Firms' Incentives to Avoid Price Competition in Oligopoly Markets
In the UK a few, large firms dominate most industries. These
industries are known as oligopoly markets. Oligopoly markets are an
example of imperfect competition. It consists of a market structure in
which there is a small number of large firms in the industry hence is
relatively highly concentrated. Barriers to entry and exit are also
likely to exist. In oligopoly markets there is product
differentiation, the extent of which depends on the type of product
produced. This leads to interdependency, as the actions of one large
firm will directly affect another large firm. Therefore, firms are
said to be operating under conditions of uncertainty because firms are
unable to judge the future actions of their competitors and hence
their own firm's future.
For example, if an oligopolist firm raises its prices, it could risk
loosing market share if its competitors do not follow which would lead
to lower profits for that firm. If the firm was to reduce prices, it
could risk starting a price war. This is because, other firms are
likely to follow, in order to stay competitive. Therefore, all firms
in the industry would suffer from a sharp fall in profits as they
continuously cut prices to compete with each other. Eventually, prices
will have to rise again to restore profitability and the firm that
started the price war could have lost market share.
Therefore firms want to avoid price competition as all firms will lose
out in the long term due to reduced profits. So there is an incentive
for firms to form a price agreement in order to reduce uncertainty.
There is a greater incentive to form price agreements in markets where
the demand for the product is inelastic e.g. sugar, petrol and oil.
This is because, increases in prices will lead to increased revenue
and in turn higher profits.
There is also a greater incentive for firms to avoid price competition
if the product produced has a high cross elasticity of...