Market Power & Oligopolies (DP IB Economics)

Market Power in Oligopoly Market Structures

• Most markets are imperfectly competitive

• Most imperfectly competitive industries operate in an oligopoly market structure

  • E.g., Banks, insurance companies, department stores, supermarkets, petrol retailers, sport stores etc.
    

• Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables
   

The level of market power is high for oligopoly firms
   

• Oligopoly firms have significant market power, a large market share and the concentration ratio of the top 5 firms is usually high
   

• There is significant market failure in oligopoly market structures

  • Governments regulate and intervene in mergers and acquisitions in order to ensure (in many economies) that no single firm gains more than 25% market share
     

Characteristics of an Oligopoly Market

Measuring Concentration Ratios

• The most commonly used concentration ratios in the UK are the five-firm, ten-firm, & twenty-firm concentration ratios
   

• A five-firm concentration ratio of around 60% is considered to be an oligopoly
   

• A one-firm concentration ratio of 100% would be a pure monopoly

  • many government regulators define a monopoly as a firm with more than 25% market share
    

    • They act to prevent mergers or acquisitions from taking place which would give one firm more than 25% market share

Reasons For Collusive & Non-collusive Behaviour

• Collusive behaviour in oligopolies occurs when firms cooperate to fix prices & restrict output

  • They cease to compete as vigorously as they can

  • The incentive to collude is high
     

• Non collusive behaviour in oligopolies occurs when firms actively compete to maintain/increase market share

  • Price wars may break out occasionally between competitors

  • Little is to be gained as competitors can quickly follow each others actions resulting with very little change in market share - but a significant loss in profits due to the lower prices generated by the price war
     

A collusive oligopoly removes competition and causes the firms in the industry to act as a monopoly
 

Diagram Analysis

•  Five firms with a concentration ratio of 80% meet secretly and agree to fix prices at a particular level

• The five firms present in the market as a single firm

• The firm produces at the profit maximisation level of output where MC = MR (Q₁)

  • At this level the AR (P₁) > AC (C₁)

  • The collusive oligopoly is making higher levels of abnormal profit

Reasons for Collusion

Types of Collusion

• Collusion can be overt or tacit

• The net effect of collusion is that a group of firms end up acting more like a monopoly in the market
  

1. Overt collusion occurs when firms explicitly agree to limit competition or raise prices (price fixing)

   • A cartel is the most restrictive form of collusion & is illegal in most countries

   • The consequences of overt collusion include:

     • Higher prices for consumers

     • Less output in the market

     • Poor quality products and/or customer service

     • Less investment in innovation

   • Overt collusion often happens in the following ways

     • Price fixing

     • Setting output quotas which limit supply & naturally results in price increases

     • Agreements to block new firms from entering the industry

     • Agreements to pay suppliers the same price thereby driving down prices in the supply chain (monopsony power)
       

2. Tacit collusion occurs when firms avoid formal agreements but closely monitor each other's behaviour usually following the lead of the largest firm in the industry

• The most common form of tacit collusion is price leadership

  • This occurs when firms monitor the price of the largest firm in the industry & then adjust their prices to match

  • It is difficult for regulators to prove that collusion has occurred

  • It provides similar benefits to firms as overt collusion, but perhaps not to the same degree

  • It has similar consequences for consumers as overt collusion, but perhaps not to the same degree

Game Theory - Interdependence Between Oligopoly Firms

• Game theory is a mathematical framework which is used by firms to ensure optimal decisions are made in a strategic setting where there is a high level of interdependence (such as in oligopoly markets)
  
  

• Any game has three elements

  • The players - (firms)

  • The strategies available to the players

  • The payoffs (outcomes) that each player receives for each combination of strategies
    

• It was first illustrated using a simple model called The Prisoners Dilemma

  • Two criminals are caught after a train robbery (Carol & Doug)

    • The prosecutor does not have much evidence

    • The criminals are guilty but have agreed with each other that they will deny all involvement

    • The prosector wants one (or both) to confess

  • The strategies & payoffs available to the prisoners are presented in a payoff matrix
    

A prisoner's dilemma payoff matrix which illustrates game theory

Diagram Analysis

• If Carol & Doug stick to their plan & deny involvement, they each get 3 years jail time

• If Doug confesses & indicates Carol's involvement, then Doug gets a lenient sentence of 1 year & Carol gets 10 years

• If Carol confesses & indicates Doug's involvement, then Carol gets a lenient sentence of 1 year & Doug gets 10 years

• There is a strong incentive to collude as it will yield the most beneficial outcome for Carol and Doug (3 years each)

• Fearing the worst, both players decide to confess and receive 5 years each

  • This outcome is called the dominant strategy as it carries the least risk

How Firms Use Game Theory

• Firms typically use game theory in the following situations:

  • When making decisions to raise or lower prices

  • When making decisions about new advertising & branding initiatives

  • When making decisions about investment in product innovation

  • When making decisions on product bundling e.g. combined phone & broadband packages
    
    

• Below is a payoff matrix representing the strategic options available to Burger King & McDonald's when making advertising decisions

  • The £ payoffs represent the likely profits for each combination of choices selected
    

A payoff matrix which illustrates the strategies & payoffs available to firms when they are deciding to advertise or not to advertise
 

Diagram Analysis

• If Burger King & McDonald's collude & agree not to advertise (top left), they can each enjoy £3 bn. in profits

  • There is a strong incentive to collude

• If Burger King advertises & McDonald's does not, then Burger King's profits are £5 bn. & McDonald's are £1 bn.

• If McDonald's advertises & Burger King does not, then McDonald's profits are £5 bn. & Burger King's are £1 bn.

• Both firms decide to advertise & receive £2 bn. of profits each

  • This outcome is called the dominant strategy as it carries the least risk

  • The risk of collusion is that one player will cheat and by doing so, get ahead
    

Price Competition

• Firms in an oligopoly market engage in three types of price competition

1. Price wars: occur when competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share. This often occurs when there is a lower level of non-price competition & where firms find it difficult to collude (either formal or tacit)
    

2. Predatory pricing: this is the practice of lowering prices when a new competitor joins the industry in order to drive them out. Prices are often lowered to a point below the cost of production. Once they have left the market, prices are raised again. This pricing strategy is usually illegal as it is anticompetitive
   
   

3. Limit pricing: occurs when firms set a limit on how high the price will go in the industry. A lower price reduces profit & disincentivize other firms from joining the industry. The greater the barriers to entry the higher the limit price is likely to be as firms are already disincentivized

Types of Non-price Competition

• Firms engage in a wide range of non-price competition strategies

  • The aim is to increase product differentiation, develop or increase brand loyalty, & to increase market share
    

A Range of Strategies used in Non-price Competition