Oligopoly (Market structures and Contestability)

An oligopoly is a market structure dominated by a few large firms. The exam does not fix a magic number of firms — a market is an oligopoly because a small number of firms hold a large share of it, measured by a high concentration ratio.

The concentration ratio adds up the market shares of the largest firms. A 5-firm concentration ratio (CR5) of 80% means the biggest five firms together supply 80% of the market — a strong sign of oligopoly. Real examples include supermarkets, mobile networks, banks and petrol retailers.

The defining feature is interdependence. Because each firm is large enough to affect the whole market, one firm's decision — a price change, a new advert, a promotion — has a noticeable effect on its rivals, who will react. So each firm's best decision depends on how it expects rivals to respond. This is completely unlike perfect competition (where a tiny firm can ignore everyone else) or pure monopoly (with no rivals). Interdependence is the idea that unlocks everything else in this topic: collusion, price wars, game theory and the kinked demand curve all flow from it.

Other characteristics:

• Barriers to entry protect the incumbents — high start-up costs, economies of scale, strong brands and control of supply chains keep new firms out.
• Products may be differentiated or homogeneous. Some oligopolies sell heavily branded, differentiated products (soft drinks, cars); others sell near-identical products (petrol, cement). Either is possible.
• Non-price competition is common (covered next), precisely because firms are wary of triggering a price war.
• Firms often earn supernormal profit in the long run because barriers to entry stop it being competed away.

In an oligopoly, competing on price is dangerous. If one firm cuts its price, interdependence means rivals are likely to match the cut to protect their market share. The result is a price war: everyone charges less, sales are shared out roughly as before, and all firms end up with lower profit. Because of this, oligopolists tend to keep prices stable and compete in ways that are harder for rivals to copy instantly — this is non-price competition.

Common forms of non-price competition:

• Branding and product differentiation — building a distinctive brand image so customers see the product as unique and are less price-sensitive.
• Advertising and marketing — persuasive advertising to build brand loyalty and shift demand, making a firm's demand more inelastic.
• Loyalty schemes — points cards, memberships and rewards that raise the cost of switching, locking customers in.
• Quality, service and product innovation — better features, reliability, after-sales service or new products.

The advantage of non-price competition is that it can build lasting brand loyalty without triggering a mutually destructive price war, and it can genuinely benefit consumers through better products and choice. The drawback is that heavy advertising and promotions are costly — those costs may be passed on to consumers in higher prices — and branding can entrench the incumbents' position, raising barriers to entry.

Faced with interdependence, oligopolists have two broad options: compete (non-collusive oligopoly) or cooperate (collusive oligopoly).

Non-collusive oligopoly. Firms act independently and compete — through non-price competition, and occasionally through price wars. Prices are often stable (see the kinked demand curve), but there is always the risk of aggressive rivalry.

Collusive oligopoly. Firms cooperate, formally or informally, to act more like a monopoly: by jointly restricting output and holding prices high, they raise joint (industry) profit. Collusion comes in two forms:

• Overt collusion — an open, explicit agreement between firms, typically forming a cartel that fixes prices or shares out the market (OPEC in oil is the classic example). Overt collusion is usually illegal in most countries because it harms consumers, so it is done secretly and punished heavily when caught.
• Tacit collusion — an unspoken understanding with no formal agreement. The commonest form is price leadership: a dominant firm (or a recognised 'barometric' firm) changes its price and the others quietly follow, so prices move together without anyone communicating. Tacit collusion is harder for regulators to prove.

The incentive to collude is clear: by behaving like a monopolist, the firms raise total profit and avoid destructive price wars. But every colluder also has an incentive to cheat. If rivals are holding prices high and restricting output, one firm can secretly undercut them, win a large slice of extra sales at the high price, and boost its own profit at the others' expense. Because each firm reasons this way, cartels are inherently unstable — the temptation to cheat keeps breaking them apart. This tension between colluding and cheating is exactly what game theory captures.

Game theory is the study of how interdependent decision-makers choose when the best move depends on what the other does — a perfect fit for oligopoly. The most famous example is the prisoner's dilemma.

Imagine two firms, A and B, each choosing either to collude (hold the price high) or cheat (cut the price to grab market share). A simple payoff table shows each firm's profit (£m) for every combination, written as (A, B):

	B colludes	B cheats
A colludes	(10, 10)	(2, 14)
A cheats	(14, 2)	(5, 5)

Read it from A's point of view:

• If B colludes, A earns 10 by colluding but 14 by cheating → A prefers to cheat.
• If B cheats, A earns 2 by colluding but 5 by cheating → A again prefers to cheat.

So whatever B does, A is better off cheating — cheating is A's dominant strategy. By symmetry, cheating is B's dominant strategy too. Both therefore cheat, landing on (5, 5) — a Nash equilibrium: a position where neither firm can do better by changing its own choice given what the other is doing.

The dilemma: both would be better off colluding at (10, 10), but the fear of being cheated (and the temptation to cheat) drives them to the worse (5, 5) outcome. This is the essence of oligopoly. It explains both why firms want to collude (to reach the better joint outcome) and why collusion is unstable (the pull toward cheating). In practice, firms that interact repeatedly can sometimes sustain collusion by punishing cheats in later rounds — but the underlying temptation never goes away.

The kinked demand curve model explains a puzzle: why prices in many oligopolies are stable (rigid) even when costs change. It starts from interdependence and one key asymmetric assumption about how rivals react to a price change.

Suppose a firm is currently charging P* and selling Q*. What happens if it changes its price?

• If the firm RAISES its price above P*, rivals ignore it — they keep their prices low to win the firm's customers. The firm loses a lot of sales, so demand is elastic (flat) above the kink.
• If the firm CUTS its price below P*, rivals follow the cut to protect their own market share. The firm gains few extra sales, so demand is inelastic (steep) below the kink.

Putting these together, the demand (AR) curve has a kink at the current price P* — flatter (elastic) above, steeper (inelastic) below.

The crucial consequence — a discontinuous MR. Marginal revenue is drawn separately for each segment of the AR curve, and each MR line is twice as steep as its AR segment. Because the two AR segments have different slopes, their two MR segments do not join up: there is a vertical gap (discontinuity) in MR directly below the kink at Q*. The upper MR (for the elastic part) drops to the top of the gap; the lower MR (for the inelastic part) starts at the bottom of the gap.

Why price is stable. A profit-maximising firm produces where MC = MR. Here, MC passes through the vertical MR gap at Q*. This means the firm's MC can rise or fall anywhere within the gap and MC will still cut MR at the same output Q* — so the profit-maximising price stays at P* and output stays at Q*. In other words, even a change in costs need not change the price. This is the model's key prediction: price rigidity / stability in oligopoly. It fits the observation that oligopoly prices often stay unchanged for long periods, and it complements the game-theory reason firms avoid rocking the boat.

A note of caution. The kinked demand curve describes price stability well but does not explain how P* was set in the first place, and evidence that firms actually behave as it assumes is mixed. Treat it as a useful model of price rigidity, not a complete theory of oligopoly pricing.

Whether oligopoly serves consumers well is a genuine 'it depends' question — exactly the AO4 judgement Unit 3 rewards.

Reasons oligopoly can harm consumers:

• Collusion (cartels, price-fixing, price leadership) can push prices toward the monopoly level and restrict output, transferring welfare from consumers to firms — the strongest anti-consumer argument.
• High barriers to entry protect supernormal profit in the long run, so it is not competed away, and allocative inefficiency ($P > MC$) is likely.
• Wasteful non-price competition — heavy persuasive advertising and promotions that mainly shuffle market share can waste resources and be passed on as higher prices.

Reasons oligopoly can benefit consumers:

• Dynamic efficiency: large firms earning supernormal profit can fund R&D and innovation, giving consumers better products over time (unlike perfect competition, which lacks the funds).
• Economies of scale: big firms can produce at lower average cost, and competition may pass some of this on as lower prices.
• Non-price competition can genuinely raise quality, choice and service, and price stability gives consumers and firms useful certainty.
• Contestability: if barriers are low and the threat of entry is real, firms may behave competitively despite being few, keeping prices closer to competitive levels.

Reaching a judgement. The verdict hinges on a few factors: whether the firms collude (collusion is the main harm), how contestable the market is (the threat of entry disciplines behaviour), and how supernormal profit is used (reinvested in innovation, or simply extracted). This is why competition policy matters — regulators ban cartels and price-fixing and try to keep markets contestable. A balanced conclusion is that oligopoly is not automatically bad: competitive, contestable, innovative oligopolies can serve consumers well, while collusive ones that exploit barriers to entry harm them — so it is collusion and contestability, not oligopoly itself, that decide the outcome.