OLIGOPOLY Chapter 11: Economics – IB Course Companion Blink & Dorton , 2007, p119-125

1. OLIGOPOLY Chapter 11: Economics – IB Course Companion Blink & Dorton, 2007, p119-125

2. The Assumptions of Oligopoly • Oligopoly is where a few firms dominate an industry. • The industry may have quiet a few firms or not many, but the key factor is that a large proportion of the industry’s output is shared by just a small number of firms. • What constitutes a small number varies, but a common indicator of concentration in an industry is known as the concentration ratio.

3. Concentration Ratios • Concentration ratios are expressed in the form of CRx where X represents the number of the largest firms. • For example: CR4 would show the percentage of market share or output held by the largest four firms in the industry. • The higher the percentage, the more concentrated is the market power of the four largest firm.

4. Concentration Ratios • While other concentration ratios such as CR8 are measured, it is the CR4 that is most commonly used to make a link to a given market structure.

5. CONCENTRATION RATIOS AND MARKET STRUCTURES

6. Case Study:US Malt Beverages Industry • In the US malt beverages industry, there are 160 firms and the CR4 is 90%. • The four largest firms produce 90% of the industry’s output and it is an industry with a high concentration of market power among the largest four companies • The malt industry is clearly example of an oligopoly.

7. Case Study:US Frozen Fish & Seafood Industry • In the frozen fish and seafood industry, there are 600 firms and the CR4 is 19% suggested low concentration. • The frozen fish and seafood industry is in monopolistic competition.

9. Type of Oligopolistic Industries • Oligopolistic Industries may be very different in nature. • Some produce almost identical products. (Eg: petrol, where the product is almost exactly the same and only the names of the oil companies are different • Some produce highly differentiated products: eg motor cars.

10. Barriers to Entry • In most examples of oligopoly, there are distinct barriers to entry, usually the large scale production or the strong branding of the dominant firms, but this is not always the case. • In some oligopolies there may be low barriers to entry. • This explained by contestable market theory.

11. Interdependence & Oligopolies • The key feature that is common in all oligopolies is that there is interdependence. • Whereas in perfect competition and monopolistic competition the firms are all too small relative to the size of the market, to be able to influence the market, in oligopoly there is small number of large firms dominating the industry. • As there are just a few firms, each needs to take careful notice of each other’s actions. • Interdependence tends to make firms want to collude and so avoid surprises and unexpected outcomes.

12. Oligopolies & Collusion • If oligopolies conclude and act as a monopoly, then they maximize industry profits. • However, there may also be tendency for firms to want to compete vigorously with each other in order to gain a greater market share.

13. Oligopolies and Price Issues • Oligopolies tend to be characterised by price rigidity. • Prices in oligopoly tend to be change much less than in more competitive markets. • Even where there are production-cost changes, oligopolistic firms often leave their prices unchanged.

14. COLLUSIVE OLIGOPOLIES Collusive Oligopoly exists when the firms in an oligopolistic market collude to charge the same prices for their products, in effect acting as a monopoly, and so divide up any monopoly profits that may be made.

15. Two Types of Collusion There are two main types of collusion: • Formal Collusion • Tacit Collusion

16. Formal Collusion • Formal conclusion takes place when firms openly agree on the price that they will all charge, although sometimes it may be agreement on market share or an marketing cartel. This type of collusion is called cartel. • Since this results in higher prices and less output for consumers, this is usually deemed to be against the interests of consumers. • Collusion is generally banned by governments and is against the law in the majority of countries

17. Anti Trust Authorities & Formal Collusion • If a country’s anti-trust authority finds that firms have engaged in anti-competitive behaviour such as price-fixing agreements, then the firms will be penalised with fines or other punishments.

18. Formal Collusion & Cartels • Formal collusion between governments may be permitted. • The prime example if OPEC • The Organization of Petroleum Exporting Countries. • OPEC is a cartel. • It sets production quotas, which has a very significant influence on the price of oil on world markets.

19. Tacit Collusion • Tacit collusion exists when a firms in oligopoly charge the same prices without any formal collusion. • A firm may charge the same price as another by looking at the prices of a dominant firm in the industry, or at the prices of the main competitors. • It is not necessary for firms to communicate with each other to charge the same price.

20. OLIGOPOLISTS ACTING AS A MONOPOLIST With both formal and tacit collusion the process is the same. The firms behave like a monopolist (single producer) charge the monopoly price, make monopoly profits and share then according to market share.

21. Collusive Oligopoly & Price Rigidity • Collusive oligopoly offers one explanation of price rigidity in oligopoly. • If firms are colluding, either formally or tacitly, and they are making their share of long-run monopoly profits, then they may try to keep prices stable in order that the situation continues.

22. NON COLLUSIVE OLIGOPOLY • Non-collusive oligopoly exists when the firms do not collude and so have to be very aware of the reactions of other firms when making pricing decisions. • The behaviour of firms in an oligopoly is strategic behaviour. They must develop strategies that take into account all possible actions of rivals

23. Extension: Game Theory • To explain firms strategic behaviour, economist often use `game theory`. • While this is not the IB Diploma Economics program, it may be covered in the Theory of Knowledge as “The prisoner’s dilemma”.

25. The Kinked Demand Curve • One way of attempting to explain the situation in a non-collusive oligopoly is the kinked demand curve devised in the 1930s by an American Economist called Paul Sweezy (1910-2004). • Although the theory has been called into question, it does provoke some interesting thoughts and discussions concerning non-collusive oligopoly

26. THE KINKED DEMAND CURVE The first assumption is that a firm only knows one point on its demand curve, - the one it holds at present. This show is shown as point `a`. If the firm raises its price, then it is unlikely that its competitors would raise theirs and so a lot of demand would be lost to other firms. This implies that demand would be relatively elastic above point `a`, since a small increase in price would lead to large fall in the quantity demanded. If the firm were to lower its price then it is likely that competitors would follow. Competitors would undercut the price of the first firm in order to regain any lost sales. This implies that demand would be less elastic below point “a”, since a decrease in price is unlikely to lead to a noticeable increase in quantity demanded. Due to these expectations, the demand curve will be kinked around the point “a”. It will also possess an MR curve that has the vertical section bc, since each part of the MC curve will be twice as steeply sloping as the two parts of the demand curve.

27. Kinked Demand Curve & Price Rigidity in Non-Collusive Oligopoly The kinked demand curves offers an explanation of why there tends to be price rigidity in non- collusive oligopoly. There are three reasons: • Firms are afraid to raise prices above the current market price, because other firms will not follow, and so they lose trade, sales and probably profit. • Firms are afraid to lower their prices below the current market price, because other firms will follow, undercutting them an so creating a price war that may harm all firms involved.

28. Kinked Demand Curve & Price Rigidity in Non-Collusive Oligopoly 3. The shape of the MR curve means that if marginal costs were to rise, then it is possible that MC would still equal MR and so the firms, being profit maximisers would not change their prices or outputs. • Based on the kinked demand curve graph, if we assume that the firm is operating on MC2 then they are maximising profits by producing at Q and selling at P. • Marginal costs could rise as high as MC1 and the firm would still be maximising profits by producing at Q and charging P. Thus the market remains stable, even though there have been significant price changes.

29. NON PRICE COMPETITION • As firms in oligopoly tend not to compete in terms of price the concept of non-price competition becomes important. Types of Non Price Competition • Brand names • Packaging • Special Features • Advertising & Sales Promotion • Personal Selling • Publicity • Sponsorship deals • Special Distribution features (eg: free delivery & after sales service)

30. Oligopoly and Advertising • Oligopoly is characterized by very large advertising and marketing expenditures as firms try to develop brand loyalty and make demand for their product less elastic. • Some may argue that this represents a misuse of scarce resources, but it could be argued that competition among the large companies results in greater choice for consumers.

31. The World’s Leading Oligopolies • Rivalry among firms in oligopolies are well known nationally and internationally: • Eg: Coke / Pepsi and Adidas / Nike. • However many of the branded consumer goods that we purchase are produced in oligopolies, which many consumer would not be aware of, when shopping.

32. Unilever and Proctor & Gamble • Unilever and Proctor & Gamble produce a vast number of brands that compete with each other in number of industries. For example: home care products, personal hygiene, health care and beauty products.

34. EXAMINATION QUESTIONSShort Response Questions Explain why prices tend to be quite stable in a non-collusive oligopoly (10 marks) 2. Explain why firms in oligopolies engage in non price competition (10 marks)

35. EXAMINATION QUESTIONS Essay Questions 1a Distinguish between a collusive and non-collusive oligopoly (10 marks) 1b. Evaluate the view that governments should maintain strong policies to control collusive behaviour by oligopolies (10 marks)