their prices the same and if they decrease their prices then the firm will start a price war.
The neo-classical kinked demand curve model
  • This shows that if a firm increases prices the other rival firms keep their prices low in order to capture the market share of the firms that raises prices. This means that demand is elastic when this occurs. 
  • Now suppose if a firm decides to reduce prices instead then other firms will follow suit because they do not want to lose their market share. This means demand is inelastic as price becomes lower. 
  • So if we put both the elastic and inelastic demand curves together we form a kinked demand curve.
  • The point at which they meet at is the point of tacit collusion where demand is neither elastic or inelastic as all firms have the same price.
  • This theory also provides an explanation of why prices are stable in oligopolies. 
  • At the point of tacit collusion MC must equal MR because firms are profit maximisers in oligopolies. There could be a range of different marginal cost curves that cause this to occur. This means that if the marginal cost of a firm were to increase they could just accept the reduced profit and leave prices unchanged. As if they were to increase price their demand would be elastic and the would lose market share.
Game theory
  • The kinked demand can be seen as a simple example of game theory.
  • It shows that firms are interdependent and need to keep prices the same in order to be successful for if they all start a price war then they ALL lose out. 
Weakness in theory
  • It does not explain how the original price came about.
  • It does not take into account the affects of non-price competition
  • Assumes that firms always react in this way. In reality firms have different reactions.
Game theory 
Game theory explores the reactions of one player to changes in strategy by another player. 
Dominant strategies 
  • Dominant strategy exists when a single strategy is best for a player irrespective of what strategy the other player adopts.
  • We can use a payoff matrix to show no matter how the other firm behaves the firm is better of raising prices.
Nash equilibrium 
  • Dominant equilibria don’t occur all too often in reality.
  • John Nash used a payoff matrix to show that a firm’s strategy is based on the other firms strategy.
  • Neither player is able to improve their position given the choice of the other.
  • For example, if one firm lowers prices - the rival firm must lower prices to otherwise they will incur a loss in profits.
Price Stability
  • As we have seen throughout this post keeping prices constant is of utmost importance. 
  • The zero sum game is one where one player is exactly offset by the losses of another player. 
  • The maximin strategy is a more popular strategy. This is where a firm works to its minimum risk. If by increasing prices the maximum risk it has is of £5 million and if by remaining unchanged the maximum risk the firm has is of £2million. The firm will pick the latter option regardless of the possible gains of increasing prices. 
Non-price competition 
  • By non-pricing competition firms don’t aim to drive out their competitors as this is very risky. They focus more one why the consumer should pick them and focus on increasing brand loyalty.
  • Ideally oligopolists would like to turn into monopolies and enjoy monopoly profits however this is not possible.
  • Branding allows firms to enjoy supernormal profits. There are two main reasons why this is the case.
  • The first  is that a strong brand has a few good substitutes which makes demand inelastic and consumers prepared to pay premium prices.
  • The second is that it is hard for competitors to challenge these brands for example it is hard for competitors to steal Kellog’s demand. In the short-term brand create monopoly profits and the long-run a few firms like Ovaltine maintain this.
  • Brand are difficult to create this is why firms prefer to pay hefty prices for existing firms.
  • In the 1950s cartels were made illegal. Before then cartels were popular in manufacturing industries.
  • Cartels are usually unstable because they rely too much on the other firm not cheating. Given that there are incentives to cheat many collusions break.
  • One way firms can cheat is by offering secret discounts or by having a sale.
Multi-firm, multi-strategy options 
  • So far we have just looked at duopoly scenarios however in reality there are many more firms hence many more strategies.
  • Game theory predicts a large number of different outcomes and this is not surprising given the amount of scenarios exist in oligopolies.

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