Economics of Oligopoly
Topic 3.3.9
Economics of Oligopoly
Topic 3.3.9
Students should be able to:• Understand the characteristics of this market structure with
particular reference to the interdependence of firms• Explain the behaviour of firms in this market structure• Explain reasons for collusive and non-collusive behaviour• Evaluate the reasons why firms may wish to pursue both
overt and tacit collusion
Key Concepts – Oligopoly
CartelAssociation of businesses or countries that collude to influence production levels and thus the market price
Collusion Takes place when rival companies cooperate for their mutual benefit
Kinked demand curveAssumes that a business face a dual demand curve for its product based on the likely reactions of other firms
Price leadershipWhen one firm has a dominant position and firms with lower market shares follow the price changes of the leader
Prisoners’ dilemmaProblem in game theory that demonstrates why two people might not cooperate even if in their best interests
Basics of an Oligopoly
• An oligopoly is an imperfectly competitive industry where there is a high level of market concentration.
• Oligopoly is best defined by the actual conduct (or behaviour) of firms within a market
• The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms.
• A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total market sales.
Oligopoly in Action! UK Petrol Market
TescoBP
ShellEsso
Sainsbury'sMorrisons
AsdaTexaco
Certas EnergyMurco
JetUnbranded
Minor brandsHarvest Energy
Maxol
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%16.5%
14.4%13.2%
10.9%10.3%
10%6.8%
5.8%3.8%
2.3%2.2%
1.5%0.8%0.7%
0.4%
Market share, per cent
Oligopoly in Action! UK Cinema Market
Cineworld
Odeon
Vue
National Amusements
Empire Cinemas
Others
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
25.5%
23.9%
22.2%
5.8%
3.8%
18.7%
Cinema market share in 2013 (per cent)
Exhi
bito
r
Global market share of the world's largest automakers in 2013
ToyotaGeneral Motors
VolkswagenHyundai-Kia
Renault-NissanFord
SAIC MotorFiat-Chrysler
HondaSuzuki
PeugeotDaimler
BMWChangOther
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%12.3%
12%11.9%
9.3%8.4%
7.8%6.3%
5.3%4.4%
3.2%3.4%
2.8%2.4%2.4%
8%
Market share
SAIC Motor Corporation Limited is a Chinese state-owned automotive manufacturing company headquartered in Shanghai, China
Shares of the Global Car Industry in 2013
Market share of mobile handset manufacturers in the UK in June 2014
Samsung Apple Nokia Sony HTC RIM Motorola LG Other0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%31.8%
22.9%
16.9%
6.7% 6.1%
3.7%2.4% 2.1%
7.4%
Mar
ket s
hare
A Contestable Oligopoly
Revenue of dominant sports betting companies
William Hill
bet365
Ladbrokes
Paddy Power
bwin
betfair
Unibet
0 0.5 1 1.5 2 2.5 3
2.5
2.18
1.82
1.07
0.74
0.73
0.48
Revenue in billion U.S. dollars in 2014
Characteristics of an Oligopoly
Best defined by the actual behaviour of firms
A market dominated by a few large firms
High market concentration ratio
Each firm supplies branded products
Barriers to entry and exit
Interdependent strategic decisions by firms
Meaning of Strategic Interdependence
• Strategic interdependence means that one firm’s output and price decisions are influenced by the likely behaviour of competitors
• Because there are few sellers, each firm is likely to be aware of the actions of the others.
• Decisions of one firm influence, and are influenced by, the decisions of other firms
• This causes oligopolistic industries to be at high risk of tacit or explicit collusion which can lead to allegations of anti-competitive behaviour
• In oligopoly there is a high level of uncertainty
The Kinked Demand Curve
• A business in an oligopoly faces a downward sloping demand curve but the price elasticity of demand may depend on the likely reaction of rivals to changes in one firm’s price and output
• (a) Rivals are assumed not to follow a price increase by one firm, so the acting firm will lose market share - therefore demand will be relatively elastic and a rise in price will lead to less revenue
• (b) Rivals are assumed to be likely to match a price fall by one firm to avoid a loss of market share. If this happens demand will be more inelastic and a fall in price will also lead to a fall in total revenue
The Kinked Demand Curve - AnalysisPrice and Cost
Output
AR1
P1
AR2
• Theory starts with assumption that firms are settled on a price P1 and quantity Q1
• At price D1 the demand curve is elastic above P1 and it is demand inelastic below P1
Q1
Kinked Demand Curve – Raising PricePrice and Cost
Output
AR1
P1
AR2
• Raising price above P1: Likely reaction of other firms is to hold their prices
• This will cause an elastic demand response for this firm
• Results in lost sales and falling total revenue
Q1
P2
Q2
Kinked Demand Curve – Cutting PricePrice and Cost
Output
AR1
P1
AR2
• Cutting price below P1 – the likely reaction of other firms is to follow the price reduction. Demand likely to be relatively inelastic – little benefit in terms of extra sales and total revenue
Q1
P2
Q2
P3
Q1
Kinked Demand Curve – The Kink!Price and Cost
Output
AR1
P1
AR2
• If demand is relatively elastic following a price rise and relatively inelastic after a price fall – we create a kink in the oligopolists demand curve (AR)
Q1
P2
Q2
P3
Q1
Kinked Demand Curve – The MR CurvePrice and Cost
Output
AR1
• The marginal revenue curve is always twice as steep as average revenue
• There will be two marginal revenues curves if AR is kinked
• We find a vertical intersection – at quantity Q1 the two curves do not actually intersect
MR1
Kinked Demand Curve – Equilibrium?Price and Cost
Output
AR1
• Is there a profit maximising equilibrium in this market? In the diagram here MC1 cuts through the gap in the marginal revenue curve
MR1
MC1
Kinked demand curve model assumes:Other firms will follow if prices are cutFirms will not follow if prices rise
Kinked Demand Curve – Price RigidityPrice and Cost
Output
AR1
• One of the key predictions of the kinked demand curve model is that prices will be rigid or “sticky” even when there is a change in the marginal costs of supply (this is assuming that firms in the market are profit seeking)
MR1
Kinked Demand Curve – Price RigidityPrice and Cost
Output
AR1
• One of the key predictions of the model is that prices will be “sticky” even when there is a change in the marginal costs of supply (assuming that firms are profit seeking)
MR1
MC1
MC2
Kinked demand curve model assumes:Other firms will follow if prices are cutFirms will not follow if prices rise
Kinked Demand Curve – Overview
On oligopoly firms have price-setting power but may be reluctant to use it
Rivals unlikely to match a price rise and rivals likely to match a price fall
If a firm is settled on one price, there may e little point in changing it
Even if costs change we often see price rigidity / stability in an oligopoly
This increases the importance attached to non-price competition
Examples of Non-Price Competition
Innovation Quality of service including after-sales
Free Upgrades to Products
Exclusivity / Loyalty Schemes Branding Sales Promotions
UK advertisers ranked by spending
British Sky Broadcasting LtdProcter & Gamble Ltd
Bt LtdUnilever UK Ltd
Tesco PlcAsda Stores Ltd
Talktalk GrpVirgin Media
William Morrison Supermarkets PlcDfs Furniture Co Ltd
Vodafone LtdMcDonalds Restrs Ltd
Reckitt Benckiser (UK) LtdLoreal Paris
Nestle
0 50 100 150 200 250 300264.34
177.26149.79
119.1116.27
97.0492.55
88.3681.52
75.6874.5972.15
68.9863.5963.15
Expenditure in million £ in 2013
Real World Examples of Price Wars
Low cost airlines
Supermarket petrol
Mobile phone tariffs
Price wars and impact on suppliersSupermarket price war squeezes small supplier profit margins by a thirdA report published in November 2015 found that small suppliers with an annual turnover below £25m lack the negotiating power of big rivals and as a result, their profit margins have fallen in one year from 3.5% to 2.1%. By contrast, at the biggest food companies, whose turnover tops £1bn, margins increased from 5.2% to 5.4% last year
Who Wins and Loses from Price Wars?
Winners• Regular
consumers• Managers –
higher sales
Losers• Shareholders -
lower profits• Suppliers – may
get squeezed
Price wars may lead to short run increases in sales and revenues, but may not be in the long-term commercial interests of a business
Long Term Tendency towards Oligopoly
• Large minimum efficient scale (high ratio of fixed to variable costs of production)
Economies of scale
• Consolidation of industries through acquisitions e.g. horizontal integration between suppliers
Mergers and takeovers
• High rates of profits and barriers to entry & exit
Rise of dominant brands
Economics of Oligopoly
Topic 3.3.9
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