Transcript Oligopoly
Structure monopoly oligopoly monopolistic competition perfect competition Examples Local, national or international e.g. rail franchise, Microsoft Mobile phones, food retailing. Many firms, slightly differentiated product e.g. driving schools, coach hire Unlikely to exist in practice (some commodity markets exhibit key characteristics) No. of sellers Single supplier A ‘few’ large firms Many small firms Many small firms Product differentiation Single product Common as prices tend to be stable. Characterized by non price competition Yes No. Product identical ‘homogenous’ Price-taker or price/maker Price maker Elements of both Small influence over price Price taker Barriers to entry Many natural and/or artificial As for monopoly. Brand loyalty very important None None Long run supernormal profit Yes Yes No No Economic consequences Allocative/ productive inefficiency Allocative/ productive efficiency Oligopoly Imperfect competition The vast majority of firms do compete with other firms, yet are not price takers. They have some degree of market power. Most markets, therefore, lie between the two extremes of perfect competition and monopoly. There are two types of imperfect competition: Monopolistic Competition and Oligopoly. Features of Oligopoly • A few firms dominate the industry • Products may be homogeneous or differentiated • There are barriers to entry and exit from the industry, the size and effectiveness of the barriers differ considerably from one industry to another. • There is interdependence of firms. Firms are mutually dependent, as each firm is affected by its rivals’ actions • Due to interdependence, there is no one single generally accepted theory of oligopoly. Firms may react differently or unpredictably. Examples of Oligopoly? Pepsi and Mirinda and 7up= Pepsico. Sprite and coca cola= Coca Cola, Oligopoly behaviour 1. Interdependence the quantity sold by any one producer depends on that producer’s price and the prices and quantities sold by the other producers. 2.Strategic behaviour Each firm must take into account the effects of its own actions on the actions of other firms There are two conflicting policies a firm in an oligopolistic industry may adopt. Competition – Firms may be tempted to compete with the other firms to gain market share and a larger slice of industry profits in the longer term. Firms compete using price, output or non price competition Collusion – Interdependence may encourage firms to club together and act as if they were collectively a monopoly. Formal : open agreement on price and output strategy (cartel) Tacit : ‘unwritten’ agreement not to compete (e.g. on price, advertising) We need to deal with the two possibilities, collusive oligopoly and non-collusive oligopoly. Collusive oligopoly Firms may engage in collusion (formally or informally), by agreeing prices, market share, advertising expenditure, product development, no poaching agreements etc. Restricting the levels of competition protects industry profits from being reduced A Cartel – Is a formal collusive agreement. Cartel members collude to act as if it (the cartel) were a monopoly, by acting like a single firm to maximise profits. Collusive oligopoly In reality, formal collusive agreements are often made illegal through legislation to promote competition. The competition commission, in the UK, enforces rules and regulations laid down in UK and EU law. Therefore, it is much more likely that collusion would be informal (which can be very difficult to prove). Informal collusion could be clearly an attempt to act anti-competitively, which would be breaking the law. Building firms informally agreeing contracts could be a clear example. Price Fixing in the news • The Office of Fair Trading (OFT), accused British Airways (BA) of fixing the price of fuel surcharges with Virgin on long-haul flights between 2004 and 2006. The case was the first criminal prosecution the OFT had pursued under powers awarded to the watchdog in 2003. One current and three former British Airways executives could have faced up to five years in prison. Price Fixing in the news • Supermarkets Sainsbury's and Asda are among companies that have agreed to pay the Treasury near-record fines of more than £116m after admitting that they fixed the price of milk, cheese and butter in a scandal estimated to have cost consumers about £270m • Dec 2007 Collusive oligopoly Firms are more likely to undertake tacit collusion. Firms tacitly ‘agree’ to avoid price cutting, excessive advertising or other forms of competition. There a number of ways firms can tacitly collude to set prices in an industry for example: • Dominant firm price leadership- largest firm sets the benchmark • Barometric firm price leadership- the most reliable firm sets the benchmark Price Collusive Oligopoly A collusive oligopolistic industry in the long run will act as if it were a monopoly. MC (industry) P AC (industry) Abnormal Profit TR>TC Total Cost (TC=ACxQ) 0 MR Q AR = D (industry) Quantity Oligopoly Even if collusion exists, there is a strong temptation to ‘cheat’ by cutting prices or selling more than the allocated quota. Economists use simple game theory to study alternative strategies of firms, based on possible actions of their rivals. The kinked demand curve is a product of kinked demand theory developed in 1939 (P. Sweezy). The model seeks to explain why, even when there is no collusion at all, prices can remain stable. The interdependence of firms in an oligopoly is important to consider here. The kinked demand curve under non- collusive oligopoly. P An oligopolist can observe current price and output, P0 but must try to anticipate rival reactions to any price change. Q0 Q The kinked demand curve The firm may expect rivals to respond if it reduces its price, Price so demand in response to a price reduction is likely to be relatively inelastic P0 D The demand curve will be steep below P0. Quantity The kinked demand curve …but for a price increase rivals are less likely to react, P P0 so demand may be relatively elastic above P0 D so the firm perceives that it faces a kinked demand curve. Quantity The kinked demand curve Given this perception, the firm sees that revenue will fall whether price is increased or decreased, so the best strategy is to keep price at P0. Prices are stable (‘sticky’) Price P0 D Q0 Quantity Homework • Monday- questions on price and nonprice competition (handout last Monday) • Investigate real- life examples of collusion eg. national bus companies in the UK, look for news articles on price fixing as a starting point • Bring in news article to discuss on Monday Non collusive oligopoly The kinked demand theory is based on two asymmetrical assumptions: 1. If an oligopolist cuts its price, its rivals will be forced to follow suit, to maintain market share and not lose customers to the price cutting firm. 2. If an oligopolist raises its price, its rivals will not follow suit, as they will gain market share from the first firm. The market price remains relatively stable. Profits are maximised where MC=MR, so prices remain stable even with a considerable change in costs. Price Non collusive Oligopoly Cost and revenue curves for a firm in a non-collusive oligopoly MC2 (firm) MC1 (firm) P1 D=AR (firm) 0 Q1 MR Quantity Notes on Model • Profit is maximised where MC= MR thus if the MC curve lies anywhere between MC1 and MC2, the profit maximising level of output is still P1 and Q1. Thus prices remain stable even with a considerable change in costs • Model does not explain how prices are set in the first place • Model predicts that prices will be raised only after MC has risen above MC2 Oligopolistic Industries In the real world, there are a number of industries that exhibit the key characteristics of oligopoly. Petrol, Cars, chemicals, Soap Powder, Soft drinks, long haul air passenger industry, top independent schools? It is important to remember, in the real world, industries may not exactly fit the theoretical market structure characteristics. Though the market characteristics are important, the behaviour of firms and the level of competition are of most interest, especially when considering oligopoly. Game theory The behaviour of a firm under non- collusive oligopoly will depend on how it thinks its rivals will react to its policies When considering whether to cut prices in order to gain market share, a firm will ask itself 2 key questions 1. How much can it get away with without inciting retaliation 2. If it’s rivals do retaliate and a price war ensues, whether it will be able to ‘see off’ some or all of its rivals while surviving itself. It is not unreasonable to compare rival firms in an oligopoly to the players in a game. They will need to choose the appropriate strategy with respect to price, advertising and product development. The firm’s choice of strategy will depend both on how it thinks its rivals will react and on how willing it is to take risks. Game theory is a mathematical method of decision making in which alternative strategies are analysed to determine the optimal course of action for the interested party, depending on assumptions about rivals behaviour. http://www.youtube.com/watch?v=uAJDD1_Oexo Single Move Games • The simplest type of ‘game’ • One ‘move’ by each firm • For example 2 firms bidding for a contract which will be awarded to the lowest bidder • Many single move games have predictable outcomes, no matter what assumptions each firm makes about its rivals’ behaviour. • Such games are known as dominant strategy games. Simple Dominant Game Strategy 2 firms with identical costs, products and demand Firm A is considering cutting its price to £3, Firm B could cut or leave at £4 £4 FIRM B £3 FIRM A £4 £3 £5m £6m* , £5m £2.5m £2.5m £6m* , £4m* , £4m* Simple Dominant- Strategy Game • Cautious approach- think that the worst could happen • if A kept at £4- B could cut to £3, As profits would fall. If A cut to £3 and B cut, profits would fall, but by less. • So if A is cautious it will cut its price • (Note if B is cautious too it will also cut its price) • Policy of adopting safer strategy is known as maximin • i.e. The firm will opt for the alternative that will maximise its minimum profit possible • An alternative is the optimistic approach and assume your rivals react in the way most favourable to you • The firm will go for the strategy that yields the highest possible profit. • In As case this means cutting its price assuming B will leave its price unchanged • If A is correct it will achieve the maximum possible profit of £6m. • This approach is known as maximax • Same argument applies to firm B. Its maximax strategy is to cut and hopefully maximise profits • In this ‘game’ both approaches, maximax and maximin, lead to the same strategy (cutting price) thus this is known as a dominant strategy game • The equilibrium outcome of a game where there is no collusion between players is known as Nash Equilibrium • Collusion would have benefited both players in this game, yet both would have been tempted to cheat and cut prices- this is known as the prisoners’ dilemma The Prisoners’ dilemma • Handout Oligopoly: Outcome under collusion or competition Collusion or competition ? Both firms comply (collude without cheating) Monopoly outcome (Pm, Qm) Both firms cheat Perfectly competitive outcome (Ppc, Qpc) One firm cheats Output : <Qpc , >Qm Price : <Pm , >Ppc SNP : < M , >PC Price, Costs, Revenue Pm Ppc AC = MC MR AR = D Qm Qpc • More complex games can be devised with more firms and many alternative prices, differentiated products and various forms of non- price competition • Multiple move games can also be created • For more info see an undergraduate Economics textbook such as Sloman, Lipsey and Chrystal (both in the library) Handout • Game Theory What determines market structure? The minimum efficient scale (MES) is the output at which a firm’s long-run average cost curve stops falling. The size of the MES relative to market demand has a strong influence on market structure • • • LAC1 offers negligible economies of scale relative to market demand, and it is unlikely that any individual firm will be able to have much influence. This is likely to end up as perfect competition. In contrast, LAC3 looks likely to be a natural monopoly, as the largest firm is always likely to dominate. LAC2 is an intermediate case, which will probably end up as an oligopoly. C LAC2 LAC3 LAC1 D Output