Oligopoly

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Chapter 10 IB Economics

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Oligopoly IB Economics

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Learning Objectives At the end of this chapter you will be able to Explain the assumptions of oligopoly Distinguish between collusive oligopoly and non-collusive oligopoly Distinguish between formal collusion and tacit collusion Define a cartel Explain the role of game theory in oligopoly Explain and illustrate the kinked demand curve Explain and give examples of non-price competition

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Oligopoly Oligopolistic industries are dominated by large firms who have the majority of the market share There may also be a large number of smaller firms in the same market Think about the supermarkets – there are hundreds of little corner shops but have no real affect on the conduct or performance of the larger firms monopolistic

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Concentration ratios We use concentration ratios to indicate the market structure Concentration ratios are expressed in the form CR x where X represents the number of the largest firms CR4 would show the percentage of market share held by 4 firms The higher the percentage the more concentrated If the CR4 was 90% this would mean that 4 firms have 90% of the market which would be very concentrated and would indicate an oligopolistic market structure If the CR4 was 19% this would suggest low concentration and a monopolistic market structure Monopoly Perfect competition Oligopoly Monopolistic competition 0% 50% 100% 80% Low concentration Medium concentration High concentration

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Watch mjm foodie video http://www.youtube.com/watch?v=ElBF2D7IHAI

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Barriers to Entry A key feature of an oligopoly is the desire to want to keep other firms out of the industry If MES is large firms may stay out e.g. car industry If this barrier does not exist oligopolists will create barriers (artificial barriers to entry) as follows Limit and predatory pricing – a firm may lower its prices so that another cannot survive Advertising if you are a large firm you can spread the cost of advertising over a large number of units. If you are just entering you will need to match the amount of advertising but won’t have the number of units to spread the costs This could explain why there are only two detergent firms in the UK Multiplicity of brands – if consumers switch brands frequently a firm can capture a larger share of the market by having lots of brands e.g. soap powder manufacturers Predatory pricing - setting a price that may bankrupt a competitor firm in order to try to take it over

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Artificial Barriers to Entry Integration – to control the supply of resources and sources of distribution they can integrate – backwards, forwards, horizontally, vertically. This would enable them to use predatory pricing Non-price competition – techniques used to persuade customers to buy without changing the price and risk starting a price war e.g. BOGOG Branding – the brand should make demand more inelastic and encourage loyalty Research and development – create new products that give them an edge over their competitors Integration - combining with other firms Price war - where firms competitively lower prices to increase their market share

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Competitive oligopoly In this market structure firms pursue an independent strategy but they interdependent If one decides to increase its price and the others leave theirs the firm that raises its price will lose market share If one decreases its price then the others will lose market share if they do not do the same creating a price war where all lose revenue In this market structure firms have to anticipate what their competition are going to do before making decisions on price or output Oligopoly is characterised by reactive behaviour (firms react in response to other firms) Interdependent – actions by one firm will have an effect on the sales and revenue of other large firms in the market

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Kinked demand curve Because an oligopolist firm can be punished for price changes, prices tend to remain fairly stable We use the kinked demand curve to explain Price rigidity Interdependence uncertainty and preference for avoiding price wars The demand curve represents an oligopolist’s estimate of how demand will change with a rise or fall in price If it raises prices above OA the firm expects demand for its product to be relatively elastic (price sensitive) competitors will leave their prices Consumers will go to the competitor The firm will suffer a drop in its market share (the amount will depend on brand loyalty) Kinked demand curve – a theoretical approach that tries to analyse the reasons for price stability in oligopoly Brand loyalty – a measure indicating the degree to which consumers will purchase firm’s product rather than a competing product A

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Kinked demand curve When the price is cut below 0A the oligopolist expects demand to be relatively inelastic Rivals are expected to lower their prices too – few if any will be lured away from rival firms This may result in a price war The total revenue will fall The oligopolist expects profit to be lost whether price is raised or cut It is better for the firm to keep its price at 0A A

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Kinked demand curve The demand curve is also the average revenue curve As we know, marginal revenue is below average revenue (twice as steep) Because the demand curve changes in elasticity this gives the MR curve 3 different parts The upper most section relates to the elastic part of the demand curve The lower section relates to the inelastic demand curve We join the two MR curves with a vertical line This is known as discontinuous marginal revenue curve Quick review - ..\..\videos\Econ concepts in 60 seconds\Econ Concepts in 60 Seconds Kinked Demand Curve.flv Insert fig 12 P33 of Philip allan book

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Kinked demand curve A discontinuous marginal revenue curve is a region over which a change in marginal costs will not lead to a change in the firm’s price and output levels The marginal cost curve can shift up and down over this section of the curve and the oligopolist will not change price or output MR = MC applies to this whole section If marginal costs increase the oligopolist absorbs the whole cost by taking a cut in profit If marginal costs decrease the oligopolists profit levels will increase. Quick review - ..\..\videos\Greek guy\micro\kinked demand curve theory.flv Insert fig 12 P33 of Philip allan book

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Non-collusive Oligopoly When we talk about the kinked demand curve we are assuming that the oligopolies are only guessing what their competitors will do They are non-collusive – they don’t get together and collude (they don’t get together and decide to keep prices the same or put prices up) When they decide to change their price they are taking a gamble – if that gamble fails they will lose profit In theory, prices will be sticky – they will stay roughly the same

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Weaknesses of the Kinked demand theory There is no explanation of how the original price was arrived at (it does not explain price determination) The theory ignores non-price competition This is is an extremely important feature of oligopoly in the real world Evidence provided by the pricing decisions of real-world firms give little support to the theory Rival firms seldom respond to price changes as assumed in the model Firms may test rivals responses by changing prices If rivals did not change their price then surely the oligopolist would change their estimates of demand which would alter the demand curve Evidence shows that prices tend to be stable when demand conditions change in a predictable or cyclical way Also evidence shows oligopolists usually raise and lower prices quickly and by significant amounts both when production costs change substantially and when unexpected shifts in demand occur.

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Non-price competition Given the problems associated with price competition oligopolies engage in many forms of non-price competition such as advertising or promotions UK supermarkets use techniques such as In-store advertising/marketing Loyalty cards Increasing range of services e.g. cash back In-store chemists, post offices and currency exchange Home delivery services Discounted petrol at hypermarkets Extension of opening hours (24 hour opening) However they spend a lot of time advertising the fact that their prices are lower than their competitors

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Time for you to do some work!! Read Did you KNOW? On P132 Complete Q1 of the examination questions on P132 – Explain why firms in oligopolies engage in non-price competition

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Game Theory As a consequence of interdependence firms want to be able to predict their rivals response to a strategy or to have strategies to respond themselves This is the basis of game theory which explores the reactions of one play to changes in strategy by another player When applied to oligopoly the players are the firms the game is played in the market Their strategies are their price or output decisions The payoff is their profits We assume that it is a zero sum game We also assume that the players are risk averse Game theory – an analysis of how games players react to changing circumstances and plan their response Zero sum game – where a gain by one player is matched by a loss by another player

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The Prisoner’s Dilemma Play the game Two people are put in different rooms with their team Give them instructions You are accused of a joint crime If you and your partner both plead innocent you will both receive a light sentence If you plead innocent but your partner pleads guilty you will receive a heavy sentence but your partner will be let off If you both plead guilty you will get a medium sentence Ask them to write down how they came to their decision

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The Prisoner’s Dilemma If you could have got together you would both have pleaded innocent and got a light sentence In isolation you cannot trust each other so each chose to plead guilty and both suffer A reasons as follows: If B pleads innocent A will get a light sentence if they plead innocent A will get no sentence if they plead guilty A pleads guilty because it is the better outcome If A assumes B pleads guilty A gets a sever sentence if he pleads innocent A gets a medium sentence if he pleads guilty Once again guilty is the best plea for A this is A’s dominant strategy B reasons in the same way As a result they will both have the same dominant strategy and both plead guilty If they had been able to collude (get together and co-operate) they could both have agreed to plead innocent and got off with a light sentence collusion – where firms co-operate in their pricing and output policies 0 Yrs 0 Yrs

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The Prisoner’s Dilemma – payoff matrix This is called a payoff matrix It shows the payoff for each strategy This is the payoff matrix for the prisoner’s dilemma 0 Yrs 0 Yrs

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Competing and colluding Using game theory we can illustrate the basic dilemma of oligopolistic firms – to co-operate or to compete They are often better to co-operate or collude but this is most often illegal Firms will want to work out what the other firm’s actions will be so that they can decide what to do The dominant strategy (their best option) is the action they will take regardless of what the other firm does Watch these videos to get more understanding and more practice ..\..\videos\Econ concepts in 60 seconds\Oligopolies and game theory.flv ..\..\videos\Econ concepts in 60 seconds\practice of game theory matrices.flv

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Real world application of game theory Game theory analysis has direct relevance to our study of the behaviour of businesses in oligopolistic markets For example the decisions that firms must take over pricing of products, and also how much money to invest in research and development spending. Costly research projects represent a risk for any business If one firm invests in R&D, can another rival firm decide not to follow? They might lose the competitive edge in the market and suffer a long term decline in market share and profitability. The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and the other firm does, then their profits fall and they lose market share. However, there are only a limited number of patents available to be won and if all of the leading firms in a market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.

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Collusive Oligopoly – Formal collusion (explicit collusion) Formal collusion is where some agreement exists between key firms in the same industry about price and output One way of doing this is to have restrictive agreements refuse to supply outlets that sell below an agreed price (Volkswagen) Agreeing to all increase prices of selected products (European pharmaceuticals and vitamins pills) The aim is to increase the level of joint profits at the consumer’s expense (price, quality or availability) It is unlikely to be in writing as huge fines can be levied against firms with restrictive agreements Restrictive agreements – where firms collude to indulge in anti-competitive policy Joint profits – where firms agree to maximise shared rather than their individual profits

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Collusive Oligopoly – Formal collusion Collusion can be seen as a way of removing uncertainty when firms have a high degree of interdependence Agreements may Ban price competition but allow non price competition Divide the market on an area basis A cartel is a group of firms that work together (they collude) The European Union has an active anti-cartel commission that tries to prevent high supernormal profits Fines can be up to 10% of turnover Cartel – a group of firms working together or colluding

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Formal collusion - Cartels To be successful a cartel requires certain conditions All major producers need to be part of it and follow its rules The market being supplied needs to be isolated by producers outside of the cartel There should be high barriers to entry There needs to be a credible punishment for any firm that does not co-operate The more homogeneous the product the greater the likelihood of success Together the firms in a cartel can behave like a monopoly, profit maximising and making supernormal profits

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Formal collusion - Cartels The producers within a cartel can Increase sales revenue and profit if the product is price inelastic Increase likelihood that producers will compete by non-price methods Increase profits and increase investment in R&D (could benefit consumers in the long term) For consumers this means Increases in prices Increase in costs for firms that use the product as an input e.g. supermarkets colluding over the price of milk Reduction of consumer surplus with increase in price Increase in non-price competition – may lead to some consumer benefit with special offers

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Informal collusion (implicit collusion) Informal collusion is much more difficult to detect and in many countries is not illegal An example is price leadership If the cartel nominates a price leader as soon as that price leader changes price the other members of the cartel will follow Price leadership may take various forms The price leader may be the dominant firm in the industry (the one with the most market share) The role may be taken by the smaller firm that is more sensitive to changes in market conditions – barometric price leadership Collusive price leadership and parallel pricing are where identical prices and price movements are maintained in the industry Firms follow the industry norm – firms reach agreement as to each other’s behaviour as a result of repeated observations over time

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Time for you to do some work!! For homework read through the chapter Create a presentation from the exam questions below (P132) Explain why firms in oligopolies engage in non-price competition (10) Distinguish between a collusive and a non collusive oligopoly (10) Evaluate the view that government should maintain strong policies to control collusive behaviour by oligopolies (15)