3.4.4 Oligopoly

Edexcel A-Level Economics (9EC0) | Theme 3.4.4

Specification Coverage: Edexcel unit 3.4.4 - Oligopoly. Students should be able to understand the key characteristics of oligopoly, calculate and interpret concentration ratios, explain the importance of interdependence, distinguish between collusive and non-collusive behaviour, and analyse competition using game theory and non-price strategies.

Key Characteristics

  • There is a high concentration ratio, with a few large firms dominating the market.
  • There are high barriers to entry and exit, such as high start-up costs, sunk costs, and economies of scale.
  • Firms are interdependent, so the decisions of one firm affect rivals and vice versa. This is the core feature of oligopoly.
  • Products are usually differentiated.

Concentration Ratios

A concentration ratio measures the degree of market concentration.

For example, a 5-firm concentration ratio of 80% means that the top five firms account for 80% of total market sales.

A high ratio means the market is more concentrated and generally less competitive.

Calculation: \[ \frac{\text{Total sales of top } n \text{ firms}}{\text{Total market sales}} \times 100 \]

Collusive and Non-Collusive Behaviour

Because firms are interdependent, they must decide whether to collude or compete.

Collusion

Collusion takes place when firms agree, formally or informally, to restrict competition.

  • Overt collusion: A formal agreement, such as a cartel like OPEC. This is illegal.
  • Tacit collusion: An informal understanding, such as price leadership, where one firm sets a price and others follow.
  • Aim: To act like a monopoly by raising price, restricting output, and earning supernormal profit.
Collusion in oligopoly diagram
Figure 1: Collusion allows firms to restrict output and raise price, leading to supernormal profit. The collusive price is higher than the competitive price, and the collusive output is lower than the competitive output.

The diagram shows how collusion can lead to a higher price and lower output compared to a competitive market. The area of supernormal profit is the shaded rectangle between the collusive price and the average cost curve at the collusive output.

Non-Collusive Behaviour

In non-collusive behaviour, firms actively compete, often through non-price competition.

Game Theory and the Prisoner's Dilemma

Game theory analyses strategic decision-making under interdependence.

Game theory diagram
Figure 2: The Prisoner's Dilemma illustrates why firms may choose to compete rather than collude, even when collusion would benefit both. The dominant strategy for both firms is to compete (charge a low price), leading to a Nash equilibrium where both firms earn lower profits than if they had colluded.

A key insight is that even when collusion would benefit both firms, the incentive to compete for short-run gain can push firms toward a more competitive outcome.

In this example, both firms have a dominant strategy to charge a low price, leading to a Nash equilibrium where both earn lower profits than if they had colluded to charge a high price.

Types of Competition

Price Competition

  • Price war: Repeated price cuts to undercut rivals, which damages profits for all firms.
  • Predatory pricing: Temporarily setting price below cost to drive out a competitor. This is often illegal.
  • Limit pricing: Setting price low enough to deter new entrants.

Non-Price Competition

Non-price competition is very common in oligopoly and includes:

  • advertising and branding
  • loyalty schemes
  • product differentiation and innovation
  • customer service, warranties, and packaging

The Kinked Demand Curve Model

The kinked demand curve model is a common explanation for price rigidity in non-collusive oligopoly.

If a firm raises price, rivals may not follow, so the firm loses many customers and demand is relatively elastic.

If a firm lowers price, rivals may match the price cut, so it gains few extra customers and demand is relatively inelastic.

This creates a kinked demand curve and a discontinuous MR curve.

Kinked demand curve in oligopoly
Figure 3: The kinked demand curve model explains price rigidity in non-collusive oligopoly. The demand curve is more elastic above the current price and more inelastic below it, leading to a discontinuous MR curve. Firms have little incentive to change price, which can result in stable prices even in a competitive market.

Exam Preparation

  • Define oligopoly and highlight interdependence as its core feature.
  • Calculate and interpret concentration ratios.
  • Distinguish between collusive and non-collusive behaviour using examples.
  • Draw and interpret a Prisoner's Dilemma payoff matrix, including the dominant strategy and Nash equilibrium.
  • Analyse why non-price competition is so common in oligopolistic markets.