Theory of Oligopoly - Unit 3 (AQA)

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Economics ­ Oligopolies (1/10/12)
The Theory of Oligopoly
Definition = The majority of the market is concentrated in the hands of a few large firms ­
this can be seen in such diverse industries as car production, food processing, banking,
insurance, consumer electrics etc. (Oligopoly is the most common market structure)
There can also be quite a large number of small firms operating within the industry
(e.g. supermarkets vs. corner shops) ­ The small firms have virtually no effect on the
conduct or performance of the larger firms
Economists measure the market strength of the large firms in terms of a
concentration ratio (expresses the percentage of the market held by large firms)
5:80 = Largest five firms posses 80% of the market share ­ The remaining 20% is
taken up by smaller firms
There is no one single theory of oligopoly, how it is likely to act and no simple set of rules
for equilibrium ­ they way the firms operate depends on the particular market
Market Conduct:
Non-Price competition ­ Use other strategies such as R&D, innovation and marketing
to compete in the market
Price Rigidity ­ Stable prices/Similar prices across the market
Price Leadership/Price Arrangements/Prices Wars (Price wars are detrimental to all
companies involved as it harms their profits that they could all keep the same and
Collusion ­ Formal or Tacit (Collective decision making)
Firms are interdependent ­ Action by one firm will lead to a reaction by a competitor
Interdependent Decision Making ­ Firms need to take into account the likely
reactions of their rivals to changes that they make (price, output etc.)
Oligopoly firms have reactive behaviour
Oligopolies are profit maximises ­ Produce where MC=MR

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Formal Collusion = Cartel occurring ­ We are going to control the price in the market (fines
from competition commission if found out)
Tacit Collusion = secretly colluding or when other companies follows suit to what another
company has done (e.g. Tesco put's their prices up so Sainsbury's do it as well) ­
Competition commission find this very hard to prove.…read more

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Informal Collusion
Collusion may operate by one of the firms acting as a price leader ­ this firms signals
changes in prices to other firms in the cartel
When the firm raises its price = All other firms in the cartel follow suit
Forms of Price Leadership:
The price leader may be the dominant firm in the industry in terms of market share
­ when it changes its price, all other firms follow
Barometric Price Leadership ­ Role is taken by a smaller firm that…read more

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Barriers to Entry:
Oligopolies desire to keep other firms out ­ barriers to entry may emerge and they may be
based on economies of scale
In the absence of such barriers, Oligopolists may decide to create them in the following
Limit & Predatory Pricing ­ The firm that has the lowest costs can `limit pricing' by
reducing its prices to a level whereby other firms are unable to compete
Advertising ­ Large firms purchase much more advertising and so their unit costs
are lower…read more

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The Kinked Demand Curve:
The Kinked Demand Curve explains price rigidity (why firms keep their prices stable in an
oligopolistic market)
Oligopolistic Firms are Interdependent ­ Concerned about what their competitors are doing
Raising Price Above P1:
Face a very elastic demand curve
A small rise in price = A disproportionate loss of market share and revenue
Lowering Price Below P1:
Don't gain any more market share ­ other firms will follow suit (Interdependent)
Face a inelastic demand curve
Could lead to a price war…read more

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Marginal Cost:
Can shift up and down without any effect on the level of output or the price
There is no incentive for firms to produce at MC3…read more


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