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Here's my oligopoly notes for A Levels, pretty intensive for those doing AQA Economics...

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OLIGOPOLY Define oligopoly: Highly concentrated market dominated by a cluster of large firms, usually between 3-7 firms protected by entry barriers and where product differentiation(branding) is a key part of non-price competition. Business behaviour is inter-dependent, i.e. one firm must take into account the likely reactions of their rivals to changes in prices and other variables. The profitability of one firm in an oligopolistic market is determined by the strategies of other firms in the industry. However, occasionally they come tgt and make decisions based on uncertainty. This is known as collusion - A form of anti-competitive behaviour where a group of businesses act to collude on price / market sharing The ‘concentration ratio’ will be the % share of the market these firms have. The remaining share of the market could be provided by a very large number of very much smaller firms. Imagine now there are three firms. 4 boxes scenario – Analyse whether it will be a good idea to lower your prices to sell more when the other two firms increase their prices. FOR:

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Game theory and collusion  

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Contextual examples of oligopoly: Petrol retailing, grocery retailing, commercial banks, airlines competing on routes, mobile phone networks

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Tacit collusion - unspoken, price-matching schemes Explicit collusion - formal agreement to fix prices / surcharges / share markets etc What might drive collusion in an oligopoly?

Application of the basic but classic Prisoners’ Dilemma can help to understand why firms collude on price A high price / high price combination leads to an increase in total (joint) profits compared to a low price / low price option

What makes collusion more likely in an oligopoly? 

AGAINST:

Businesses in a cartel may recognise their mutual interdependence and decide act together – the main aim is to maximise joint profits i.e. achieve the level of total profits that might occur in a monopoly Successful collusion leads to rising profits/producer surplus / shareholder value – leading to higher share prices Collusion lowers the costs of competition e.g. highly expensive marketing wars which can run into millions of pounds Collusion is a way of reducing uncertainty in a market - uncertainty is a key feature of an oligopoly Colluding on research projects helps bring down the cost of innovation

Industry regulators are weak and/or ineffective (a possible source of regulatory failure) Penalties for being caught colluding / price-fixing are low relative to the potential gains in revenues / profits Participating firms have a high percentage of total sales – this allows them to control market supply Firms trust each other and they have similar strategic objectives over a period of time Industry products are standardised and output is easily measurable e.g easier in cement, maple syrup, bitumen Brands are strong so that consumers will not switch demand when collusion raises price (i.e. a low cross price elasticity of demand)

Real world examples of price fixing   

2015 - Fines for French Yoghurt Cartel 2016 - EU slaps record $3 bil cartel fine on truck firms 2014 - German brewers fined 106.5m euros for price-fixing

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2016 - UK model agencies found guilty of price-fixing 2015 - Banks fined for manipulating LIBOR interest rates

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Evaluation Discuss the barriers to collusion / circumstances under which collusion breaks down in an oligopoly

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Game theory suggests that price collusion between firms will break down because there is an incentive to cheat on a price-fixing deal whereby lowering price and increasing output will increase total profits.

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In a cartel, although joint profits might be maximised, this is not the same as any individual firm maximising their own profits. There are good reasons for expecting cartels to weaken as time goes by.

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Threats to cartels include:      

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Enforcement problems: The cartel aims to restrict production to maximise total profits. Each individual seller finds it profitable to expand their production. Other firms who are not members of the cartel may opt to take a free ride by selling just under the cartel price Falling market demand in a recession creates excess capacity in the industry and puts pressure on profits and cash-flow The successful entry of non-cartel firms into the industry undermines a cartel’s control of the market The exposure of price-fixing by whistle-blowing firms – these are firms previously engaged in a cartel that pass on information to the competition authorities in order to escape prosecution When trust breaks down within a cartel, it is highly likely to come under pressure and many eventually collapse.

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Final reasoned comment:

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There are good reasons to expect more collusion in an oligopoly than in any other market structure. The crucial point is that firms in an oligopoly are interdependent, they must consider the likely reactions of their rivals. Collusion is a way of lowering some of the costs of competition and maintaining supernormal profits in the long run.

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But most cartels either collapse or are under-mined by the entry of disruptive businesses who do not follow the same pricing model and are looking to make the market more contestable and take some of the supernormal profits. Although there is probably significantly more tacit collusion in markets than consumers are aware of, industry regulators seem to becoming more effective in investigating and tackling cartel behaviour. The size and volume of fines for anti-competitive behaviour in the UK and more widely in the EU has grown in recent years. From 2014-17, the EU imposed fines in 133 cartel cases totalling Euro 7.5 billion. Regulators worldwide are cracking down on cartels, levying billions of dollars in fines and even putting some executives in jail. Last month the EU raided German carmakers Daimler, Volkswagen Group and BMW Group on suspicion of conspiring to fix prices in diesel and other technologies, putting them at risk of fines up to 10 percent of their turnover if found guilty of wrongdoing. Among other recent investigations in the auto industry, the Commission has handed down a record 3.81 billion euro fine to a group of truckmakers. Other cases in the pipeline involve electronic brakes and electrolytic capacitors. Evaluate the view that collusion between firms in an oligopoly always works against consumer and society’s interests. Use game theory in your answer. KAA 1: An oligopoly is where the industry or market is dominated by a few producers/firms with a high level of market concentration, where the component firms have a high level of interdependent decision making. Collusion can be tacit and/or explicit, and the aim of which is to achieve higher supernormal profits, with the firms as a whole achieving joint profit maximisation. Collusion between firms is harmful to consumers. This is because firms collude to raise prices, as mentioned earlier, resulting in the price level seen below. This reduces the consumer surplus available, reducing the welfare of individuals. This can often be highly regressive, if the impact of increased prices, such as with the Big Six Gas Suppliers, has a disproportionate impact on the less well off. Furthermore, because firms are working together, with internal quotas to divide up sales, there is less need to compete, resulting in less dynamic efficiency. This results in less innovation, and thus little improvement in the quality of products available to individuals. Indeed, the UK Competition and Markets Authority supports this claim, arguing that collusion can result in “reductions of output, efficiency, innovation and choice, all of which are harmful to consumers.” An example of this can be seen with Apple, who were sued by consumers for price-fixing with publishers to force consumers to over pay for e-books. EVAL 1: However, collusion between firms can often derive benefits for consumers. For instance, tacit collusion includes firms who monitor what other firms sell to

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ensure that they are matching the cheapest price in a geographical area, or who market that consumers are “never knowingly undersold” such as John Lewis. This is a case in which firms are technically engaging in tacit collusion, but which may also result in driving down of prices as firms seek to match improvements in cost efficiencies made by other firms. This is also true with products such as mobile phone contracts where it is easy to compare prices. KAA2: Collusion in an oligopoly can hugely benefit firms, which can have beneficial consequences for society. For instance, collusion between coffee growers allows small firms to push for fairer prices against more dominant monopsonistic corporations such as Starbucks. Furthermore, because these producer cooperatives like Fairtrade are often based overwhelmingly in less developed regions, this can also be useful in helping to alleviate extreme poverty. Furthermore, collusion allows for firms to lower the costs of competition, that can then be passed onto consumers. Because oligopolies exist in highly concentrated markets dominated by a few firms, there is often a huge degree of branding and differentiation that needs to take place in order for firms to stand out, e.g. with the UK retail banking industry with firms such as Barclays and HSBC. If all firms engage in marketing wars, there is no net societal benefit. However, if firms collude, they can reduce the need to fund these marketing wars, that can allow for cost savings to be passed onto consumers. Additionally, collusion allows for agreed upon industry standards, for instance with procedures in testing on humans in pharmaceutical research, which benefits both consumers and firms. EVAL 2: However, the extent to which this occurs depends on a few factors. Firstly, the vast majority of collusion that takes place isn’t that of poor farmers working together - oligopolies are more concentrated industries with very high barriers to entry, such as the Big Four Accountancy Firms, and pharmaceutical companies. Furthermore, the benefits that accrue from firms working together are dependent on those firms passing those cost savings onto consumers - however, if they are all explicitly colluding, they may decide to spend that money on share buy-back schemes and dividends, which may not benefit society at large. Indeed, in 2017, US firms spent more money on share buy-backs than they did on research and development. Lastly, the benefits from firms agreeing upon industry standards are likely to be very marginal given the government and regulatory bodies, such as the Financial Conduct Authority (FCA) tend to set industry standards centrally. Conclusion: In conclusion, the extent of the impact on consumers and firms depends fundamentally on how long the oligopoly is able to carry on collusion - we can analyse this through game theory. Assuming the following pay offs in a cartel such as OPEC, where states agree to collude to reduce production levels and benefit from a higher price:

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If all firms cooperate, they will achieve £4bn revenue. However, if one firm decides to defect and to increase production while still gaining from higher prices, they will gain £5bn. The socially optimal equilibrium in this model (for firms) is to cooperate, because the total utility is greater than any other option. However, this is an unstable equilibrium: no matter what the other firm does, each agent is better off by defecting, resulting in a Nash equilibrium of Defect, Defect. Indeed, this model can be shown by how in October 2018, Iran accused Saudi Arabia and Russia of breaking OPEC’s agreement on cutting output. Thus, the effects of collusion are very much dependent on how long it is able to last.

An understanding of game theory and the Prisoner’s Dilemma helps appreciate the concept of interdependence. Strategy Strategy is extremely important to firms that are interdependent. Because firms cannot act independently, they must anticipate the likely response of a rival to any given change in their price, or their non-price activity. In other words, they need to plan, and work out a range of possible options based on how they think rivals might react. Oligopolists have to make critical strategic decisions, such as: • Whether to compete with rivals, or collude with them. • Whether to raise or lower price, or keep price constant. • Whether to be the first firm to implement a new strategy, or whether to wait and see what rivals do. The advantages of ‘going first’ or ‘going second’ are respectively called 1st and 2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-start profits. 2nd mover advantage occurs when it pays to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them. Barriers to entry Oligopolies and monopolies frequently maintain their position of dominance in a market might because it is too costly or difficult for potential rivals to enter the market. These hurdles are called barriers to entry and the incumbent can erect them deliberately, or they can exploit natural barriers that exist. Natural entry barriers include: Economies of large scale production. If a market has significant economies of scale that have already been exploited by the incumbents, new entrants are deterred. Ownership or control of a key scarce resource Owning scarce resources that other firms would like to use creates a considerable barrier to entry, such as an airline controlling access to an airport. High set-up costs High set-up costs deter initial market entry, because they increase break-even output, and delay the possibility of making profits. Many of these costs are sunk costs, which are costs that cannot be recovered when a firm leaves a market, and include marketing and advertising costs and other fixed costs.

High R&D costs Spending money on Research and Development (R & D) is often a signal to potential entrants that the firm has large financial reserves. In order to compete, new entrants will have to match, or exceed, this level of spending in order to compete in the future. This deters entry, and is widely found in oligopolistic markets such as pharmaceuticals and the chemical industry. Artificial barriers include: Predatory pricing Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals out of the market. Limit pricing Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants cannot make a profit at that price. This is best achieved by selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make. Superior knowledge An incumbent may, over time, have built up a superior level of knowledge of the market, its customers, and its production costs. The superior knowledge of an incumbent can give it considerable competitive advantage over a potential entrant. Predatory acquisition Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete buy-out. As with other deliberate barriers, regulators, like the Competition and Markets Authority (CMA), may prevent this because it is likely to reduce competition. Advertising Advertising is another sunk cost - the more that is spent by incumbent firms the greater the deterrent to new entrants. A strong brand A strong brand creates loyalty, ‘locks in’ existing customers, and deters entry. Loyalty schemes Schemes such as Tesco’s Club Card, help oligopolists retain customer loyalty and deter entrants who need to gain market share. Exclusive contracts, patents and licences These make entry difficult as they favour existing firms who have won the contracts or own the licenses. For example, contracts between suppliers and retailers can exclude other retailers from entering the market. Vertical integration Vertical integration can ‘tie up’ the supply chain and make life tough for potential entrants, such as an electronics manufacturer like Sony having its own retail outlets (Sony Centres). Vertical integration in the media industry is widspread, with Netflix having purchsed the US based ABQ studios in 2018, and completing an agreement in 2019 with the UK's Pinewood studio group giving it access to 14 sound stages, workshops, and office space. Collusive oligopolies

Another key feature of oligopolistic markets is that firms may attempt to collude, rather than compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher profits over the long term. Types of collusion Overt Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form trade associations like the Association of Petrol Retailers. Covert Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid detection by regulators, such as when fixing prices. Tacit Tacit collusion (also called 'rule-based' collusion) arises when firms act together, called 'acting in concert' but where there is no formal or even informal agreement. For example, it may be accepted that a particular firm is the price leader in an industry, and other firms simply follow the lead of this firm. All firms may ‘understand’ this, but no agreement or record exists to prove it. If firms do collude, and their behaviour can be proven to result in reduced competition, they are likely to be subject to regulation. In many cases, tacit collusion is difficult or impossible to prove, though regulators are becoming increasingly sophisticated in developing new methods of detection. Competitive oligopolies When competing, oligopolists prefer non-price competition in order to avoid price wars. A price reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but the danger is that rivals will simply reduce their prices in response. This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more beneficial strategy may be to undertake non-price competition. Pricing strategies of oligopolies Oligopolies may pursue the following pricing strategies: 1 Oligopolists may use predatory pricing to force rivals out of the market. This means keeping price artificially low, and often below the full cost of production. 2 They may also operate a limit-pricing strategy to deter entrants, which is also called entry forestalling price. 3 Oligopolists may collude with rivals and raise price together, but this may attract new entrants. 4 Cost-plus pricing is a straightforward pricing method, where a firm sets a price by calculating average production costs and then adding a fixed mark-up to achieve a desired profit level. Cost-plus pricing is also called rule of thumb pricing.There are different versions of cost-pus pricing, including full cost pricing, where all costs - that is, fixed and variable costs - are calculated, plus a mark up for profits, and contribution pricing, where only variable costs are calculated with precision and the mark-up is a contribution to both fixed costs and profits.

- others may follow-suit so that the strategy becomes a shared one, which acts as a pricing rule. This takes some of the risk out of pricing decisions, given that all firms will abide by the rule. This could be considered a form of tacit collusion. Non-price strategies Non-price competition is the favoured strategy for oligopolists because price competition can lead to destructive price wars – examples include: 1 Trying to improve quality and after sales servicing, such as offering extended guarantees.

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Cost-plus pricing is very useful for firms that produce a number of different products, or where uncertainty exists. It...