Model Answer - Oligopoly 15 mark question

“Explain how interdependence and uncertainty affect the behaviour of firms in oligopolistic markets” (15 marks)

Start with a brief definition of an oligopoly 
An oligopoly is a market dominated by a few producers where there is a high level of market concentration. Examples of markets that can be described as oligopolies include the markets for petrol in the UK, soft drinks producers and the major high street retail banks. Another example is the global market for sports footwear – 60% of which is held by Nike and Adidas.

Develop the explanation
Oligopoly is best defined by the conduct (or behaviour) of firms within a market and this behaviour is often complex - there are many different models of oligopolistic decision-making.

There is no single theory of price and output under conditions of oligopoly. If a price war breaks out, oligopolists may choose produce and price much as a highly competitive industry would; whereas at other times they act like a pure monopoly.

Focus on inter-dependent decision-making and uncertainty
Inter-dependence means that firms must take into account the likely reactions of their rivals to any change in price, output or forms of non-price competition. Game theory can help to understand some of the pay-offs from different decisions made by “players” in a market dominated by a small number of competing businesses.

Because of the uncertainty in the market informal and formal collusive behaviour can common feature of many oligopolistic markets.

For example - tacit collusion such as price leadership where prices and price changes established by a dominant firm, or a firm are usually accepted by others and which other firms in the industry adopt and follow. When price leadership is adopted to facilitate tacit (or silent) collusion, the price leader will generally tend to set a price high enough that the least cost-efficient firm in the market may earn some return above the competitive level.

We see examples of this with the major mortgage lenders and petrol retailers where many suppliers follow the pricing strategies of leading firms. Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting or not attacking each other’s market

Some businesses in an oligopoly may choose to enter into price-fixing  or market-sharing cartels. This behaviour is deemed illegal by UK and European competition law. But it is hard to prove that a group of firms have deliberately joined together to raise prices. The EU has recently fined businesses involved in price fixing in the soap powder industry who agreed to raise prices even though they had all made their products smaller for the consumer.

Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly.  To collude on price, producers must be able to exert some control over market supply.

The explanation for this question can be supported by an analysis diagram for example the kinked-demand curve diagram that supports the idea of sticky prices and a focus on non-price competition within an oligopoly