Edexcel A-Level Economics · Revision notes

3.4.4 Oligopoly

An oligopoly is a market dominated by a few large firms. Supermarkets, mobile networks, energy suppliers and airlines are all examples. What makes oligopoly different from every other market structure is that each firm's best decision depends on what its rivals do, so firms must constantly anticipate each other's moves.

Characteristics of oligopoly

• High barriers to entry and exit. Economies of scale, brand loyalty, control of supply chains, high start-up costs and patents make it hard for new firms to compete with established ones. A new entrant would have to produce on a large scale straight away to match the low average costs of existing firms, and much of what it spent on advertising and equipment would be lost if it failed. Barriers allow established firms to keep making supernormal profit in the long run without attracting new competitors.
• High concentration ratio. A small number of firms account for a large share of the market's sales. Each firm therefore has some control over the price it charges, unlike a firm in perfect competition, which must accept the market price.
• Interdependence of firms. Because each firm is large, its decisions on price, output or advertising affect its rivals, who are likely to respond. Every firm must take its rivals' likely reactions into account. For example, if one supermarket cuts its prices, its rivals lose customers unless they match the cut, so the first firm may end up gaining very little.
• Product differentiation. Products may be similar, as with petrol, or heavily differentiated through branding, as with soft drinks and cars. The more differentiated the products, the less likely customers are to switch when a rival cuts its price, so firms have more freedom to set their own prices.

Key idea: Interdependence is the defining feature. A firm in perfect competition ignores its rivals; a monopolist has none. An oligopolist cannot ignore them.

Concentration ratios

An n-firm concentration ratio is the combined market share of the n largest firms in a market.

A worked example. The five largest firms in a market have these shares:

• The 3-firm concentration ratio is 30 + 22 + 15 = 67%.
• The 5-firm concentration ratio is 30 + 22 + 15 + 10 + 8 = 85%.

A market is usually considered oligopolistic when a few firms hold a large share, for example when the five-firm ratio is well above half.

Significance and limits.

Evaluation: A high concentration ratio suggests firms may have market power and that competition may be weak. But the ratio says nothing about how firms behave: two firms with 40% each might compete fiercely or collude.

It also ignores how shares are distributed among the top firms, and how easily new firms could enter.

Collusive and non-collusive behaviour

Collusion is when firms cooperate rather than compete, for example by agreeing to fix prices or share out the market.

Reasons firms collude:

• To reduce uncertainty about what rivals will do. If firms agree on prices, none of them needs to worry that a rival will start a price war, so they can plan output and investment with more confidence.
• To raise joint profits by acting together like a monopoly, restricting output and raising price. Together the firms face the whole market demand curve, so by limiting supply they can push the price above the competitive level and share the supernormal profit.
• To deter entry, by acting together against new rivals. For example, the firms can all cut prices when a new firm enters, making it hard for the entrant to cover its costs.

Collusion is more likely when there are few firms, products are similar, firms have similar costs, and it is easy to see what rivals are charging.

Reasons firms do not collude:

• It is illegal. In the UK, price-fixing agreements are banned, and the Competition and Markets Authority can impose fines of up to 10% of a firm's worldwide turnover. Individuals involved in cartels can also face criminal charges, so the expected cost of being caught may outweigh the extra profit.
• The incentive to cheat. Each firm can gain by secretly undercutting the agreed price, so agreements tend to break down. A firm that cuts its price slightly can win customers from the others while their prices stay high, but once the others notice, they cut too and the agreement collapses.
• Many firms or very different firms make agreement harder to reach and enforce. Firms with different costs want different prices: a low-cost firm would profit from a lower price than a high-cost firm, so they find it hard to agree.
• Low barriers to entry mean new firms could undercut any agreement. If the colluding firms raise prices, the supernormal profit attracts new firms, which win customers by charging less.

Overt and tacit collusion

• Overt collusion is an open, formal agreement between firms, such as a cartel: a group of firms that agree to restrict output and fix prices. OPEC, the organisation of oil-exporting countries, operates in this way between governments. Between firms in the UK, cartels are illegal. Because they are formal, cartels leave evidence such as meetings, emails and written agreements, which competition authorities can use to prove wrongdoing.
• Tacit collusion is cooperation without any formal agreement. Firms simply avoid competing on price, often by following each other's moves. It is most common in markets where prices are easy to see, such as petrol stations, where each firm can watch its rivals' prices and respond at once.

Price leadership is a common form of tacit collusion. One firm, usually the largest, changes its price and the others follow. No agreement is made, but the result is similar to one. Because it involves no communication between firms, tacit collusion is very hard for regulators to prove.

Simple game theory: the prisoner's dilemma

Game theory models decisions where each player's outcome depends on what the others do. The prisoner's dilemma shows why collusion is unstable.

Two firms, X and Y, each choose a high price or a low price. The table shows their profits (£m), with X's profit first.

• If both charge a high price, each earns £10m. This is the best joint outcome.
• But each firm can do better by cutting its price if the other keeps its price high, earning £14m.
• Whatever Y does, X earns more by choosing the low price (14 rather than 10, or 6 rather than 4). The same is true for Y. Choosing the low price is each firm's dominant strategy.
• So both cut prices and earn only £6m each, worse for both than if they had kept prices high.

Key idea: This explains why firms have a strong incentive to collude, and also why collusive agreements tend to collapse: each firm is tempted to cheat.

It also shows why firms might prefer to reach agreements that can be enforced, which is exactly what competition law forbids.

Types of price competition

When oligopolists do compete on price, it can take several forms:

• Price wars. Firms repeatedly cut prices to win market share. Consumers benefit in the short run, but firms' profits fall and weaker firms may be forced out. If firms leave the market, the survivors may gain more market power and raise prices again, so the long-run benefit to consumers can be small.
• Predatory pricing. A firm deliberately sets its price below cost to drive a rival out of the market, intending to raise prices once the rival has gone. The predator must be able to survive the losses for longer than its rival, so it is usually a large firm with other profitable activities or large cash reserves. It is illegal, but it is hard to distinguish from fierce but fair competition.
• Limit pricing. Established firms set a price low enough to make entry unprofitable for potential rivals, while still making some supernormal profit. It works because a new entrant, which would have higher costs at first, would make a loss at that price. The established firms give up some profit now in return for keeping the market to themselves.

Key distinction: The aim of limit pricing is to deter entry, not to remove existing rivals.

Types of non-price competition

Because price cuts can be matched instantly and trigger a price war, oligopolists often compete in other ways:

• Advertising and branding, to build loyalty and make demand less price elastic. Customers who are loyal to a brand are less likely to switch when a rival cuts its price, so the firm can charge more without losing many sales.
• Product development and quality, such as new features or better design. A better product gives customers a reason to choose one firm over another, and a new design can be protected by patents for a time.
• Loyalty schemes, such as supermarket reward cards. These reward repeat purchases, which makes switching to a rival less attractive, and they give firms data on what customers buy so that offers can be targeted.
• Customer service and after-sales support. Good service builds a reputation that rivals cannot copy overnight, especially for expensive products such as cars and mobile phone contracts.
• Location and distribution, such as the number and convenience of outlets. Customers often choose the nearest or most convenient seller, so a wide network of outlets can win sales without cutting prices.

Non-price competition is harder for rivals to copy quickly than a price cut.

Key terms

Common mistakes

• Defining oligopoly by the number of firms alone. The key feature is interdependence.
• Adding the wrong shares in a concentration ratio. Use the n largest firms only.
• Treating predatory and limit pricing as the same. Predatory pricing removes an existing rival; limit pricing deters a potential entrant.
• Reading the prisoner's dilemma backwards. The point is that individually rational choices lead to an outcome worse for both firms.
• Assuming a high concentration ratio proves collusion. It shows market structure, not behaviour.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in nine formats:

• 25-mark "Evaluate" essay — asked twice across 2 series (2019 to 2021)
• 15-mark "Discuss" data response — asked once (2021)
• 12-mark "Discuss" data response — asked 4 times across 4 series (2018 to 2025)
• 5-mark calculation — asked once (2022)
• 5-mark "Explain" data response — asked 4 times across 4 series (2017 to 2023)
• 4-mark "Draw" diagram — asked once (2022)
• 4-mark "Explain" data response — asked once (2024)
• 2-mark calculation — asked once (2018)
• 1-mark multiple choice — asked twice across 2 series (2022 to 2024)

Where this goes next

Barriers to entry draw on 3.3.3 Economies and diseconomies of scale, and the efficiency criteria used to judge oligopoly are in 3.4.1 Efficiency. The threat of entry as a check on oligopolists is covered in 3.4.7 Contestability, and the regulation of anti-competitive behaviour in 3.6.1 Government intervention. Mergers that create oligopolies are covered in 3.1.2 Business growth.