The theory of oligopoly Concentrated markets The theory of oligopoly

Oligopoly defined Oligopoly is best defined as a market structure where the majority of market share (generally, anything from 70% upwards) is concentrated in the hands of a few firms (generally 3-5 dominant firms). There is however, no real consensus on the precise theory of how oligopolistic market perform for it is a market structure that is more defined by the behaviour of firms rather than a set of rules. As a result, two markets can have the same characteristics in respect of firms in the market and market share, but see one to be fiercely competitive while the other to exhibit collusive behaviour and the market to operate more like a monopoly. Many markets have moved towards oligopoly, much of this has been driven by the increasing number of takeovers and merger since the 1990s. Examples include the petrol industry, food retailing, banking and insurance, car production and consumer electronics.

Defining market structure Concentration ratio. This takes the market share of the ‘largest’ firms in the market, aggregates them and then quotes the number of firms against this aggregate as a ratio. Firm Market share (%) Concentration ratio A 28 1 Firm 1:28 B 22 2 Firm 2:50 C 20 3 Firm 3:70 D 15 4 Firm 4:85 E 7 5 Firm 5:92 F 2 G H 1 I All others 100

Competitive oligopoly Firms pursue an independent strategy, but due the ‘potentially’ competitive nature of oligopoly, there is interdependence between the firms in the market. Oligopoly is characterised by reactive behaviour for the actions of one firm is likely to provoke a response from another. Reactive behaviour is evident when firms pursue non-price competition strategies, and not so evident in price competition. The later is best considered in the context of the ‘kinked demand curve’

Deriving the kinked demand curve The theory of the kinked demand curve is based on the premise that a firm’s pricing decision will provoke a response from other firms in the industry. The response to a price rise is likely to be different from that of a price reduction. As a result the firm faces two distinct demand, or AR curves. Price rises are not likely to be followed by the competition. The firm initiating the price rise will thus face an elastic demand curve for its product in this case. This is represented by a shallow demand curve (DARe). Price falls are likely to be followed by the competition. In this case the firm initiating the price fall will thus face an inelastic demand curve for its product. This is represented by a steeper demand curve (DARi) P Qd

The kinked demand curve The effect on total revenue when a firm increases its prices A represents the current price adopted by a firm. Points to the left of A run along a demand curve that has an elastic PED. That is, price increaes will see a fall in total revenue E.g P1 = £10,QD1 = 100, TR =£1,000 P2 = £11,QD2 = 80, TR = £880 P Qd

The kinked demand curve The effect on total revenue when a firm reduces its prices A represents the current price adopted by a firm. Points to the right of A run along a demand curve that has an inelastic PED. That is, price reductions will see a fall in total revenue E.g P1 = £10, QD1 = 100, TR =£1,000 P3 = £9, QD3 = 105, TR = £945 P Qd

The kinked demand curve A theory of competition or collusion? The kinked demand curve is a theoretical approach that endeavours to analyse the reasons for price stability in oligopoly. What does the point A represent? One must question is price stability, also referred to as ‘sticky prices’ or ‘price rigidity’ , a result of collusive behaviour that ensures prices do not fall, or a competitive strategy that ensures prices do not rise? P Qd

‘Sticky prices’ and the consequences for non price competition in oligopolistic markets Non price competition in the retail food industry (Tesco)  The effect of non-price competition on the firm’s demand curve.

Oligopolistic markets :- Game Theory The Prisoners’ Dilemma Supports the argument that oligopolists will collude for the benefits of doing so outweigh those of engaging in competition. Oligopolists are essentially risk averse, preferring not to take any action that might provoke a retaliatory response from the competition.

Oligopolistic markets :- Game Theory The Prisoners’ Dilemma Prisoner A A pleads innocent A pleads guilty Prisoner B B pleads innocent A gets 0 years A gets 2 Years B gets 0 years B gets 10 years B pleads guilty A gets 10 years A gets 5 years B gets 2 years B gets 5 years

Oligopolistic markets :- Game Theory The pay-off matrix Company A Not to compete Compete Company B £10,000 profit £12,000 profit £5,000 profit £7,500 profit

Oligopolistic markets :- Collusive oligopoly Formal Collusion Formal agreements that aim to remove the uncertainty of competing when firms have a high degree of interdependence. Usually formalised in written agreements that form cartels, agreements on supply, prices and profits will restrict the workings of the free market. The result is to see the market operate more like that of a monopoly where SNPs are not only generated, but secured in the long run. Revenue/cost Quantity

Oligopolistic markets :- Collusive oligopoly Informal Collusion Often referred to as ‘tacit agreements’, these are non written and are more likely to be a ‘working understanding’ between the dominant firms in the market. Unwritten rules are likely to be reached on industry norms such as price, location and other supply.