Pricewars

Why might firms have an incentive to avoid price competition in oligopoly markets; why nevertheless might price wars breakout, illustrate your answer with relevant examples.

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 demand. This is a measure of the responsiveness of the quantity demanded of product A when the price of product B is changed. This means that, consumers can easily find substitutes if a firm raises its prices.

If the firms have similar costs then firms are also less likely to want to initiate a price war because it would be unprofitable for firms to simultaneously