gcea-level & ibeconomics

OligopolyGCE A-LEVEL&IB ECONOMICS

WhatisOligopoly?Amarketcontrolledbyafewlargefirms.

- Highbarrierstoentryandexit◦ Duetolarge-scaleproduction(economiesofscale)orbranding/long-termstandinginthemarket

- Interdependence◦ I.e.actionsofonefirmcaneasilyaffectothers

- Non-pricecompetition◦ Duetopricerigidity,youwillseewhylater

- Differentiatedorhomogenousgoods◦ E.g.laundrypowder

ConcentrationRatios

ConcentrationRatiosaresimplythecombinedmarketshareoftopfirms.Canyoufigureourthe3,4and5firmconcentrationratiosinthetableontherightforHongKongPrivateResidentialHousingDevelopers?

PrivateResidentialHousingDevelopers

MarketSharein2015

---------------------------ConcentrationRatioPercentage

DeveloperA 33.83%

DeveloperB 21.04%

DeveloperC 14.47% CR3 (3FirmConcentration Ratio)

DeveloperD 4.97% CR4 (4FirmConcentration Ratio)

DeveloperE 4.32% CR5 (5FirmConcentrationRatio)

ConcentrationRatios

ConcentrationRatiosaresimplythecombinedmarketshareoftopfirms.Canyoufigureourthe3,4and5firmconcentrationratiosinthetableontherightforHongKongPrivateResidentialHousingDevelopers?

PrivateResidentialHousingDevelopers

MarketSharein2015

---------------------------ConcentrationRatioPercentage

DeveloperA 33.83%

DeveloperB 21.04%

DeveloperC 14.47% CR3 (3FirmConcentration Ratio)

69.34%

DeveloperD 4.97% CR4 (4FirmConcentration Ratio)

74.31%

DeveloperE 4.32% CR5 (5FirmConcentrationRatio)

79.63%https://www.researchgate.net/publication/317811921_Concentration_Analysis_of_New_Private_Residential_Units_Market_in_Hong_Kong?_sg=MNY8GbNcgC2X_7wp461unCrwuW7zWKvjReS7_zW8HrpGdQiWZUxkpFpaKt2ns5YlBe3TLwLiQw

ConcentrationRatios

Aruleofthumbisthatanoligopolyexistswhenthetopfourfirmsinthemarketaccountformorethan60%oftotalmarketsales.(i.e.CR5 >60%)

ExamplesofOligopolies

https://www.scmp.com/business/article/2050088/hong-kongs-developer-cartel-beginning-lose-its-grip

RealEstateDevelopersSupermarketChains

BigFourAccountingFirms

Non-CollusiveOligopolyRevenues

Underanon-collusiveoligopoly,whenafirmraiseprices,otherplayerswillkeeppricesconstant.Becauseofthis,existingcustomerswillswitchtocheaperalternatives.Thismeansasmallincreaseinpricewillcausealargerfallinquantitydemanded.

Hence,upperpartsofthedemandcurveiselastic.

Price

Output

P

Q

AR=D

Priceelastic

Priceinelastic


Whenafirmdecreaseprices,otherplayersareassumedtoalsodecreasepricestonotlosemarketshare.Becauseofthis,asteepdecreaseinpriceisrequiredtoattractothercustomerstobuyyourproduct.Thismeansabiggerfallinpriceisrequiredtoincreasequantitysold.Hence,upperpartsofthedemandcurveiselastic.

Price

Output

P

Q

AR=D

Priceelastic

Priceinelastic


GiventheMRistwiceassteepastheAR,theMRinakinkeddemandcurvewillshapelikethis.

Noticethebreakinthemiddle–thereareactually2partstotheMRcurve,onecorrespondingtoeachARline.

Price

Output

P

Q

MRAR=D

a

b

Non-CollusiveOligopolyDiagramThisisthediagramyouwillhavewhenyoucombinetheMCcurve.TheisnodifferenceinpriceaslongastheMCcurve‘intersects’withMRbetweenMC1andMC2

Wheredoesthefirmmaximizeprofitsagain?Youneedtobeawareoftheprofitmaximizationpointtodrawthisdiagramaccurately– thepricealwaysneedtobeatthekink.

Price

Output

P

Q

MR

MC1MC2

AR=D

a

b

Non-CollusiveOligopolyDiagram

Thisdiagramshowstheabnormalprofitsthatcanbemadeinanoligopoly.

Price

Output

P

Q

MR

MC

AR=D

AC

C

Non-CollusiveOligopolyDiagram

Alosscanalsobemade– thisalldependsonwheretheACandARcurveispositioned.

Price

Output

P

Q MR

MC

AR=D

AC

C

AreOligopoliesCompetitive?

Butwhydoweassumethefirmswillcompetewitheachotherformarketsharewhenpricesfall?

Orwhywillthebigplayersalwaysaimtogainothers’marketsharewhenafirm’spricesincrease?

Wecanthinkaboutthisusingananalogy.

ThePrisoner’sDilemma

Don’tbetray

Betray

Betray Don’tbetray

Loki

5years

5years

15years

15years

1 year

1 year 3 years

3 years

Twoprisoners(players),LokiandBaelish havebeenarrestedforbankrobberyandinterrogatedseparately.Policehaveevidenceofminorcrimesforbothprisoners.However,theyarelookingtopinamajorcrimeononeorbothoftheprisoners.Bothplayershaveevidenceoneachotherthattheytookpartinthemajorcrime.

Baelish


Don’tbetray

Betray


Loki

5years

5years

15years

15years

1 year

1 year 3 years

3 years

Thepolicearewillingtobemorelenientiftheprisonersprovidethemwiththisevidenceandbetraytheirpartnerincrime.Eachplayerhasastrategy – betrayordon’tbetray.

Thereisapayoff foreachstrategyundertaken.Thisisshowninthetablee.g.ifAandBbothbetraytheyeachget5yearsinprison.

Baelish


Don’tbetray

Betray


5years

5years

15years

15years

1 year

1 year 3 years

3 years

Thedominantstrategyisthebeststrategyundertakenbyaplayerregardless ofthestrategyundertakenbytheotherplayers.

NomatterifLokibetraysBaelish ornot,Baelish willalwaysgetlesstimeinprisonifhebetraysLoki.i.e.5yearsratherthan15 yearsifLokibetrayshim;and1yearratherthan3yearsifLokidoesn’t.Viceversa.

Loki

Baelish


Don’tbetray

Betray


5years

5years

15years

15years

1 year

1 year 3 years

3 years

Hencethedominantstrategyforbothofthemistobetraytheother.ThisequilibriumiswhatwecalltheNashequilibrium.

Thisisassumingthattheydidnotagreebeforehandonwhethertheyshouldbetraytheotherornot.

Loki

Baelish

TheFirm’sDilemma

IncreaseP

MaintainP IncreasePB

A

£100

£100

£75

£75

£150

£150 £125

£125

Sowithoutaformalagreementbetweeneachother,thefirmsfacethesameproblem.

Thedominantstrategywillbetomaintainpricestokeepmarketshare.

MaintainP

IsthereaMutuallyBeneficialOutcome?

Inreallife,firmswillbeabletocommunicatewithoneanother.

Whatcanthebigplayersintheindustrydo/agreeon,whichcanbemutuallybeneficial?

Theobjectiveofthiswillbetomaximizeandsharejointprofits intheindustry,whichwillbehigherthancompetingwitheachother.

OvertCollusionTobenefitasagroup,thefirmscan

- Raisepricestogether(orsetthem)

- Produceanagreed,fixedamountofoutput(tomaximizeprofits)

- Splitthemarketbetweenthemselves(e.g.geographically,byproduct)

- Notpassonnewcostsavingstoconsumerstogether(e.g.fromtechnology)

Acartelisaformalagreementbetweenfirmstocolludeinthemarket.

Youcanseethecartelactslikeamonopolyandhasmuchbiggermarketpowercomparedtoafirminanoligopoly.

CaseStudy– LaundryDetergents

MeanwhileinAustralia...

https://www.smh.com.au/business/companies/project-mastermind-colgate-colluded-with-rivals-and-woolworths-to-rip-you-off-20160428-goh9ji.html

Unilever,ColgateandSupermarketChainWoolsworth colludingnottopasscostsavingsfromproductinnovationtocustomers,throughpricefixingandoutputrestrictions.

TacitCollusion

However,notalltypesofcollusionincludeaformalagreement(cartel)betweenthefirms.Theycanalsodoitinanimplicitmanner.Thisiswhatwecalltacitcollusion.

Forexample,firmsmaychargethesamepricesasthedominantfirmintheindustry(insteadofchallengingit).Thefirmwithpriceleadership willchargeahigheramountforotherfirmstofollowsuit,suchthatthewholeindustrybenefitswithhigherprofitsbutconsumersloseout.

Thisisascenariowhereanimplicitpriceagreementisinplace.

TheRisksofCollusion

1.Betrayal/CheatingfromotherPlayers

- Otherfirmsinthemarketmaynotcontinuewiththeagreement.Forexample,ifanagreementisreachedtoraiseprices,ifaplayerdoesnotfollowthrough,hewillbeabletogainmarketshareforhimselfandreducerevenuesforotherplayers.

2.RegulationandFines

- Thereislegalriskespeciallyforanovertcollusiveagreementbetweenfirms.Theycaneasilybepenalizedaheftyfine.Also,therewillbetheriskofafirmwhistleblowingtotheindustryregulatorfortheactivity.

TheRisksofCollusion

3.PublicRelationsandBranding

- Collusion,whendiscovered,willharmthepublicimageoffirms.Publicimageandbrandingisanintangibleassetthatcanbequitevaluabletoafirmgiventheimportanceofnon-pricecompetitionwithinanoligopolisticmarketstructure.

However,whenfirmscollude,itismostlikelythattheserisksaretakenintoaccountandtheexpectedprofitsmaximizedandsharedfromcollusionmaybehigherthanpotentiallosses.

PriceCompetitioninanOligopoly

Whydo youthinkoligopolieswouldnotfavorprice-basedcompetitionandwouldexhibitpricerigidity?

P

Q

MR

MC1MC2

AR=D

a

b

Price

Output

PriceCompetitioninanOligopoly

Pricewarsoccurwhenafirmlowerspriceinordertoincreasemarketshare.Otherfirmswillreacttolosingmarketsharebyloweringpricetoo.Thiswillcontinueasfirmsseektoregainlostmarketshare.Theconsumerwillbenefitfromlowerpricesbuttheoligopolists willloseoutasoverallrevenueswillfall.

Hence,inanon-collusiveoligopoly,pricesshouldbestableandrigidaccordingtotheoryandthediagram.

TypesofNon-priceCompetition

Assuminganoligopolydoesnotcolludeorworkwithoneanother,theywillcompetewitheachotherintermsofnon-pricefactors.Thereasonisthatcompetingonpricewillreducerevenuesandlikelyaffectprofits.

Whatdoyouthinkaresomewayswhicholigopolisticfirmscancompete,notonthebasisofprice?

TypesofNon-priceCompetition

Advertising isanexampleofasunkcostanddetersnewentrants

Firmswillspendheavilytryingtoestablishbrandloyalty andrepeatcustomerse.g.loyaltyschemes

Byinvestinginnewproductdevelopmentthefirmcanincreasedemandandmaintainbrandloyalty

Heavyinvestment undertakenwillhavehighlevelsofcapitalinvestmentinoligopoly, leadingtoasteadyincomestreamforthefuture

EvaluatingOligopolies

Howwouldyouevaluateoligopolies?Towhatextentaretheybeneficialorharmfultosociety?

EvaluatingOligopoliesAdvantages:

- Generallystablepricesforconsumersandproducersdownthevaluechain

- Researchanddevelopmentthroughnon-pricecompetitionwillleadtoproductinnovation

- Canbenefitfromeconomiesofscalewhilepassingonlowerpricestoconsumerstosomedegree

Disadvantages:

- Risksofcollusionmaycauseconsumerstoloseoutinthelongrun

- Difficulttoregulateandprovetacitcollusionthroughpriceleadership(hardtoarguewhatisasuitablepricepointsgivendifferentcoststructuresacrossfirms)

- Notthemostefficienttypeofmarketstructurepossibleduetoprofitmaximization

ShortQuestions- Oligopoly

- Suggest3characteristicsofanoligopolisticmarket.

- Whydooligopoliesgenerallyexhibitpricerigidity?Explaintheshapeofthekinkeddemandcurve.

- Name2waysfirmsinoligopolycancompetewitheachotherapartfromprice.

- Whataresomewayswhichfirmsinoligopolycancollude?

- Thinkof1advantageand1disadvantageunderoligopoly.

gcea-level & ibeconomics

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