LECTURE 8

Oligopoly and Monopoly

Learning Outcomes
Students should be able to

 Understand the notion of concentration ratios

 Describe various barriers to market entry
 Distinguish between collusive and non-collusive
strategies of oligopolists
 Explain why collusive strategies of oligopolists
tend to be disadvantageous to consumers
The overall picture:
Many small firms, some very large firms

In the UK, and many other countries, the large majority of firms
are small (fewer than 50 employees) or medium sized (between
50 and 249 employees).
However, the picture
differs between
individual industries.
Some consist mainly of
large numbers of small
or medium sized firms.
Others, are dominated
by a few large firms.
Source: Dept. of Business Innovation and Skills ( see
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/377934/bpe_20
14_statistical_release.pdf
)
Measuring dominance:
Concentration Ratios

One way of measuring the degree of dominance of

large firms in an industry is to calculate the share of
total output produced by the few (for example 5 or 15)
largest firms. This measurement is called a
concentration ratio (see box 11.1 on p.146)
For example the 5-firm concentration ratio in the UK sugar
industry (with very large suppliers such as British Sugar and Tate
& Lyle) is 99%
On the other hand the 15-firm concentration ratio in the
production of furniture is only 13%
Let’s try
Relaxing one of the assumptions:
Barriers to Entry

In many industries there are significant barriers to entry.

Barriers to entry are any obstacles that prevent new competitors
from entering a market or industry.
The extreme case where only one firm
supplies the whole market for a good or
service is called monopoly.
In practice whether a firm truly has a
monopoly depends on how widely or
narrowly one defines the market.

For example, a rail company may have the monopoly on rail

travel between two towns, but won’t have a monopoly on all
paid for transport between the two towns
 Different Barriers
Kinds of Barriers include
 successful exploitation of network effects, or economies of
scale or scope
(see lecture 6) by incumbent firms

 If these economies are very significant the MES of a single firm may be so
large that it can supply the whole market at lower average costs than any
potential competitor. This situation is called a natural monopoly.

 high start-up costs for new entrants

 incumbents may have established strengths such as expertise, specialist
machinery or brand loyalty that require significant upfront investment
from new entrants

 legal restrictions
 Incumbent firms may be protected by legal protection such as patents or
special privileges. Such situations are called legal monopoly
Oligopoly:
Structure, Conduct, Performance

An industry is oligopolistic if it is
dominated by a few large firms, often due to
considerable barriers to entry.

The conduct of oligopolistic firms is often

guided by the interdependence of their
decision making (or strategic interaction).

Different strategies can be classified as

collusive or non-collusive strategies
 Non-collusive strategies:
Dangers of (Price) Competition explained
This example illustrates how the profitability of
pricing decision depends on the responses of
competitors. (Instead of ‘price’, the decision
variable could have been ‘production level’,
‘advertising’ or ‘market segment’)

If firm X decides between a higher price (£2) or a

lower price (£1.80), it needs to consider what its
competitor may do.
If firm Y charges a high price, firm X can improve
profit by charging a low price (£12m instead of
£10m).
And if firm Y charges a low price, firm X should also
charge a low price (£8m instead of £5m)

Note: 1. Note that firm Y would reason the same way when deciding between a high or a low
price.
2. In fact both firms would conclude that the best strategy is to charge lower prices regardless of
choice of the other (this is formally called a dominant strategy)
3. They could get involved in a tit-for-tat price war of lowering prices, resulting in lower and
lower profit margins
Examples
Choice between non-collusive
and collusive behaviour
 Some factors favouring non-collusive behaviour:
 competitors face different cost structures
 new entrants
 lack of trust between competitors
 macroeconomic and technical change
 strong anti-collusive government policies

 Some factors favouring collusive behaviour:

 competitors face similar cost structures
 competitors know each other, credible threats
 stable economic conditions
 high entry barriers
 weak anti-collusive government policies
 Collusive Oligopoly – definition
‘When oligopolists agree, formally or informally, to limit
competition between themselves. They may set output
quotas, fix prices, limit product promotion or development,
or agree not to ‘poach’ each other’s markets’. (p165).
Formal collusive arrangements are
called cartels, in which incumbent
firms make agreements about
price levels, production quotas or
sales areas. They also have
recognised procedures for
enforcing the agreements.
Collusive oligopoly: Tacit Collusion

Oligopolistic firms may also engage in tacit collusion, that is

when they have ‘an unspoken agreement to engage in a
joint strategy’ (p166)
Agreements may be about not engaging in price cutting or
excessive advertising
Tacit collusion on prices includes
 Dominant firm price leadership- when firms follow the

prices set by one dominant firm, who often is a cost leader

and hence could credibly retaliate if others undercut prices.
 Barometric firm price leadership - when there is a

consensus amongst competitors that one firm’s pricing is

typical for the general cost structures and market
conditions in the industry.
The kinked demand curve
Considerable price stability in markets does not have to be due to tacit collusion.
One explanation why firms may be reluctant to change prices is offered by the
hypothesis of the kinked demand curve.
 A rise in price by one firm would give competitors the opportunity to increase
market share by not raising their prices. This would lead to a large fall in sales
of the firm that raises its price, as customers switch to the now lower priced
rivals.
 A reduction in price by one firm would be met by rivals lower their prices too.
Therefore customers would not switch, or at most bring only a modest
increase in sales.
 In either case, revenues are expected to fall and competitors stick with
the existing price.
Kinked demand for a firm under oligopoly
£
Demand is relatively elastic
above the kink

P1 Demand is relatively
inelastic below the kink

O Q1 Q
Competition Policy

Cartels are almost always disadvantageous to consumers because they

lead to higher prices and/or reduced choice. Therefore most countries
operate a competition policy to counter formal collusive arrangements
between businesses.

In practice it is often difficult to prove that apparently collusive

behaviour in specific industries is due to formal agreements between
firms.

In Britain the Competition & Markets Authority has the task of

enforcing anti-collusive legislation
see https://www.gov.uk/cartels-price-fixing/overview
Implications of oligopoly for conduct and
performance

 If oligopolists collude, prices may be very high and choice

reduced.
 Due to high barriers to entry, supernormal profits are likely to
persist
 When oligopolists do not collude they may compete fiercely to
maintain or gain market share. This can happen by means of
 marketing and advertising
 product - or process innovation
 (more occasionally) pricing
Monopoly:
Conduct: Profit maximising

MC
£ A monopolist firm has
control over the price it
a charges for its products. In
P=AR order to maximise profit it
would choose a level of
output where MC=MR,
that is, Qm. At that level it
can sell a price P

AR
MR
O Qm Q
Conduct : Profit maximising under monopoly
MC

AC
£

AR
a At output level
Qm, Average
Costs are at level
Acm. Profits are
ACm shown by the
shaded area

AR
MR
O Qm Q
Performance
 In principle, since monopolists have no direct competitors one
expects them to achieve typically high and persistent super-
normal profits at the sales prices and output levels they choose
to operate at.

 However, two points to note:

1. It cannot be said that monopolists will always charge higher
prices (and produce at a lower output levels) than firms in more
competitive markets.
Especially, if a monopoly is due to large economies of scale (i.e., if it is
a natural monopoly) then a firm may be able charge lower prices (and
produce at higher output levels ), than firms under competitive
conditions, while still making supernormal profits .

2. Monopolists may be constrained in their conduct by potential

competitors. See next slide..
The theory of contestable markets
The behaviour of monopolists (or generally firms with a very strong market position)
may not be influenced only by actual, current competitors (or rather lack of them).
Instead it may be influenced by the potential threat of competitors that could enter
the market.
 This threat of entry by new competitors (attracted by high supernormal profits) may

affect the current pricing decisions of monopolists, or for example force them to be
more innovative than they would have been without the threat of new entrants.
 In addition, whether a firm truly has a monopoly depends on how widely or
narrowly one defines the market. For example, a rail company may have the
monopoly on rail travel between two towns, but won’t have a monopoly on all
paid for transport between the two towns.
 Goods and services may be substitutes across industries. E.g. smartphones
are now substitutes not just for landline phones, but also for cameras,
restaurant guides, maps etc. Hence markets may be contestable across
industries
Workshop 8
 Read pp. 192-212.
 Prepare Worksheet 8