AQA ECON3 JANUARY 2011 ESSAY 2

D Oligopolies are concentrated markets with a few firms sharing a large percentage of
market supply, while a contestable market has low entry and exit barriers. Sunk costs (such
as advertising or capital investments which cannot be recovered) and legal barriers creating
statutory monopolies are examples of entry barriers which reduce contestability.

I Oligopolistic markets may not operate efficiently if firms enjoy price-making powers. An
This is especially likely if collusion occurs. Collusion offers firms the opportunity to limit the
uncertainty generated by interdependence in oligopolistic markets. There is the potential
for firms to operate as a joint monopoly, with the effect that output is squeezed and price is
raised. As a result the price (which indicates the marginal benefit received by the last
consumer) is raised above the marginal cost of production. This suggests that further units
of the good could be produced and that these units would carry a net benefit to society.
Collusive oligopoly is then seen as a source of inefficiency, creating a market failure and a
deadweight welfare loss to society. This is illustrated in the diagram.

An Diagram Collusive oligopoly may reduce efficiency

I Making oligopolistic markets more contestable has the potential to improve the efficiency
of the market. An This is because removing entry barriers allows the threat of potential new
competition to act as a discipline on the conduct of incumbent firms. Incumbents are less
likely to collude if entry barriers are low, because collusion raises prices and creates
supernormal profit, which acts as a signal for new firms to enter the market. Given that
incumbents are unlikely to welcome new entry, this threat may cause them not to collude. I
Indeed, it points towards the possibility of incumbent firms adopting entry limit pricing,
pricing at a level sufficiently low to deter new entry. An If there were no entry barriers at
all, this would imply pricing at a level where only normal profits were made. The result is a
high output, low price combination more similar to the outcome of a competitive market
than a monopolistic one.

I A second method of improving the efficiency of oligopolistic markets is to put in place

stringent methods to detect and prevent collusion between firms. Kn /Ap Formal collusive
agreements such as quotas for output, market sharing and bid-rigging are illegal in the UK,
for example. A range of penalties are available to the authorities, including fines of up to
10% of company turn over and jail sentences for company directors. Meanwhile, cases of
implied or tacit collusion, where firms come to recognise that it is in their mutual interest to
refrain from competing (without having entered into a formal agreement with each other)
can be investigated to see if they operate against the public interest. If they do, then the
authorities can put into place remedies to help the market to work more effectively, such as
measures to help consumers switch more easily between utility providers, for example.

I A third method of improving the efficiency of oligopolistic markets is to regulate prices in

those markets, placing a ceiling on what firms are allowed to charge. An This involves the
regulator trying to judge the price that would be charged if the market were competitive
and to impose this on firms. Resource allocation would then be similarly efficient to that in
competitive markets. Kn This was common in utility industries in the UK after their
privatisation and still occurs in the water industry.

Evaluation/final judgement (s)

Making markets more contestable to improve their efficiency has been used extensively in
the UK in past years. Kn/Ap Markets have been deregulated by removing statutory entry
barriers. Examples include the gas and electricity markets, directory enquiries, financial
services and bus services. The success of deregulation has been mixed, casting doubt on
whether it can be considered as the best way of improving efficiency in oligopolistic
markets. Kn/Ap In directory enquiries, for example, heavy branding has occurred and there
is significant evidence that lack of consumer knowledge limits the effectiveness of
competition. Consumers are apt simply to use the service of the best-known provider,
leading to inelastic demand curves for firms, granting them monopoly power. I It should
also be noted that deregulation can only remove statutory entry barriers, and not the costs
that are associated with entering a market. I Dergulation could be supplemented by
measures to prevent firms erecting artificial entry barriers, but there are many markets that
it is not possible to make contestable due to the high natural entry barriers present. This
applies particularly to markets tending towards natural monopolies. So, there are some
markets for which improving contestability cannot be the best measure.

I There is evidence to suggest that the UK’s current policy framework for deterring collusion
in oligopolistic markets has been particularly effective. Kn/Ap The number of cases of
formal collusion has declined over the years as high profile cases such as that of Hasboro
games in collusion with Argos and Littlewoods and BA and Virgin over fuel surcharges, have
highlighted the risks of collusion to firms. The effectiveness of the policy has also been
bolstered by the improved information that the authorities have been able to gather
through their powers to conduct “dawn raids” and through the provision for the exemption
from punishment of firms who “blow the whistle” on a collusive agreement.

I Meanwhile, regulation of prices is only desirable if it is not possible to introduce actual

competition are at least the threat of new competition into an industry. An It is very
difficult for regulators to gain enough information to mimic the prices that would be
charged in a competitive market and to judge whether firms are making excessive profits. I
There is also the danger of regulatory capture, by which regulators may come to serve the
interests of the firms they are meant to be controlling.

Thus, it is not possible to reach a conclusion that improving contestability is the best way of
improving efficiency in oligopolistic markets, because it is not possible to remove entry
barriers in all markets and there are likely to be other obstacles to the efficient working of
markets that limit the effectiveness of this policy. This argument is strengthened when one
adds to the arguments already covered the fact that lack of consumer information and the
existence of consumer inertia are present in many oligopolistic markets, especially those for
utilities. Measures to improve efficiency should be taken in accordance with the particular
circumstances applying to each market, with price regulation as a last resort, while it is
particularly important that stringent measures continue to be taken to prevent collusion
between firms.