OLIGOPOLY: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

OLIGOPOLY: Perfect competition, imperfectly competitive markets and monopoly

AQA students must understand the following content [taken from the syllabus]

• The main characteristics of oligopolistic markets.

• Oligopolistic markets can be very different in relation to, for example, the number of firms, the degree of product differentiation and ease of entry.

• Oligopoly can be defined in terms of market structure or in terms of market conduct (behaviour).

• Concentration ratios and how to calculate a concentration ratio.

• The difference between collusive and non-collusive oligopoly.

• The difference between cooperation and collusion.

• The kinked demand curve model.

• The reasons for non-price competition, the operation of cartels, price leadership, price agreements, price wars and barriers to entry.

• The factors which influence prices, output, investment, expenditure on research and advertising in oligopolistic industries.

• The significance of interdependence and uncertainty in oligopoly.

• The advantages and disadvantages of oligopoly.

INFORMATION YOU NEED TO KNOW

[NOTE: supporting diagrams and questions at the end]

Introduction: Oligopolies

A market structure called the oligopoly sits somewhere between monopoly and perfect competition. There are just a few dominant firms that operate in the market, which distinguishes the oligopoly market structure from other market structures. In this piece, we will go deep into the complexities of oligopolistic markets, examining their key traits, behaviour, and effects on price, competition, and market outcomes.

1. Characteristics of Oligopolistic Markets:

Oligopolistic markets have a number of significant traits:

- Number of Firms: Oligopolies are characterised by a small number of dominant enterprises that control the market. These businesses frequently control pricing and other market decisions and hold a substantial market share.

- Product Differentiation: To achieve a competitive advantage, businesses in oligopolistic markets may differentiate their products by branding, quality, features, or marketing tactics.

- Entry Barriers: Oligopolies frequently include entry barriers that make it difficult for new businesses to enter the market. These obstacles may be brought on by economies of scale, high starting costs, or legal restrictions (such as patents).

2. Oligopoly in Terms of Structure and Conduct:

Market structure and market conduct are the two dimensions in which oligopoly can be understood. While market conduct looks at the actions and tactics taken by businesses operating in an oligopoly, market structure concentrates on the number of firms, concentration ratios, and product differentiation.

3. Concentration Ratios:

To gauge the degree of market concentration within an oligopoly, concentration ratios are used. They show the overall market share of a particular number of the largest businesses in that industry. By adding the market shares of the leading companies and expressing the result as a percentage of the overall market share, concentration ratios may be measured.

The typical concentration ratios used to describe oligopoly firms change based on the particular market and industry. The four-firm concentration ratio (CR4) and the eight-firm concentration ratio (CR8) are two concentration ratios that are frequently employed. When comparing two industries, the four-firm concentration ratio calculates the combined market share of the top four companies, while the eight-firm concentration ratio calculates the combined market share of the top eight companies.

In general, a higher concentration ratio suggests a more concentrated and oligopolistic market structure and a higher level of market power held by a limited number of companies. Although the precise threshold may vary based on the business and regulatory context, concentration ratios exceeding 40% or 50% are sometimes seen to be evidence of an oligopoly market. It is crucial to remember that concentration ratios alone do not give a whole picture of market dynamics, and thus oligopoly markets should be evaluated in light of other characteristics such as entry barriers, product differentiation, and competitive behaviour.

4. Collusive and Non-Collusive Oligopoly:

Collusive oligopoly is an arrangement in which businesses band together and make agreements that decrease competition. Price-fixing agreements, market-sharing, or output coordination are a few examples of this. On the other hand, under a non-collusive oligopoly, firms make decisions on their own without establishing any explicit agreements.

Collusion in oligopoly can take different forms:

1. Explicit or Overt collusion: Direct agreements between businesses, like price-fixing or market-sharing, are used to influence pricing and lessen competition.

2. Tacit collusion: Without explicit agreements, firms frequently coordinate their behaviour through observing and reacting to one another's market-based actions.

3. Cartels: Firms establish a formal organisation to plan activities, establish prices, and limit output, which frequently results in increased profits.

4. Implicit collusion: Through public statements or displays, businesses communicate their intentions to one another, influencing market behaviour and easing competitive tensions.

Oligopoly firms are likely to collude for several reasons:

1. Mutual Interdependence: Because oligopolistic enterprises are so interconnected, their choices and actions have a direct impact on the revenue and market share of their competitors. By coordinating their actions, businesses can reduce uncertainty and avoid fierce pricing competition that could hurt their profitability.

2. Maximising Profits: Through the use of collusion, businesses can collectively maximise their profits by deciding on prices, output quotas, or market shares. Collusion allows businesses to participate in strategic actions that are advantageous to the whole organisation without undercutting one another's prices.

3. Stabilising the Market: By minimising price swings and uncertainty, collusion helps maintain market stability. Colluding businesses can make the market more predictable and less erratic by maintaining higher pricing and restricting output, which can be beneficial for long-term planning and investment.

4. Barrier to Entry: Potential competitors may find it difficult to enter the market due to collusion. Partnering businesses can prevent new entrants from joining the market, protecting their market share and lessening the prospect of heightened competition by coordinating their actions and maintaining high prices.

5. Legal and Regulatory Environment: In some circumstances, the legal and regulatory framework may unintentionally promote collusion. For instance, in industries where mergers and acquisitions are heavily regulated or restricted, firms may opt for collusion as an alternative means to coordinate their behavior and avoid regulatory scrutiny.

It's crucial to remember that collusion is frequently prohibited by antitrust laws and is subject to them in many jurisdictions. To ensure fair competition, safeguard consumer interests, and advance market efficiency, authorities regularly monitor and penalise anti-competitive behaviour. Consumer welfare may suffer as a result of collusion, which can result in increased costs, less innovation, and fewer options.

5. Cooperation vs. Collusion:

Both collusion and cooperation in oligopoly markets involve types of coordination between rival enterprises, but their nature and legality are different. The distinction between cooperation and collusion in an oligopoly is summarised as follows:

Cooperation: When businesses cooperate, they voluntarily and legally agree to take mutually beneficial measures without breaking the law on antitrust. It involves open and honest collaboration with the goal of boosting market performance, cutting expenses, and raising total industrial performance. Joint ventures, strategic alliances, collaborations in research and development, and organisations that create standards are a few examples of cooperation. As it can result in advantageous outcomes including economies of scale, information exchange, innovation, and market expansion, cooperation is often favoured.

An example could be the joint venture between Tesla and Panasonic on co-developing battery technology.

Collusion: In contrast, collusion refers to covert, illegal agreements between rival businesses that manipulate market outcomes, limit competition, and increase shared profits at the expense of customers. In order to fix prices, split market shares, rig bids, or engage in other anti-competitive behaviour, colluding businesses coordinate their operations. Collusion frequently results in increased costs, decreased output, fewer consumer choices, and thwarted innovation. To ensure fair competition and safeguard consumer welfare, authorities actively monitor and punish collusive behaviour.

6. The Kinked Demand Curve Model & Price Stickiness:

Price Stickiness: The theory of oligopoly suggests that, once a price has been determined, firms will stick to it. This is mainly because firms cannot pursue independent strategies. For example, if an airline raises the price of its tickets from London to New York, rivals will not follow suit, and the airline will lose revenue - the demand curve for the price increase is relatively elastic. Rivals have no need to follow suit because it is to their competitive advantage to keep their prices as they are. However, if the airline lowers its price, rivals would be forced to follow suit and drop their prices in response. Again, the airline will lose sales revenue and market share. The demand curve is relatively inelastic in this context.

Kinked Demand Curve [see diagram below]: A model for analysing price rigidity in oligopolistic markets is the kinked demand curve theory. It implies that businesses functioning in an oligopoly encounter a demand curve that has a kink, showing that demand has differing price elasticities above and below the prevailing price. The somewhat elastic demand curve, in accordance with the idea, makes it unlikely that competitor firms will increase their prices in response to a firm's price hike.

However, if a company lowers its price, competitors are more likely to follow suit since the demand curve becomes comparatively inelastic.

The kinked demand curve theory sheds light on how businesses interact in oligopolistic marketplaces, however its application is flawed and lacking of strong empirical support.

Weaknesses of the kinked demand curve model:

• Limited evidence to support the validity of the theory

• Oversimplifies oligopololistic behaviour e.g. no decision making

• Neglects the significance of non-price competition

• Doesn’t explain how the initial equilibrium in the market was reached in the first place [see diagram below]

7. Non-Price Competition and Market Strategies:

1. Product Differentiation: Firms focus on creating unique features, branding, or packaging for their products to distinguish themselves from competitors. For instance, smartphone companies differentiate their products through design, features, and user experience.

2. Advertising and Marketing: To increase brand awareness and draw in customers, businesses extensively invest in campaigns. This may involve radio ads, print ads, television ads, web ads, sponsorships, and endorsements. For instance, soft drink firms use significant advertising to build brand loyalty.

3. Quality Improvement: Businesses compete by raising the quality and performance of their goods and services. This may entail making research and development investments, using premium components, or applying cutting-edge production methods. The goal of automakers is to constantly improve safety and fuel efficiency.

4. Customer Service and Support: Businesses set themselves apart by offering superior warranties, after-sales support, and loyalty programmes. To entice and keep consumers, airlines, for instance, could provide individualised help, priority boarding, or frequent flyer rewards.

5. Exclusive Distribution: Companies may enter into partnerships or exclusive distribution arrangements with retailers or distributors, so limiting access to their products and fostering a sense of exclusivity. This tactic is frequently used by luxury apparel brands to uphold their high-end reputation.

8. Interdependence and Uncertainty:

Oligopolistic markets have interdependence among firms as a basic characteristic. One company's decisions and actions have a big impact on other companies. Making decisions in oligopolies is made more difficult by uncertainty regarding the activities of rival companies, market demand, and future circumstances.

Game Theory: In economics, game theory is a mathematical framework used to examine how people or businesses interact strategically. It explores how people make decisions when their actions have an impact on other people's decisions. It offers perceptions into the actions and choices made by rational actors in competitive settings.

It assumes the actions of firms are comparable to that of players within a fictional game, where each player takes actions to optimise their future outcomes and win.

Let’s take a look at some examples of game theory in action.

Price Leadership: Price leadership in oligopolies is a situation in which one business, referred to as the price leader, takes the lead in setting the price for the industry, and other businesses in the market follow suit by adjusting their pricing in line with this new standard. Other businesses decide to match or closely align their prices with the price leader after interpreting the price leader's activities as signals.

Example of Price Leadership: The airline industry is a prime example of price leadership. Consider a market where there are three significant airlines operating. Airline A, which sets prices, is seen as the dominant business (the price leader).  When airline A raises the cost of its tickets, airlines B and C notice the change and decide to follow suit in order to preserve price uniformity. In a comparable way, if Airline A cuts its pricing, it is likely that other airlines will do the same to prevent losing market share. In this case, Airline A's pricing decisions act as a standard for the industry and have an impact on how other airlines set their prices.

Prisoner’s Dilemma: A well-known game theory illustration of the tension between individual and collective rationality is The Prisoner's Dilemma. Two people are involved, both of whom are detained in separate cells after being arrested for a crime. The prosecution makes a deal with each prisoner: if one doesn't speak up (coopers), the other confesses (defects), the defector would get a lighter sentence, and the silent prisoner will get a harsher one. If both inmates confess, both are given light sentences. If neither speaks, their sentences are reduced for both.

The problem occurs because neither prisoner can know the other's decision, and each must choose between cooperating and defecting. Defecting is the logical course of action because it reduces the possible harm regardless of the other person's choice. However, if both inmates opt for this course of action, their overall results are lower than if they had both cooperated. This illustrates how individual self-interest and collective welfare collide.

The Prisoner's Dilemma is a key idea in economics because it illustrates the conflicts that can occur when people or businesses make decisions in situations that are competitive. It draws attention to the conflict between individual welfare and group interests. In economic settings, it is typical for people to encounter circumstances in which their decisions have an impact on others. This problem highlights the difficulty in attaining solutions that are advantageous to all parties. The Prisoner's Dilemma aids economists in comprehending the effects of self-interested behaviour and in the analysis of price choices, market competition, and strategic interactions. It highlights the necessity of approaches and regulations that promote collaboration and handle the issues of individual vs group rationality.

Examples of the Prisoner’s Dilemma within the Field of Economics and Game Theory:

1. OPEC and Oil Production: When considering whether to reduce oil output in order to raise prices and revenues collectively, OPEC member countries are faced with a dilemma. To raise their particular market share, each member is motivated to lie and produce more. However, if everyone decides to cheat, it results in an excess of oil and lower prices, which reduces everyone's revenue.

2. Advertising and Price Wars: Companies in oligopolistic markets must choose between aggressive advertising and price wars. In order to achieve a competitive advantage, every business is motivated to do this. However, if every business engages in excessive advertising or price cuts, it reduces earnings for everyone because costs go up and prices go down.

3. Common Resources and Overexploitation: Situations involving the usage of shared resources, like fisheries or natural resources, can also be analysed using The Prisoner's Dilemma. Each person or business has a motivation to maximise their use of the resource for personal gain. The resource will eventually run out and provide fewer benefits for all parties if they all overuse it.

4. International Trade and Tariffs: When considering whether to implement tariffs or trade restrictions, nations that engage in international trade are presented with a problem. Each nation may be motivated to raise tariffs and defend home businesses, but if all nations adopt protectionist policies, it may limit international trade and the economic well-being of all parties.

9. Advantages and Disadvantages of Oligopoly:

Arguments for Oligopoly Market Structures:

1. Innovation and Efficiency: Oligopolistic markets frequently push businesses to innovate and boost productivity to acquire a competitive advantage. The existence of a small number of dominating enterprises encourages rivalry, which results in cost savings and technological breakthroughs. This is an example of ‘dynamic efficiency’.

2. Economies of Scale: Economies of scale can help oligopolies, enabling them to manufacture goods and services more efficiently. Lower average costs are frequently a result of large-scale production, and these savings can be passed on to customers in the form of reduced prices.

3. Product Differentiation: Product differentiation distinguishes oligopolistic markets, where businesses compete through branding, promotion, and distinctive characteristics. More choice and satisfaction for consumers may result from this characteristic.

Arguments against Oligopoly Market Structures:

1. Lack of Competition: Due to the small number of companies in the industry, oligopolies frequently limit competition. As a result of businesses having more control over market conditions, this may lead to less customer choice and higher pricing.

2. Collusion and Cartels: Collusion among oligopolistic businesses may result in anti-competitive behaviour. Cartels, in which businesses band together to fix pricing or output levels, can have a negative impact on consumer welfare and raise prices.

3. Barriers to Entry: Significant entry barriers can exist in oligopolistic marketplaces, making it harder for new businesses to enter and compete. This may impede market access, inhibit innovation, and reduce consumer options.

4. Income Inequality: Oligopolies can often make income inequality worse because they give a small number of companies the ability to make large profits at the expense of consumers and smaller competitors.

Conclusion:

In conclusion, oligopoly market structure creates a varied and complex economic landscape. A small number of dominant firms that have the power to affect market conditions as well as outcomes identify it. Although oligopolies can promote innovation, economies of scale, and product diversification, they can also be problematic due to their low levels of competition, collusion, entry barriers, and income inequality. Oligopoly's effects on consumer welfare and market efficiency are influenced by a number of variables, including business behaviour, governmental restrictions, and the presence of entry barriers. A significant challenge in handling and understanding oligopolistic markets is finding a balance between promoting competition, encouraging innovation, and preserving consumer interests.

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SUPPORTING DIAGRAMS

kinked demand curve explains the idea of price stickiness or price rigidity within the market structure of oligopoly - if firms raise prices, rival firms are unlikely to follow suit - if firms decrease prices then rivals are likely to follow which leads to a price war and worse profits for everyone

this is a payoff matrix which explains the prisoner’s dilemma - 2 prisoners have to make a choice either to confess or deny their crime - if they both confess then they both get a reduced sentence - if they deny then they could get away with it altogether, however there is an issue of trust - if there is a lack of trust between the 2 prisoners then they are more likely to confess and get the reduced sentence - this explains why colluding firms sometimes ‘come clean’ to regulators in exchange for reduced financial penalties - the game-optimal outcome is also called the Nash Equilibrium which is the best possible choice when all other choices have been considered

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SUPPORTING QUESTIONS

Question 1:

Suppose a country with significant oil reserves wants to join OPEC, an oligopolistic organisation that coordinates oil production and pricing.

Explain the benefits the new member might gain from joining OPEC and the potential impact on its oil industry.

Answer:

If a country with substantial oil reserves joins OPEC, it can reap several benefits:

1. Market Influence: By becoming a member of OPEC, the country gains a platform to influence global oil prices and market outcomes. OPEC's production quotas and pricing strategies can provide stability, higher prices and profits on its oil exports - this leads to increased revenue and economic growth.

2. Production Coordination: Joining OPEC allows the country to coordinate its oil production levels with other member nations. This coordination helps prevent excessive oil production, which could lead to price declines, and enables the country to align its output with market demand, maintaining stable prices and avoiding overproduction.

3. Market Access: OPEC membership provides the country with access to a network of major oil-producing nations, fostering collaborations and partnerships. This can facilitate technology transfer, knowledge sharing, and joint ventures, which can enhance the country's oil industry capabilities and promote long-term development.

4. Market Stability: OPEC's efforts to stabilise oil markets through production agreements and price targets can benefit the new member by reducing price volatility and ensuring a predictable market environment. Stable prices provide a favourable investment climate, encouraging industry growth and attracting foreign direct investment.

Question 2:

In a market with four major firms, calculate the concentration ratio using the market shares of each firm:

Firm A with a market share of 40%, Firm B with 20%, Firm C with 15%, and Firm D with 12%. What is the 4-firm concentration ratio in this oligopoly market?

Answer:

To calculate the concentration ratio in an oligopoly market, we sum up the market shares of the largest firms.

Concentration Ratio = Market Share of Firm A + Market Share of Firm B + Market Share of Firm C + Market Share of Firm D

= 40% + 20% + 15% + 12% = 87%

Therefore, the concentration ratio in market is 87%. This indicates that the market is highly concentrated, with the four major firms accounting for the 87% of the market share. The high concentration ratio suggests that the market is an oligopoly which has major impacts on stakeholders within the industry.