Essay: Discuss how firms in Oligopoly are likely to compete with each other

Oligopoly is a market structure in which a few firm dominate the industry, it is an industry with a 5 firm concentration ratio of greater than 50%.

In Oligopoly, firms are interdependent; this means their decisions (price and output) depend upon how the other firms behave:

  • Barriers to entry are likely to be a feature of Oligopoly
  • There are different models to explain how firms may behave

The kinked demand curve model suggest firms will be profit maxi misers.

Kinked Demand Curve Diagram

kinked

At p1 if firms increased their price, consumers would buy from the other firms therefore they would lose a large share of the market and demand will be elastic. Therefore, firms will lose revenue from increasing price

If Firms cut Price then they would gain a big increase in Market share, however it is unlikely that firms will allow this. Therefore, other firms follow suit and cut price as well. Therefor,e demand will only increase by a small amount: Demand is inelastic for a price cut and revenue would fall.

This model suggests price will be rigid because there is no incentive for firms to change the price

If prices are rigid and firms have little incentive to change prices they will concentrate on non price competition. This occurs when firms seek to increase revenue and sales by various methods other than price.

For example, a firm could spend money on advertising to raise the profile of their product and try and increase brand loyalty, if successful this will increase market sales. Advertising is a big feature of many oligopolies such as soft drinks and cars. Alternatively they could introduce loyalty cards or improve the quality of their after sales service. When buying a plane ticket price is not the only factor consumers look at, they may prefer airlines with more leg room, airmiles e.t.c.

Non price competition depends upon the nature of the product. For example, advertising is very important for soft drinks but less important for petrol.

However, in reality this model doesn’t always occur. Often the objectives of firms is not to maximise profit. For example, they may wish to increase the size of their firm and maximise sales. If this is the case, they may be willing to take part in a price war, even if this does lead to lower profits. Price wars involve firms selling goods at very low prices to try and gain market share. For example, newspapers such as the Times and the Sun have recently been sold very cheaply. Price wars are more likely if:

1. A big firms is able to cross subsidise one market from profits elsewhere
2. In a recession markets are more competitive as firms seek to retain customers

However, price wars may only be short term

A firm may engage in predatory pricing, this occurs when the incumbent firm seeks to force a new firm out of business by selling at a very low price so that it cannot remain profitable.

Under certain circumstances firms may be able to collude with each other and avoid any form of price competition. Collusion involves firms agreeing to raise prices and restricting output in order to increase profits of the industry. Collusion will be possible if:

1. A small number of firms, who are well known to each other make it easier to stick to output quotas
2. A dominant firm, who is able to have a lot of influence in setting the price
3. Barriers to entry, this is important to stop other firms entering to take advantage of the high profits
4. Effective communication and monitoring of output and costs
5. Similar production costs and therefore will want to raise prices at the same rate
6. Effective punishment strategy’s for firms who cheat
7. No effective govt legislation, collusion is illegal in the UK

Conclusion:

There is no certainty in how firms will compete in Oligopoly; it depends upon the objectives of the firms, the contestability of the market and the nature of the product.

See also:

Page created by: Tejvan Pettinger,November 28, 2012