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