4.4 Oligopoly

1. Concentration ratios: Concentration ratios measure the proportion of total market output or sales accounted for by the largest firms, indicating the degree of market concentration and the level of competition.

DEFINITIONS:

1. Oligopoly: An oligopoly is a market structure characterized by a small number of large firms that dominate the market and are interdependent in their decision-making.
2. Non-price discrimination: Non-price discrimination refers to the strategies firms use to attract customers and differentiate their products or services through means other than price, such as quality, branding, or customer service.
3. Interdependence: kinked demand curve: The kinked demand curve theory in oligopoly suggests that firms face a demand curve that is more elastic for price increases and less elastic for price decreases, leading to price rigidity and interdependent pricing strategies.
4. Formal collusion: Formal collusion occurs when firms in an oligopoly openly agree, often through a cartel, to set prices or output levels to maximize collective profits.
5. Informal collusion: Informal collusion involves firms in an oligopoly implicitly coordinating their actions, such as price setting or market sharing, without explicit agreements, often to avoid legal repercussions.
6. Product differentiation: Product differentiation is the process by which firms make their products distinct from those of their competitors through variations in quality, features, branding, or other attributes.

Explain:

4.4.1 The characteristics of oligopoly

An oligopoly is a market structure characterized by a small number of firms that dominate the market. The key characteristics of an oligopoly include:

7. Few Large Firms: There are only a small number of firms in the market, each holding a significant market share. These firms are large enough to influence market conditions.
8. Interdependence: Firms are interdependent, meaning the actions of one firm directly affect the others. As a result, firms are highly responsive to competitors' pricing and output decisions.
9. Barriers to Entry: High barriers to entry prevent new firms from entering the market easily. These barriers can be due to high start-up costs, economies of scale, brand loyalty, or legal restrictions.
10. Non-Price Competition: Firms often compete on factors other than price, such as product quality, brand loyalty, advertising, and customer service, to avoid price wars which can be mutually harmful.
11. Price Rigidity: Prices in oligopolistic markets tend to be stable. Firms are reluctant to change prices for fear of sparking a price war. Instead, they might use non-price competition strategies to increase market share.
12. Collusion: Oligopolistic firms might engage in collusion, either overtly (forming cartels) or tacitly (informal understandings), to set prices or output levels and maximize joint profits. Collusion is often illegal and regulated by competition authorities.
13. Kinked Demand Curve: This theory suggests that an oligopolist's demand curve is kinked at the current price level. If a firm raises prices, it will lose a significant market share because competitors will not follow suit. Conversely, if it lowers prices, competitors will also lower theirs, leading to a relatively inelastic demand curve below the current price level. In summary, oligopolies are marked by a few large firms with significant market control, high entry barriers, interdependent decision-making, and a preference for non-price competition to maintain market stability.

4.4.2 Non-price competition

Non-price competition refers to strategies that firms use to attract customers and increase market share without changing the price of their products or services. These strategies can be particularly important in markets where products are similar, and firms want to differentiate themselves from competitors. The main forms of non-price competition include:

14. Product Differentiation: Enhancing the features, quality, or design of a product to make it more attractive. This can involve innovations, variations in style, or additional functionalities.
15. Advertising and Branding: Creating a strong brand identity and advertising to increase consumer recognition and loyalty. Effective advertising can emphasize the unique qualities and benefits of a product.
16. Customer Service: Providing superior service, such as free delivery, extended warranties, or excellent after-sales support. Good customer service can create a positive customer experience and encourage repeat business.
17. Sales Promotions: Offering promotions like discounts, loyalty programs, or free samples to attract customers. These promotions can stimulate demand and encourage customers to choose one brand over another.
18. Packaging: Using attractive and innovative packaging to make the product stand out on the shelves. Packaging can also communicate the quality and uniqueness of the product.
19. Distribution Channels: Ensuring that products are widely available and easily accessible through various distribution channels, such as online platforms, physical stores, and exclusive dealerships. By focusing on these aspects, firms aim to gain a competitive edge and build a loyal customer base without engaging in price wars, which can erode profits.

4.4.3 Interdependence: kinked demand curve

the concept of interdependence is crucial in understanding how firms in an oligopoly market structure behave. One key model used to illustrate this is the kinked demand curve theory.

Kinked Demand Curve

The kinked demand curve model explains why prices in oligopolistic markets tend to be stable. Here's a concise explanation:

20. Interdependence: Firms in an oligopoly are interdependent, meaning each firm's decisions affect and are affected by the actions of other firms in the market. This leads to strategic behavior, particularly regarding pricing.
21. Assumptions:

• If a firm raises its price, other firms will not follow, leading to a significant loss of market share for the firm that increased its price.
• If a firm lowers its price, other firms will follow to avoid losing their market share, resulting in only a small gain in market share for the firm that decreased its price.

22. Demand Curve:

• The demand curve is kinked at the current market price.
• Above the kink (higher prices): Demand is relatively elastic because consumers can switch to other firms, leading to a significant drop in quantity demanded if one firm raises its price.
• Below the kink (lower prices): Demand is relatively inelastic because all firms lower their prices, leading to only a slight increase in quantity demanded if one firm lowers its price.

23. Marginal Revenue Curve:

• The marginal revenue (MR) curve corresponding to the kinked demand curve has a discontinuity or a gap. This occurs because the slope of the MR curve changes abruptly at the kink.

24. Price Rigidity:

• The kinked demand curve explains price rigidity in oligopolistic markets. Firms have little incentive to change prices because increasing prices leads to a loss of market share, while decreasing prices triggers a price war with minimal gains.

Diagram

In the kinked demand curve diagram:

• The kink occurs at the current market price and quantity.
• The upper segment of the demand curve is more elastic than the lower segment.
• The MR curve has a vertical gap or discontinuity at the quantity corresponding to the kink.

Conclusion

The kinked demand curve model shows how interdependence among firms in an oligopoly leads to price stability. Firms avoid changing prices due to the anticipated reactions of their competitors, leading to a situation where prices remain relatively rigid despite changes in marginal costs.

4.4.4 Types of collusion

Collusion refers to agreements between firms to restrict competition, usually to increase their collective profits. There are two primary types of collusion: formal collusion and tacit collusion.

Formal Collusion

• Definition: Formal collusion, also known as overt collusion, occurs when firms openly agree on prices, market shares, or production levels.
• Example: Cartels, such as the Organization of Petroleum Exporting Countries (OPEC), where member countries agree on oil production quotas to control prices.
• Characteristics:
  • Legal agreements or contracts.
  • Often results in price fixing, output restrictions, or market sharing.
  • Illegal in many countries due to anti-trust laws.

Tacit Collusion

• Definition: Tacit collusion, or covert collusion, happens when firms indirectly coordinate actions without explicit agreements, often by following a dominant firm's pricing or output strategies.
• Example: Price leadership, where one firm sets the price and others follow suit without direct communication.
• Characteristics:
  • No formal agreements or explicit communication.
  • Firms understand mutual benefits of maintaining higher prices.
  • More difficult to detect and regulate compared to formal collusion.

Comparison

• Transparency: Formal collusion is transparent and involves explicit agreements, while tacit collusion is implicit and involves no direct communication.
• Legality: Both types are generally illegal in most countries, but tacit collusion is harder to prove and regulate.
• Stability: Formal collusion can be more stable due to enforceable agreements, whereas tacit collusion relies on mutual understanding and can be more fragile. Understanding these types of collusion is crucial in analysing market structures, particularly oligopolies, where a few firms dominate the market and have the potential to collude, impacting consumer welfare and market efficiency.

4.4.5 Product differentiation

Product differentiation is a key concept in economics that refers to the strategies firms use to make their products distinct from those of competitors. This can be achieved through various means, including:

25. Quality Differences: Enhancing the product's quality to make it superior to others.
26. Branding: Creating a unique brand identity that differentiates the product from others.
27. Features and Design: Adding distinctive features or innovative designs.
28. Customer Service: Offering superior customer service or support.
29. Packaging: Using unique or attractive packaging. By differentiating their products, firms aim to create a competitive advantage, attract more customers, and potentially charge higher prices. This strategy can reduce direct competition and build customer loyalty.

Evaluation and Calculation

4.4.6 Concentration Ratios

Definition: Concentration ratios measure the proportion of the market controlled by a specific number of the largest firms. The most common concentration ratios are the CR4 and CR8 ratios, which look at the market share of the four and eight largest firms, respectively.

Calculation: The concentration ratio is calculated as the sum of the market shares of the largest firms in the industry. It is usually expressed as a percentage.

Conclusion:

Concentration ratios are useful tools for assessing the level of competition in an oligopolistic market. However, they should be used alongside other measures and analyses to get a comprehensive understanding of market dynamics and competitive behaviour.