What is an agreement among firms to divide the market, set prices, or limit production called

Defining and measuring oligopoly

An oligopoly is a market construction in which a few firms dominate. When a market is shared between a few firms, it is said to be highly full-bodied. Although simply a few firms dominate, it is possible that many pocket-size firms may also operate in the market. Because the market place for air travel, major airlines like British Airways (BA) and Air France oftentimes operate their routes with only a few shut competitors, but in that location are also many pocket-size airlines catering for the holidaymaker or offer specialist services. Similarly, while the 'Large Half dozen' free energy suppliers dominate the United kingdom market place, with a combined market share of 78% for electricity supply (according to the energy regulator, Ofcom), there are currently 54 agile suppliers. (2017 data).

Concentration ratios

Oligopolies may exist identified using concentration ratios, which measure the proportion of total market place share controlled past a given number of firms. When there is a high concentration ratio in an industry, economists tend to identify the manufacture as an oligopoly.

Example of a hypothetical concentration ratio

The following are the annual sales, in £m, of the 6 firms in a hypothetical marketplace:

A = 56
B = 43
C = 22
D = 12
E = three
F = 1

In this hypothetical case, the 3-house concentration ratio is 88.3%, that is 121/137 x 100.

Examples

Fixed Broadband services

Stock-still broadband supply in the United kingdom is dominated by four main suppliers - BT (with a market share of 32%), Virgin Media (at twenty%), Heaven (at 22%) and TalkTalk (at fourteen%), making a four-house concentration ratio of 86% (2015). Source: OFCOM.

Fuel retailing

Fuel retailing in the UK is dominated by six major suppliers, including Tesco, BP, Shell, Esso, Morrisons and Sainsbury, as shown below:

Further examples

Movie house attendances Banking

The Herfindahl – Hirschman Index (H-H Index)

This is an alternative method of measuring concentration and for tracking changes in the level of concentration following mergers. The H-H index is constitute by calculation together the squared values of the % market shares of all the firms in the market. For example, if 3 firms exist in the market the formula is Ten² + Y² + Z²; where X, Y and Z are the percentages of the three house's market shares. If the index is below 1000, the marketplace is not considered full-bodied, while an index above 2000 indicates a highly concentrated market or manufacture – the higher the figure the greater the concentration. Mergers between oligopolists increase concentration and 'monopoly power' and are likely to be the subject of regulation.

Key characteristics

The main characteristics of firms operating in a marketplace with few close rivals include:

Interdependence

Firms operating nether conditions of oligopoly are said to be interdependent , which means they cannot act independently of each other. A business firm operating in a market with just a few competitors must take the potential reaction of its closest rivals into account when making its own decisions. In the example of petrol retailing, a seller like Texaco may wish increase its market share past reducing price, but information technology must take into business relationship the possibility that close rivals, such as Beat and BP, who may also reduce their price in retaliation. An understanding of game theory and the Prisoner'southward Dilemma helps capeesh the concept of interdependence.

Strategy

Strategy is extremely of import to firms that are interdependent. Considering firms cannot act independently, they must anticipate the likely response of a rival to any given change in their price, or their non-toll action. 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 heighten or lower price, or keep price constant.
Whether to exist the first firm to implement a new strategy, or whether to expect and see what rivals do. The advantages of 'going first' or 'going second' are respectively chosen 1st and 2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-get-go profits. 2d mover reward occurs when information technology pays to wait and see what new strategies are launched by rivals, then try to improve on them or find means to undermine them.

Barriers to entry

Oligopolies and monopolies ofttimes maintain their position of dominance in a market might because it is also costly or difficult for potential rivals to enter the market. These hurdles are called barriers to entry and the incumbent can cock 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 resource that other firms would like to use creates a considerable barrier to entry, such as an airline controlling access to an airport.

Loftier set-upwards costs

High set-up costs deter initial market entry, because they increment 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 advertizing costs and other stock-still costs.

High R&D costs

Spending money on Research and Development (R & D) is frequently 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 business firm deliberately tries to push button prices low enough to strength rivals out of the market place.

Limit pricing

Limit pricing ways the incumbent business firm sets a low price, and a loftier output, so that entrants cannot make a profit at that price. This is all-time achieved past selling at a price only beneath 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 upwardly a superior level of noesis of the market place, its customers, and its production costs. The superior knowledge of an incumbent can give it considerable competitive reward over a potential entrant.

Predatory acquisition

Predatory conquering involves taking-over a potential rival past purchasing sufficient shares to gain a controlling interest, or by a complete purchase-out. As with other deliberate barriers, regulators, similar the Contest and Markets Potency (CMA), may prevent this considering it is likely to reduce competition.

Advertising

Advertising is another sunk price - the more than that is spent by incumbent firms the greater the deterrent to new entrants.

A stiff make

A stiff brand creates loyalty, 'locks in' existing customers, and deters entry.

Loyalty schemes

Schemes such as Tesco's Guild Menu, assist oligopolists retain customer loyalty and deter entrants who demand 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 case, 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 understanding in 2019 with the U.k.'south Pinewood studio grouping giving it access to 14 audio 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 tin enjoy the benefits of higher profits over the long term.

Types of collusion

Overt

Overt collusion occurs when at that place is no endeavour to hide agreements, such as the when firms form merchandise associations like the Association of Petrol Retailers.

Covert

Covert collusion occurs when firms effort to hibernate the results of their collusion, usually to avoid detection past regulators, such as when fixing prices.

Tacit

Tacit collusion (also called 'rule-based' bunco) arises when firms act together, chosen 'acting in concert' simply where at that place is no formal or even breezy agreement. For case, it may be accepted that a particular firm is the price leader in an industry, and other firms just follow the lead of this firm. All firms may 'understand' this, but no agreement or record exists to prove information technology. If firms do collude, and their behaviour can exist proven to event in reduced competition, they are likely to exist subject field to regulation. In many cases, tacit collusion is hard or impossible to testify, though regulators are becoming increasingly sophisticated in developing new methods of detection.

Competitive oligopolies

When competing, oligopolists prefer non-toll competition in order to avoid cost wars. A price reduction may attain 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 trivial or no gain, but can lead to falling revenues and profits. Hence, a far more than beneficial strategy may be to undertake non-cost competition.

Pricing strategies of oligopolies

Oligopolies may pursue the post-obit pricing strategies:

Oligopolists may use predatory pricing to force rivals out of the market. This means keeping price artificially depression, and often beneath the full cost of product.
They may also operate a limit-pricing strategy to deter entrants, which is also called entry forestalling price.
Oligopolists may collude with rivals and raise price together, but this may concenter new entrants.
Cost-plus pricing is a straightforward pricing method, where a firm sets a cost by computing average product costs and and then adding a stock-still marking-up to achieve a desired profit level. Price-plus pricing is also chosen dominion of pollex pricing.There are different versions of toll-pus pricing, includingfull cost pricing, where all costs - that is, stock-still and variable costs - are calculated, plus a mark up for profits, and contribution pricing, where merely variable costs are calculated with precision and the mark-up is a contribution to both fixed costs and profits.

Cost-plus pricing is very useful for firms that produce a number of unlike products, or where uncertainty exists. It has been suggested that cost-plus pricing is mutual because a precise calculation of marginal cost and marginal revenue is difficult for many oligopolists. Hence, it can be regarded every bit a response to information failure. Cost-plus pricing is as well mutual in oligopoly markets considering it is likely that the few firms that dominate may oft share similar costs, as in the case of petrol retailers. However, at that place is a take chances with such a rigid pricing strategy every bit rivals could adopt a more flexible discounting strategy to gain marketplace share. Toll-plus pricing tin can besides exist explained through the application of game theory. If 1 firm uses cost-plus pricing - perchance the dominant firm with the greatest market share - others may follow-arrange 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 dominion. This could be considered a form of tacit bunco.

Not-price strategies

Non-price competition is the favoured strategy for oligopolists considering toll competition tin lead to destructive price wars – examples include:

Trying to improve quality and after sales servicing, such as offering extended guarantees.
Spending on advert, sponsorship and product placement - also called hidden advertizing – is very pregnant to many oligopolists. The UK'due south football Premiership has long been sponsored past firms in oligopolies, including Barclays Banking concern and Carling.
Sales promotion, such as buy-one-go-one-free (BOGOF), is associated with the large supermarkets, which is a highly oligopolistic market place, dominated past three or iv large chains.
Loyalty schemes, which are common in the supermarket sector, such as Sainsbury's Nectar Carte du jour and Tesco's Club Card.

Each strategy tin exist evaluated in terms of:

How successful is it likely to be?
Volition rivals be able to copy the strategy?
Will the firms get a 1st - mover advantage?
How expensive is it to introduce the strategy? If the toll of implementation is greater than the pay-off, conspicuously it will be rejected.
How long will it take to piece of work? A strategy that takes five years to generate a pay-off may be rejected in favour of a strategy with a quicker pay-off.

Price stickiness

The theory of oligopoly suggests that, in one case a price has been determined, will stick it at this cost. This is largely because firms cannot pursue independent strategies. For example, if an airline raises the price of its tickets from London to New York, rivals will not follow suit and the airline will lose revenue - the demand bend for the price increase is relatively elastic. Rivals take no need to follow suit because information technology is to their competitive advantage to keep their prices every bit they are. However, if the airline lowers its price, rivals would be forced to follow conform and driblet their prices in response. Again, the airline volition lose sales revenue and market place share. The demand curve is relatively inelastic in this context.

Kinked demand curve

The reaction of rivals to a cost change depends on whether price is raised or lowered. The elasticity of need, and hence the gradient of the demand curve, volition be also be dissimilar. The demand curve will exist kinked, at the electric current cost. Even when there is a large rise in marginal cost, price tends to stick close to its original, given the high price elasticity of demand for any price rise. At price P, and output Q, revenue will be maximised.

Maximising profits

If marginal revenue and marginal costs are added it is possible to show that profits will also be maximised at price P. Profits will always exist maximised when MC = MR, and then long as MC cuts MR in its vertical portion, and so profit maximisation is notwithstanding at P. Furthermore, if MC changes in the vertical portion of the MR curve, price all the same sticks at P. Even when MC moves out of the vertical portion, the effect on price is minimal, and consumers will not proceeds the benefit of any cost reduction.

A game theory approach to price stickiness

Pricing strategies tin can also be looked at in terms of game theory; that is in terms of strategies and payoffs. There are 3 possible price strategies, with dissimilar pay-offs and risks:

Heighten toll
Lower price
Go on toll constant

The choice of strategy will depend upon the pay-offs, which depends upon the actions of competitors. Raising cost or lowering price could pb to a beneficial pay-off, only both strategies can lead to losses, which could exist potentially disastrous. In short, changing cost is too risky to undertake. Therefore, although keeping price constant will non lead to the single all-time event, it may be the least risky strategy for an oligopolist.

The Prisoner's Dilemma

Game theory as well predicts that: There is a trend for cartels to form considering co-performance is likely to be highly rewarding. Co-operation reduces the uncertainty associated with the mutual interdependence of rivals in an oligopolistic market place. While cartels are 'unlawful' in nearly countries, they may nevertheless operate, with members concealing their unlawful behaviour. Cartels are designed to protect the interests of members, and the interests of consumers may suffer because of:

Higher prices or hidden prices, such every bit the hidden charges in credit card transactions
Lower output
Restricted selection or other limiting weather associated with the transaction

A classic game called the Prisoner's Dilemma is ofttimes used to demonstrate the interdependence of oligopolists.

Examples of Oligopoly

Oligopolies are common in the airline industry, banking, brewing, soft-drinks, supermarkets and music. For example, the manufacture, distribution and publication of music products in the UK, as in the EU and United states, is highly concentrated, with a three-firm concentration ratio of around 70%, and is usually identified as an oligopoly. The key players in 2016 were:

Evaluation of oligopolies

Oligopolies are significant because they generate a considerable share of the UK's national income, and they boss many sectors of the UK economic system.

The disadvantages of oligopolies

Oligopolies can exist criticised on a number of obvious grounds, including:

High concentration reduces consumer choice.
Cartel-like behaviour reduces competition and can lead to higher prices and reduced output.
Given the lack of contest, oligopolists may be gratis to engage in the manipulation of consumer decision making. By making decisions more complex - such equally financial decisions nearly mortgages - individual consumers autumn back on heuristics and dominion of thumb processes, which tin can lead to decision making bias and irrational behaviour, including making purchases which add no utility or even damage the individual consumer.
Firms tin can be prevented from entering a market because of deliberate barriers to entry.
There is a potential loss of economic welfare.
Oligopolists may exist allocatively and productively inefficient.

Oligopolies tend to be both allocatively and productively inefficient. At profit maximising equilibrium, P, prce is above MC, and output, Q, is less than the productively efficient output, Q1, at indicate A.

The advantages of oligopolies

However, oligopolies may provide the following benefits:

Oligopolies may adopt a highly competitive strategy, in which case they can generate similar benefits to more competitive market structures, such as lower prices. Even though at that place are a few firms, making the market uncompetitive, their behaviour may be highly competitive.
Oligopolists may be dynamically efficient in terms of innovation and new production and procedure development. The super-normal profits they generate may be used to innovate, in which case the consumer may gain.
Toll stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle.

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Source: https://www.economicsonline.co.uk/business_economics/oligopoly.html/