1. Market structures: oligopoly
3.14 Operational Strategies: location
Market structures: oligopoly

2. Candidates should be able to:
Syllabus
Candidates should be able to:
Define the characteristics of oligopoly (high barriers to entry and exit; high concentration ratio; interdependence of firms; product differentiation)
Calculate n-firm concentration ratios and assess their significance
Analyse reasons for collusive and non-collusive behaviour.
Evaluate why firms may use overt and tacit collusion with reference to cartels and price leadership
Use simple game theory: the prisoners’ dilemma in a simple two firm/two outcome model
Analyse types of price competition (price wars, predatory pricing, limit pricing)
Analyse types of non-price competition

3. Concentration ratios – definitions
What is a concentration ratio?
A concentration ratio measures the extent to which a market is dominated by a small number of large firms (at one extreme) or a large number of small firms (at the other).
It calculates the market share of the largest firms in an industry.
E.g. a three firm concentration ratio of 94% shows that the ________ largest firms have a combined market share of ________

4. Concentration ratios – UK supermarkets
In June 2014 market shares were as follows:
Tesco 28.9%
Asda 17.1%
Sainsbury 16.7%
Other 13.1%
Morrison 10.9%
Waitrose 5.0%
Aldi 4.7%
Lidl 3.6%
Find the three firm and the four firm concentration ratio.

5. Concentration ratios and their significance
In general, the higher the concentration ratio, the ________ competition.
A low concentration ratio (0 – 50%) in an industry suggests that the industry is ______ competitive as there are a lot of firms. They will struggle to compete on price.
A high concentration ratio (80 – 100%) suggests that the largest firms have significant market control. The __________________ may try and regulate these firms to stop them abusing their power.
A medium ratio is 50 – 80%

6. Concentration ratios - what is market share?
We know that concentration ratios measure market share.
How can market share be calculated?

7. Drawbacks of concentration ratios
Different measure of __________ share give different answers
It can be difficult to __________ an industry
It doesn’t give information on _________ barriers or _________ differentiation within the industry
It doesn’t differentiate between national and ________ competition
define, entry, foreign, market, product

8. An oligopoly is when the market is dominated by a ________ suppliers.
Definition
An oligopoly is when the market is dominated by a ________ suppliers.
The market concentration ratio must be ______
E.g. some sources suggest an oligopoly is defined when there is a 5 firm concentration ratio of greater than 50%; others suggest a four-firm concentration ratio over 90% is a good indication of oligopoly.
Why might it be possible to have an oligopoly when there are lots of firms?

9. Key points in an oligopoly
Firms must be interdependent, what does this mean?
There are high barriers to entry and exit. Why?
There are high concentration ratios
Firms produce differentiated products - they may be similar but are not identical (e.g. ________________)
Often non-price competition: the other aspects of the Marketing Mix are important
Prices tend to be stable (slow to change)
L shaped cost curves rather than U shaped
Collusion often occurs

10. Examples of an oligopoly

11. Research barriers to entry

12. Draw an L shaped cost curve and mark on the MES
In an oligopoly the optimum level of production extends over a wide range

13. 3.14 Operational Strategies: location
Interdependence
When firms introduce a new product or wish to change prices they will need to consider their competitors (rather than just their customers)
E.g.
Why do firms tend to keep prices stable?
This is why oligopoly firms have an incentive to work together through collusive agreements.

14. 3.14 Operational Strategies: location
Collusion
Collusion is defined as collective agreements between producers which restrict competition
Collusive oligopoly occurs when firms collude and form a cartel
What are the reasons for collusion?
Formal (overt) collusion exists when firms agree to restrict competition. It is illegal in the UK
Tacit collusion is when firms understand it is in their own interests to restrict output and competition. They monitor each other and follow unwritten rules.

15. Edexcel definitions: tacit collusion
3.14 Operational Strategies: location
Edexcel definitions: tacit collusion
“There seems to be a major problem in understanding the concept of tacit collusion. The OECD definition is the best reference, which indicates that the collaboration is implicit or unspoken. Some candidates suggested that some forms of collusion are legal, but this is an ill-advised approach. If an action is collusion it is illegal, but may not be able to be proven as such. Having said this, students could go on to earn further marks discussing collusion in whatever form they understood it and many discussed the difficulty of finding evidence, regulatory capture, asymmetric information and lack of regulatory power.”
June 2013

16. 3.14 Operational Strategies: location
Competition - pricing
Price wars are when firms continually ____ prices to undercut each other. Designed to gain market share, it assumes price is key for customers (but this depends on PED). It is very risky
Predatory pricing occurs when a firm sells a good below ________ (or very cheaply) to try and force rivals out of business. It’s illegal in the UK
Price leadership is when a firm sets the price for a good in the industry and competitors feel obliged to ________ it.
Limit pricing is when a firm tries to discourage entry. Prices are set below the profit maximising level and output is increased up to the level where a new firm will not be able to make any _______ on entering the market. Excess capacity may be used as a threat that if firms enter, it will reduce price even further.

17. Competition – non price competition
3.14 Operational Strategies: location
Competition – non price competition

18. The kinked demand curve – diagram
3.14 Operational Strategies: location
The kinked demand curve – diagram
What would happen if a firm in an oligopoly increased its price?
What would happen if a firm reduced its price?
What is the best scenario for prices?

19. The kinked demand curve – explains price rigidity in oligopoly
3.14 Operational Strategies: location
The kinked demand curve – explains price rigidity in oligopoly

20. Diagram of an oligopolistic firm
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Diagram of an oligopolistic firm
An oligopolistic firm is neither productively or allocatively efficient at its long-run equilibrium point. Draw this

21. Game theory introduction
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Game theory introduction
The concept of Game theory started in 1838 when Augustin Cournot tried to explain the behaviour of duopolists.

22. 3.14 Operational Strategies: location
What is a game?
A game must have:
Rules, which govern the behaviour of the players
Pay-offs (results) e.g. win, lose or draw
Strategies, which influence the decision making process

23. When can game theory be used?
3.14 Operational Strategies: location
When can game theory be used?
It can be used when making decisions about:
Price and output – increase? Lower? Hold?
Products – keep existing products? Develop new ones?
Promotion – spend more on advertising? Spend less? Spend the same as now?

24. What pay-offs could firms expect?
3.14 Operational Strategies: location
What pay-offs could firms expect?
Firms may gain:

25. Game theory - definitions
3.14 Operational Strategies: location
Game theory - definitions
Game theory is used to analyse situations when firms are interdependent.
Typically it could be used in oligopolistic markets looking at competition between firms.
It is used when there are two options and it tries to identify the best strategy in a conflict situation.
A payoff matrix shows the outcomes of a game for one firm given different possible strategies
A Nash Equilibrium results when every firm in an industry chooses the best strategy given the strategies chosen by its competitors (not on syllabus)

26. The Prisoner’s Dilemma
3.14 Operational Strategies: location
The Prisoner’s Dilemma
The prisoner’s dilemma is a simple game which shows the choice facing oligopolies.
The dilemma is that their pay-off (result) is dependent on the behaviour of the other prisoner.
To avoid the worst case situation they should both confess.
If collusion is possible they can both agree to deny – BUT then there is a strong incentive to cheat (one denies and the other confesses). So the safest option is to confess.

27. The Prisoner’s Dilemma - diagram
3.14 Operational Strategies: location
The Prisoner’s Dilemma - diagram

28. 3.14 Operational Strategies: location
Dominant strategy
A dominant strategy is the best outcome irrespective of what the other player chooses. It is better or equivalent to any other available strategy. A rational firm will select a dominant strategy.
In the prisoner’s dilemma, the dominant strategy is to confess.
The prisoners’ dilemma is a situation where each player chooses a dominant strategy but each could do better if both chose different strategies.
But, in the prisoners’ dilemma, they do not co-operate.

29. Airline example – flight prices
3.14 Operational Strategies: location
Airline example – flight prices
What price should airline A charge?
They should charge
What could the airlines earn if they colluded?

30. 3.14 Operational Strategies: location
Tit-for-tat
A tit-for-tat strategy is when a player responds in one period with the same action their opponent used in the last period.
It makes it possible for firms to cooperate without colluding. It can be successfully employed in repeated games
Game theory relates to economics and firms as it suggests that firms are unlikely to trust each other, even if they collude and agree to say increase the price of a good.

31. Game theory – example of a dominant strategy
3.14 Operational Strategies: location
Game theory – example of a dominant strategy
What should firm B do?
Firm B
Raise price
Leave price unchanged
Firm A
+ £5m / £5m
+ £3m / + £3m
+ £2m / + £1m
+ £0m / + £0m

32. 3.14 Operational Strategies: location
Zero sum game
A zero sum game is when a gain for one side entails a corresponding loss for the other side
Sharing a cake is a zero-sum game!

33. 3.14 Operational Strategies: location
Non-zero sum game
The prisoners’ _________ is a non-zero sum game as it could result in a win-win situation (or lose-lose!)
In non-zero-sum games there is no __________ solution like that of zero-sum games.
E.g. in the theory of ___________ advantage, there are benefits to both sides from trading if each focuses its resources on ______________ in the product in which it has a comparative advantage.
The important thing to remember with these games is that there is no one 'best' solution.
comparative, dilemma, optimal, specialising