MARKET STRUCTURES (CONTINUED………..):OLIGOPOLY

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Introduction to Economics ECO401

Lesson 6.4

MARKET STRUCTURES (CONTINUED...........)

OLIGOPOLY

Similar to monopoly in the sense that there are a small number of firms (about 2-20) in the

market and, as such, barriers to entry exist.

Similarity of Oligopoly with other Market Structures:

It is similar to perfect competition in the sense that firms compete with each other, often

feverishly, which may result in prices very similar to those that would obtain under perfect

competition.

It is similar to monopolistic competition since there is a possibility of having differentiated

products.

Strategic interaction:

It differs from other forms of competition in that the strategy of each oligopolistic firm depends

on the action/reaction of other firms in the industry.

It also differs from all other forms in that it is not possible to identify a single equilibrium.

Collusion:

Collusion occurs when two or more firms decide to cooperate with each other in the setting of

prices and/or quantities.

Firms collude in order to maximize the profits of the industry as a whole by behaving like a

single firm. In doing so, they try to increase their individual profits. Often there is a tension

between these two goals ad this can lead to collusion to break down.

A collusive oligopoly (or cartel) can be formed by deciding upon market shares, advertising

expenses, prices to be charged (identical or different) or production quotas.

Cartel:

A cartel is most likely to survive when the number of firms is small, there is openness among

firms regarding their production processes; the product is homogeneous; there is a large firm

which acts as price leader; industry is stable; government's strictness in implementing anti-

trust (or anti-collusion) laws.

Govt. regulations are helpless against internationally operational cartels or when collusion is

tacit (or hidden) not explicit.

Break down of Collusive Oligopoly:

A collusive oligopoly (say based on production quotas) is likely to break down when the

incentive to cheat is very high. This can arise, for instance, in a situation where there is a lure

of very high profits so that individual firms cheat on their quota and try to increase output and

profits. But this causes everyone else to do the same and therefore supply soars and prices

tumble producing in effect a non-collusive oligopoly.

The incentive to collude becomes strong for members of a non-collusive oligopoly when firms

are not making good profits. Thus oligopolies usually oscillate between collusive and non-

collusive equilibria.

Prisoner's Dilemma Situation:

A prisoner's dilemma situation for oligopolistic firms arises when 2 or more firms by attempting

independently to choose the best strategy anticipation of whatever the others are likely to do,

all end up in a worse position than if they had cooperated in the first place.

Introduction to Economics ECO401

Maximin and Maximax strategies:

Maximin strategy is a cautious (pessimistic) approach in which firms try to maximize the worst

payoff they can make. A maximax strategy involves choosing the strategy which maximizes

the maximum payoff (optimistic).

Kinked Demand Curve:

A kinked demand curve explains the "stickiness" of the prices in oligopolistic markets. The

main insight is that if one firm raises prices, no one else will and so the firm will face declining

revenues (elastic demand). However if one firm lowered its price, everyone else would lower

their prices as well and everyone's revenues, including the first firm's revenues would fall

(inelastic demand).

Non Price Competition:

Non price competition means competition amongst the firms based on factors other than price,

e.g. advertising expenditures.

Introduction to Economics ECO401

END OF UNIT 6 - EXERCISES

Give two examples of markets which fall into each of the following categories.

Perfect competition: grains; foreign exchange.

Monopolistic competition: taxis; van hire, restaurants.

Oligopoly: (homogeneous) white sugar; (differentiated) soap; banks.

Monopoly: WAPDA (electricity transmission); local bus company on specific routes.

Would you expect general building contractors and restaurant owners to have the same

degree of control over price?

Other things being equal, restaurant owners are likely to produce a more differentiated

product/service than general builders (as opposed to specialist builders), and are thus likely to

face a less elastic demand. This gives them more control over price. Note, however, that the

control over price depends on the degree of competition a firm faces. If, therefore, there were

only a few builders in a given town, but many restaurants, the above arguments may not hold.

It is sometimes claimed that the market for the stocks/ shares of a company is perfectly

competitive, or nearly so. Go through the four main perfect competition assumptions

you have been taught about (large no. of price taking firms, no entry barriers,

homogenous product, and perfect information) and see if they apply to HUBCO shares.

a. Most aspects of the four assumptions of perfect competition apply.

b. There is a very large number of shareholders (although there are some large institutional

shareholders.)

c. People are free to buy HUBCO shares (though, in reality, this depends on how liquid, i.e.

accessible/available for sale the HUBCO shares are).

d. All HUBCO shares are the same.

e. Buyers and sellers know the current HUBCO share price, but they have imperfect

knowledge of future share prices.

Is the market for gold perfectly competitive?

It is almost similar to the market for HUBCO shares. There are many buyers and sellers of gold,

who are thus price takers, but who have imperfect knowledge of future gold prices. Also,

countries with large gold stocks (e.g. the USA) could influence the price by large-scale selling (or

buying). [Note also that the `price' would have to refer to a weighted average of the price in all

major currencies to take account of exchange rate fluctuations.]

What are the advantages and disadvantages of using a 5-firm "concentration ratio" rather

than a 10-firm, 3-firm or even a 1-firm ratio?

The fewer the number of firms used in the ratio, the more useful it is for seeing just how powerful

the largest firms are. The problem with only including one or two firms in the ratio, however, is

that it will not pick up the significance of the medium-to-large firms. For example, if we look at

the 3-firm ratio for two industries, and if in both cases the three largest firms have a 50 per cent

market share, but in one industry the next largest three firms have 45 per cent of the market (a

highly concentrated industry), but in the other industry the next three largest firms have only 5

per cent of the market (an industry with many competing firms), the 3-firm ratio will not pick up

this difference. Clearly, this problem is more acute when using a 2-firm or a 1-firm ratio.

The more the firms used in the ratio, the more useful it is for seeing whether the industry is

moderately competitive or very competitive. It will not, however, show whether the industry is

dominated by just one or two firms. For example, the 10-firm ratio for two industries may be 90

per cent. But if in one case there are 10 firms of roughly equal size, all with a market share of

approximately 9 per cent, then this will be a much more competitive industry than the other one,

if that other one is dominated by one large firm which has an 85 per cent market share.

Introduction to Economics ECO401

A more complete picture would be given of an industry if more than one ratio were used:

perhaps a 1-firm, a 2-firm, a 5-firm and a 10-firm ratio.

Why do economists treat normal profit as a cost of production?

Because it is part of the opportunity cost of production. It is the profit sacrificed by not using the

capital in some alternative use.

What determines (a) the level and (b) the rate of normal profit for a particular firm?

It is easier to answer this in the reverse order.

a. The level of normal profit depends on the total amount of capital employed.

b. The rate of normal profit is the rate of profit on capital that could be earned by the owner

in some alternative industry (involving the same level of risks).

Will the industry supply be zero when the price of a firm A falls below P1 , where P1 <

AVC for the firm?

Once the price dips below a firm's AVC curve, it will stop production. But only if "all" firms have

the same AVC curve will the "entire industry" stop production. If some firms have a lower AVC

curve than firm A, then industry supply will not be zero at P1.

Why is perfect competition so rare?

· Information on revenue and costs, especially future revenue and costs, is imperfect.

· Producers usually produce differentiated products.

· There are frequently barriers to entry for new firms.

Why does the market for fresh vegetables approximate to perfect competition, whereas

that for aircraft does not?

There are limited economies of scale in the production of fresh vegetables and therefore there

are many producers. There are such substantial economies of scale in aircraft production,

however, that the market is only large enough for a very limited number of producers, each of

which, therefore, will have considerable market power.

What advantages might a large established retailer have over a new e-commerce rival to

suggest that the new e-commerce business will face difficulties establishing a market for

internet shopping?

· Customers are familiar with the retailer's products and services and may trust their

quality.

· Consumers may prefer to be able to ask advice from a sales assistant, something they

can't do when buying over the internet.

· The retailer may have sufficient market strength to match any lower prices offered by the

e-commerce firm.

· The retailer may have sufficient market strength to force down prices from its suppliers.

· Consumers may prefer to see and/or touch the products on display to assess their

quality.

· Consumers may prefer the `retail experience' of going shopping.

As an illustration of the difficulty in identifying monopolies, try to decide which of the

following are monopolies: Pakistan Telecommunications Corporation Limited PTCL);

your local morning newspaper; the village post office; ice cream seller inside the cinema

hall; food sold in a university cafeteria; the board game `Monopoly'.

In some cases there is more obvious competition than in others. For example, with the growth of

mobile phones supplying phone services too, PTCL has lost some of its monopoly status for a

section of the population. In other cases, such as ice creams in the cinema, village post offices

and university cafeterias, there is likely to be a local monopoly. In all cases, the closeness of

substitutes will very much depend on consumers' perceptions.

Introduction to Economics ECO401

A monopoly would be expected to face an inelastic demand. And yet, if it produces

where MR = MC, MR must be positive, demand must therefore be elastic. Therefore the

monopolist must face an elastic demand! Can you solve this puzzle?

Demand is elastic at the point where MR = MC. The reason is that MC must be positive and

therefore MR must also be positive. But if MR is positive, demand must be elastic.

Nevertheless, at any given price a monopoly will face a less elastic demand curve than a firm

producing the same good under monopolistic competition or oligopoly. This enables it to raise

price further before demand becomes elastic (and before the point is reached where MR = MC).

If the shares in a monopoly (such as a water supply company in a European country)

were very widely distributed among the population, would the shareholders necessarily

want the firm to use its monopoly power to make larger profits?

If the water company raised its charges and thereby made a larger profit, shareholders would

gain from larger dividends, but as consumers of water would lose from having to pay the higher

charges. Except in the case of shareholders with only a few water shares, however, the gain is

likely to outweigh the loss. Nevertheless, with shares very widely distributed, the average net

gain would be only very small, and the wider the distribution, the more shareholders there would

be who would suffer a net loss from the higher charges.

In what respects might the behaviour of Microsoft, increasingly becoming a monopoly in

the software and operating systems market, be deemed to be: (a) against the public

interest; (b) in the public interest?

a) Prices are likely to be higher, given the lack of competition; there may be less product

development, because potential competitors fear Microsoft's power to block their entry to

the market, or drive them from it if they do succeed in entering; less choice for

consumers.

b) By developing products that are in general use round the world, it is more convenient for

businesses and their employees, who do not have to learn different sets of programmes

or have problems with incompatibility of programmes and operating systems; monopoly

profits can lead to high levels of investment and product development, which can help to

reduce prices over the longer term.

In which of the following industries are exit costs likely to be low: (a) steel production;

(b) market gardening; (c) nuclear power generation; (d) specialist financial advisory

services; (e) production of a new medicine. Are these exit costs dependent on how

narrowly the industry is defined?

a) High. The plant cannot be used for other purposes.

b) Relatively low. The industry is not very capital intensive, and the various tools and

equipment could be sold or transferred to producing other crops.

c) Very high. The plant cannot be used for other purposes and decommissioning costs are

very high.

d) Low. The capital costs are low and offices can be sold.

e) Low to moderate. It is likely that a pharmaceutical company can relatively easily switch

to producing alternative drugs. Substantial exit costs are only likely to arise if the

company is committed to a long-term research and development programme or if

equipment is not transferable to producing alternative drugs.

Give some other examples of monopolistic competition.

Examples include: taxis, car hire, hotels and restaurants, insurance agents, estate agents, office

equipment suppliers, antique dealers, computer systems.

Why may a food shop charge higher prices than wholesale markets (or supermarkets) for

`essential items' and yet very similar prices for "delicacy" items?

Introduction to Economics ECO401

Because the demand for such essential items from a local food shop is likely to be less price-

elastic than the demand for the delicacy items: if people run out of basic items, they will want to

obtain them straight away from the nearest shop rather than waiting until they visit the

supermarket. Also the supermarkets may obtain bulk discount from their suppliers on basic

items, but not on delicacy items, where the sales turnover is much lower.

Which of these two items is a PSO or Shell petrol station more likely to sell at a discount:

(a) petrol; (b) sweets? Why?

Petrol. The reason is that demand is more price elastic. People will be tempted to buy now,

rather than waiting, if they see a reasonable discount. In the case of sweets, these are often an

impulse buy and the price is very low anyway relative to the amount already spent on petrol. A

penny or two price reductions will probably make very little difference to sales.

In monopolistic competition, why does the LRMC curve cross the MRL curve directly

below the tangency point of the LRAC and ARL curves?

One way of answering the question is to note that long-run profits are maximized where long-run

MR equals long-run MC (let's call it QL). But at QL, long-run AR equals long-run AC, whilst at

any other output long-run AR is below long-run AC. Thus profits must be maximized at QL.

Assuming that supernormal profits can be made in the short run in a monopolistically

competitive industry; will there be any difference in the long-run and short-run elasticity

of demand? Explain.

Yes. The entry of new firms, attracted by the supernormal profits, will make the long-run

demand for the firm more elastic: there are now more alternatives for consumers to choose from.

Why would you expect additional advertising dollars spent by a firm to cause smaller and

smaller increases in sales? In other words why should advertising suffer from

"diminishing returns"?

Because fewer and fewer additional people will see each extra advertisement (i.e. many of the

people will have seen the adverts already and thus there will be little additional effect on their

demand).

Which would you rather have: five restaurants to choose from, each with very different

menus and each having spare tables so that you could always guarantee getting one; or

just two restaurants, charging a bit less but with less choice and where you have to book

quite a long time in advance?

Many people would choose the first, but clearly it is a question of personal preference.

How will advertising affect a cartel's MC and AR curves? How will this affect the profit-

maximizing output?

If advertising increases total cartel sales, the cartel's AR curve will shift to the right and possibly

become less elastic. The MC curve will only shift if the advertising varies with output. Given that

the amount that member firms will advertise might not be known and, even if it were, the exact

effects of any amount of advertising on AR are impossible to identify and compute, it would

become difficult for the cartel to identify the profit-maximizing price with any degree of precision.

You have been taught about the conditions that facilitate the formation of a cartel?

Which of these conditions were to found in the oil market in (a) the early 1970s; (b) the

· There are relatively few oil producing countries (but more in the 1980s than in the

1970s).

· The OPEC members meet openly to discuss pricing and quotas (in all three periods)

· Production methods are relatively similar, although costs vary according to the

accessibility of the oil.

Introduction to Economics ECO401

The (final) product is very similar and there is an international price for each type of

crude.

Saudi Arabia is the dominant member of OPEC: its dominance over the world market,

however, waned from the mid-1980s as non-OPEC production increased and there was

a world glut of oil. With a growing world economy in the late 1990s, Saudi Arabia's

influence grew again.

Entry barriers, however, have "not" been significant. This has allowed several non-

OPEC members (e.g. Mexico, Norway and the UK) to break into the market.

The market is relatively stable in the short run (given the price and income inelasticity of

demand). There has been a problem, however, of a decline in demand over the longer

term.

Governments round the world have been relatively powerless to curb OPEC's collusion,

although from time to time (e.g. during the Gulf War) the USA has released oil from its

huge stock piles to prevent excessive price increases.

Could OPEC have done anything to prevent the long-term decline in real oil prices since

1981?

Very little, given that the supply of substitutes (both oil and non-oil) for OPEC oil has increased

substantially. Perhaps, with hindsight, if OPEC had not raised prices so much in 1973/74 and

1979 there would have been less incentive to develop substitutes and to break the power of the

cartel.

Many oil analysts are predicting a rapid decline in world oil output in 10 to 20 years as

world reserves are depleted. What effect is this likely to have on OPEC's behaviour?

The fall in output will drive up prices. Provided that OPEC can prevent its members from

pumping oil more rapidly to take advantage of the rising price, OPEC's power could increase. It

could demonstrate to its members the rising trend in oil prices and attempt to persuade them of

the benefit of reducing production even further. It could `sell' this policy to the world as one of

being prudent with dwindling oil stocks.

In which of the following industries is collusion likely to occur: bricks, margarine,

cement, crisps, washing powder, blank audio or video cassettes, and carpets?

In all cases collusion is quite likely: check out the factors favouring collusion discussed in the

lecture and also above. In some cases it is more likely than others: for example, in the case of

cement, where there is little product differentiation and a limited number of producers, collusion

is more likely than in the case of carpets, where there is much more product differentiation.

Assume that there are two major oil companies operating filling stations in an area. The

first promises to match the other's prices. The other promises that it will always sell at

Re.1 per liter cheaper than the first. Describe the likely sequence of events in this `game'

and the likely eventual outcome. Could the promise of the second company be seen as

credible (i.e. you will believe)?

Prices would be driven down, and hence profits reduced, until one of the companies could no

longer stick to its promise either the first accepting that its price will be Re. 1 above the

second, or the second accepting the same price as the first. Alternatively both companies

simultaneously may decide to abandon their policy and collude to raise prices. This may involve

a secret meeting between them, or simply `letting it be known' that they would be willing to raise

prices, providing that the other company did the same.

The promise of the second company could be seen as credible if it had lower costs or greater

financial backing than the first company. In such circumstances, the first company may be forced

to give up its policy first. If they have similar costs and financial strength, then the threat is not

credible.

Introduction to Economics ECO401

Consider a train company which charges different prices for first and standard class, for

traveling on different days in the week or different times in the day etc. Are these

examples of price discrimination?

Price discrimination occurs when the same product or service (with the same marginal cost) is

sold at different prices to different customers. Thus, strictly speaking, charging a different price

for first and standard class, for travel on different times of day, or on different days of the week,

or at different times of the year are not the purest examples of price discrimination, since (a) the

service is different and (b) the marginal cost is not the same. On the other hand, charging a

different price for children, students, old people, people traveling on single rather than return

tickets etc. are examples of price discrimination since they allow travel on the same seat on the

same train to different classes of people.

Are these various forms of price discrimination in the traveler's interest?

If the lower-price fares are making travel possible for people who could otherwise not afford it,

then clearly they are benefiting. For the people paying the higher-priced fares, then there are

advantages and disadvantages. Clearly, they will not like paying more than they would in the

absence of price discrimination, but given that at peak times some lines are operating to full

capacity, the higher price may be necessary to prevent queuing or grossly overcrowded trains

(though note, as explained in the answer to the last question, charging higher prices at peak

times to everyone is strictly speaking not a form of price discrimination).

If, over time, consumers are encouraged to switch their use of dial-up internet

connections to off-peak periods, what will happen to peak and off-peak prices?

The difference between the prices will narrow.

To what extent is peak-load pricing (i.e. charging the highest price for a product/service

when the loan of demand for it is highest; e.g. charging a high rate for dial-up internet

connection in the day rather than after midnight) in the interests of consumers?

It may help to keep the average price down, if it spreads the use of fixed factors (like bandwidth

or telephone lines) more evenly. It may also help to ease congestion (e.g. on trains) at peak

times for those who have no alternative but to use the service at that time. Peak users may

prefer a higher priced journey to a more congested journey or having to queue, and possibly

running the risk of not getting the service (e.g. not getting on the train or bus because it is full).

Is total consumption likely to be higher or lower with a system of peak and off-peak

prices as opposed to a uniform price at all times?

Higher, since some people would only be prepared to buy the product at off-peak prices.

Which type of price discrimination do cinemas pursue when they charge different prices

for adults and children? First, second or third degree? Would it be possible for the

cinema to pursue either of the other two types?

It is third-degree price discrimination. It groups cinema goers into two types: adults and children.

It could not practice first-degree discrimination: it would not be possible to negotiate a separate

ticket price with each customer! It could possibly practice a form of second-degree price

discrimination, however, if it gave tokens to people each time they purchased a ticket and then

sold tickets at reduced prices to people with tokens.

If all cinema seats could be sold to adults in the evenings at the end of the week, but only

a few on Mondays and Tuesdays, what price discrimination policy would you recommend

to the cinema in order for it to maximize its weekly revenue?

Offer reduced-price tickets to children in the evenings as well as in the afternoon for the first part

of the week, but not for the end of the week.

Introduction to Economics ECO401

Would the cinema make more profit if it could charge adults a different price in the

afternoon and the evenings?

Possibly. The danger for the cinema, however, is that adults who would have gone to the

cinema anyway may now choose to go in the afternoon, thereby losing the cinema revenue.

Ideally the cinema would like to discriminate in such a way as to encourage people to go in the

afternoon at a reduced price who would not have gone at all (whether in the afternoon or the

evening), like old people for e.g., if they had to pay the higher price.

Why is the Prisoners' Dilemma game discussed in the lecture a dominant strategy

`game'?

Because, whatever assumption is made about the other's behaviour, each prisoner is likely to

confess.

How would each prisoner's strategy change if there were five prisoners (who committed

the joint crime) and not two, and if all five all of them had been caught?

The more people there were involved in the crime, the greater would be the likelihood of one of

them confessing and therefore the greater the temptation for any individual prisoner to confess.

Can you think of any other non-economic examples of the prisoners' dilemma?

Children in a class agreeing not to do homework, but parents keeping them apart after school so

that they can persuade their children to do their homework, telling them, `The other children will

also be doing theirs and you will not want to show up by doing badly compared with them.' What

should the children do? Do their homework in the fear that everybody else would do the

homework (the equivalent of "confessing" in the fear of the other prisoners confessing) or not do

the homework hoping that the others won't do it as well (the equivalent of "not confessing" in the

hope that the others won't do it either).

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