Monopoly

In this video I look at what is a monopoly? what characteristics does it have? Why might a firm want to be one? How does it do its pricing? What does a monopoly diagram look like? What efficiencies are associated with a monopoly? What are the costs and benefits to consumers? 


I also made a booklet on this, please click here to see it.

Monopolistic Competition

In this video I explore what monopolistic competition is with examples of it, characteristics required to achieve this, diagrams of it in the short-run and long-run.




Monopolistic Comeptition by Komilla Chadha

Pricing Strategies

In this video I explore what are the various pricing strategies (cost-plus pricing, price discrimination, predatory (destroyer) pricing, limit pricing, price skimming and penetration pricing. I look at some of the benefits and costs of these strategies and what are the diagrams used to shows them.

Game Theory: Kinked Demand Curve Theory

Game Theory: Kinked Demand Curve

The Kinked Demand theory is a theory of what a oligopolistic firm’s demand curve should look like, it has three main parts. 

The first part is the equilibrium E. It is assumed in this theory that at this equilibrium MC=MR. This is the standard output an oligopolistic firm should operate at. This point can be known as tacit collusion. In order to understand the other two parts to this theory we will explore two scenarios.

Scenario One

Imagine in an oligopolistic industry, if one firm decides to increase the price then the competitors will respond by not changing their price so that they can capture the market share lost the firm who has increased prices. This implies that demand is price elastic. For if it was not then all the other firms would increase prices too. This is why above the price P the demand curve is elastic.

Scenario Two

Imagine now in an oligopolistic market that a firm decides to lower its price. Other rival firms in the market will follow suit to stop the firm from capturing market share and a price war will break through. This implies that demand is inelastic because firms are following suit which means demand will not change much. This is why at an price below P the demand curve is inelastic.

The kinked demand curve shows that firms are better off engaging in non-price competition and in tacit collusion. It is a great way to show how firms loose out by increasing or decreasing their price in an oligopoly.

Competitive Oligopolies: Prisoners Dilemma (Game theory)

In this video I explore how the prisoners dilemma shows how firms in an oligopoly behave through dominant and non-dominant strategies.

Competitive Oligopolies - Prisoners Dilemma (Dominant and Non-Dominant Strategies)

The Prisoners Dilemma is a form of Game Theory used to show how firms in an oligopoly are interdependent. We will look at how the Prisoners Dilemma shows how firms can have a dominant strategy or not have a dominant strategy.

A dominant Strategy

A dominant strategy is were a firm has an incentive (to gain market share and increase profits) no matter what the other firm does. 

		Firm A
Firm B		£2.00	£1.50
	£2.00	£200k each	£100k (B) £1mil (A)
	£1.50	£1mill (B) £100k (A)	3 million each

So both Firm A and B have an incentive to keep their price at £1.50 regardless of what the other firm keeps. But you might be wondering then what has this got to do with interdependence? The ‘pay-off matrix’ shows that if Firm A decided they wanted to keep their price at £2.00 so they can pursue other objectives such as Corporate Social Responsibility then Firm B can only make a maximum profit of £1million this shows their interdependence. As, if they were not interdependence their maximum amount of profit would not be reliant on the price set by rival firms.

No Dominant Strategy

This when a firm has to react to what another firm does in order to be better off. So the difference is that if they had a dominant strategy no matter what another firm does they will be better off at Price X, but here they can only be better off at Price X if the rival firm also charges at Price X or the other firm will need to follow suit to recapture lost market share and profits. This might sound a bit confusing so I will explain this using the ‘pay-off matrix’ below.

		Firm A
Firm B		£1.50	£1.30
	£1.50	£3 million each	£1.5m (B) £5m (A)
	£1.30	£5m (B) £1.5m (A)	£1 million each

So if again we look at firm B who is deciding whether to price at £1.50 or £1.30. This decision will be based on firm A (unlike when the firm was choosing between £2.00 and £1.50 and had a dominant strategy). For example, if firm B charges at £1.50 it might loose out because firm A is charging at £1.30 and if it chooses to charge at £1.30 it might loose out again if the firm B is charging at £1.30. So this strategy also shows interdependence because it shows how a firm bases its prices on competitors. The non-dominant strategy which seems to be more common also shows why firms have an incentive to collude as well as cheat and engage in non-price competition. 

Measure of Market Concentration: Concentration Ratio

What is a concentration ratio?

A concentration ratio is a percentage which shows the percentage of output/sales of a group of firms in an industry. We usually show this b stating whether it is the top 2, 3, 5 etc. firms e.g. the 3-firm market concentration for the grocery market is 64.7% in 2008. 

Why is this important?

From this measurement we can induce what market structure a particular industry belongs to. For example if a few firms dominate the market (oligopoly) the concentration ratio for the top x-firms will be high whereas if no firms dominate the market (perfect competition) then the concentration ratio for the same number of firms will be significantly lower. 

In an exam, as far as my knowledge goes you can be asked to calculate it, verify it or use it to suggest what market structure an industry belongs to.

Shut-down point

 In this video I explain where the shut down point exists and why. 

Law of Diminishing Returns

The law of diminishing marginal returns

What you need to know...

The law of diminishing returns is an economic concept which exists to explain the parabola shape of the short-run average cost curve.

The first most important thing to remember is that in the short-term at least one factor of production (land, labour, capital and enterprise) is fixed, for example, the time period a firm only has three printers/computers/machines.

The average cost curve can be split into three parts: the downward sloping part, the middle part and the upward sloping curve. 

The downward sloping curve

The downward sloping part shows that as a firm increases labour the productivity increase. The marginal product (additional product per worker) increases too. This section seems logical.

The middle part

The middle part is where the total productivity is increasing but the marginal product is decreasing. This is because the resources are fixed. For example, if I own a gardening company which has two lawnmowers, when I recruit my third person the amount of productivity they can add to the business will be less than the first and second person as there are only two lawnmowers. 

The upward sloping curve

This is when total productivity starts to fall and the marginal product is negative. This is because what happens is the workers start getting in each others way and the motivation disappears. This makes sense because if there are too many people then no-one will work (just think of large study/revision get togethers). 

Economies and Diseconomies of Scale

In this video I look at the different types of internal and external economies and diseconomies of scale. 

Mergers and Demergers

Mergers and Demergers 

How can firms grow?

Firms can grow in two ways: internally and externally.

Internal growth is the growth of a firm through the re-investment of profits.

External growth occurs when a firm integrates with another to create a bigger firm.

What are the different external methods used to grow?

There are four different types of integration: horizontal, forward vertical, backward vertical and conglomerate. 

Horizontal: This is when a firms of the same industry and stage of production integrate. For example a flour mill integrates with another flour mill. This provides a fairly quick way of capturing marker share and achieving economies of scale.

Forward vertical: This is when a firm integrates with another one in the same industry but at a later stage of production for example a mill integrating with a bakery. This allows firms to control it outlets which helps to capture profits and take advantage from economies of scale.

Backward vertical: This is when a firm integrates with a firm in the same industry but at an earlier stage of production for example a mill integrating with a farm. This helps to create barriers to entry as firms benefits from controlling inputs and capturing profit that would have otherwise gone to suppliers.

Conglomerate: This is when firms of two different industries integrate for example when a mill integrates with a cinema chain. This helps diversify the risk for firms and achieve certain economies of scale e.g. financial economies.

Why merger or takeover?

The main purpose behind merging appears to become a dominant firm in a market either through creating barriers to entry or making costs savings and subsequently reducing prices. Conglomerate integration seems to be different this is solely done to diversify risk. However, it can be conceived  that by diversifying risk they can lower prices in one of the markets and dominate it.

Why stay small and not grow?

The main advantage of growing big is to achieve economies of scale. However, there are many advantages of staying small. I have listed some below:

• They are easier and cheaper to set up. There is less paper work involved.
• When targeting a niche market you don’t need a big firm and makes no sense to have a big firm when the market is small.
• They can provide a more personal service to consumers and better treatment to employees.
• Easier to react to changes in the market (demand and supply)

Why do demergers occur?

• To improve communication and managerial control.
• To motivate staff
• It is a quick way of raising money
• Perhaps to increase profitability if diseconomies of scale is occurring

Barriers to entry and exit

In this video I go through all the barriers to entry and exit. 

Oligopolies - Notes from A Level Economics textbook

Oligopolies    

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.

Branding 

• 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.

Collusion 

• 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.

Public Private Partnerships

 In this video I look at types of PPPs, why they exist and their advantages and disadvantages. 

Public Private Partnerships

What are they?

This is an organisation which includes both the private sector and public sector. These schemes have been a key way to improve services since 1997. 

Why do they exist?

The public sector, in theory, has more power and funding which can benefit the private sector and the private sector is believed to be more efficient in terms of price, output and choice which is great in terms of promoting consumer welfare.

Examples of PPP

Partial Privatisation - When a public firm is partly owned by the private sector.

PFI (Public Finance Initiative) - This is when a private sector firms produces a service that the government provides e.g. roads, schools, hospitals etc and leases it out to the government.

Contracting Out - This is when the private sector delivers services such as hospitals, schools etc (think private schools, private healthcare, toll roads)

Contracting out is usually done in partnership with ‘Competitive tendering’ - This is where the private sector is given the opportunity to provide public sectors by bidding for this opportunity. This means that firms need to make their plans seems the best for consumers because the government picks the firm with the best deal to consumers.

Pros of PPP

1. Private sector firms are guaranteed to make a profit.
2. The government can produce more as it does not have to pay up front. In the short-term it costs the government much less.
3. The evidence of the success of this we have already seen e.g. in recent years the amount of hospitals, schools etc that have come about has never been this high.
4. As the cost is spread over a longer period of time the government does not have to raise taxes or borrow money in the short-term. 

Cons of PPP

1. Private sector firms have an incentive to charge sky high prices and make a large profit as this is a monopsony market structure and this is bad for consumers and the government.This higher profit could have gone to the government.
2. Is the governments (in terms of competitive tendering) interested in the welfare of consumers or how much tax revenue they will make?
3. Higher cost once you add all the rents.
4. Private firms may cut cost to maximise profit e.g. construction material might be poor quality and this could subsequently lead to poor motivation by workers.