An oligopoly is when a few large firms dominate the market.
Another definition suggests the largest five firms in the market have combined market share of over 60%. In other words, the 5-firm concentration ratio is over 60%.
Below I discuss key economic models for oligopoly, with examples, evaluation and analysis.
For more A-level economics help, including model answers and practice questions, check out the links below:
Contents
Properties of an oligopoly
Key properties of an oligopoly include:
- A small number of large firms.
- Firms are price makers.
- Interdependence between firms – one firm’s actions affect outcomes for other firms. This can lead to price wars and/or collusion.
- High barriers to entry
- Non-price competition (as price competition can create a price war)
Typical examples of oligopolies are:
- Supermarkets
- Soft drinks
- Petrol
Game theory
Consider the “prisoner’s dilemma” game theory model.
There are two firms, firm A and firm B. Each firm can either choose to raise its prices or lower its prices.
As these firms are interdependent, one firm’s decision will affect the other.
Suppose firm A lowers its price. While firm B keeps its price high.
Then firm A gains market share and profit. B loses market share and loses profit.
This payoff matrix below shows the outcomes.
Each number denotes the profit made by firm A, then by firm B in each case
The “Nash equilibrium” is the set of actions where both firms are playing their “best responses” to the action the other firm undertakes.
Suppose we have the assumptions of Nash equilibrium, such as rational players, perfect information and common knowledge of rationality (firm A knows that firm B is rational etc.). Then we predict the Nash equilibrium will be played.
The Nash equilibrium here is for both firms to drop their prices. If firm A is dropping their price, then it is best for firm B to lower their price (and vice versa). This means a price war, where firms keep reducing their prices.
However if firms can communicate and trust one another, they can work together. Firm A and B both raise prices and have higher total profits compared to if one of them lowered their price. This would be collusion, which is illegal in many advanced economies.
Also the conclusions of the prisoner’s dilemma depend on the exact payoffs or profits from each decision.
In addition it matters whether the game is a one-off game or an (infinitely) repeated game. If the game is repeated, then actions today may influence actions in the future. A firm may choose the “grim trigger” strategy: keep prices high, but if the other firm lowers their price, you lower your price too to “punish” them. This disincentivises lower prices. It makes cooperation, with both firms setting higher prices, more likely to become an equilibrium.
Kinked demand curve
Another model of oligopoly is the kinked demand curve model.
The average and marginal cost curves are the typical cost curves for any market structure.
However the average revenue, or demand, curve is “kinked” in the middle.
Why is the average revenue curve kinked in oligopoly? Because of firm interdependence:
- If the firm raises its price above the price p*, the kinked demand curve assumes other firms do not follow. This means other firms increase their market share, demand and profits. The original firm sees a significant fall in demand as consumers switch to cheaper firms, i.e. the PED is relatively elastic.
- If a firm lowers its price below the price p*, other firms follow by also lowering their prices. This means the original firm gains little increase in demand or market share, so the PED is relatively inelastic.
This firms the firm is likely to be maximising its revenue by pricing at p* and setting quantity q. Provided MC=MR at quantity q, the firm will also maximise its profit at quantity q and price p*.
There is little incentive for the firm to change its price. This is called “price stickiness”.
The marginal revenue shape follows from the shape of the average revenue. At p*, there is a kink in the demand curve. This means the rate at which revenue changes suddenly falls. So the marginal revenue suddenly drops at this point.
Efficiencies
Under the kinked demand curve model, oligopoly exhibits the following features:
- Productive inefficiency – the firm is not usually minimising its average cost. The quantity is generally not the same as the minimum point on the ATC curve.
- Allocative inefficiency – price exceeds marginal cost generally.
- Dynamic efficiency – oligopolistic firms make supernormal profits. The firms may reinvest these profits over time. This could reduce their costs or improving the product quality.
Issues with the kinked demand curve
The kinked demand curve assumes if one firm raises its price, other firms do not follow. But we do see collusion take place. For example the Competition and Markers Authority has provisionally found evidence of illegal cartels in the construction industry (see here).
This means the demand curve is not actually kinked but straight.
This model also suggests that prices are likely to be sticky. However we also see oligopolistic firms reduce prices in practice. For example, there are price wars among supermarkets.
This includes price-matching guarantees. This is where a competitor guarantees that their prices will be at least as cheap as their competitors. If not, then they will refund the difference.
Game theory models have now mostly taken the place of the kinked demand model.
Colluding oligopoly as monopoly
One can view two colluding firms as one firm with market power. In other words, colluding firms behave like a monopoly. In this case you can use monopoly analysis. Please see the link to the monopoly article.
Other evaluation points
Contestability of the market and strength of assumptions. Oligopolies usually have high barriers to entry. Suppose there is a reduction in the size of barriers to entry. Then maybe firms cannot keep prices high and make supernormal profits. This is because of the threat of entry.
The impact of brand image and the price elasticity of demand (PED) for the product. A firm may not want to be seen as colluding. Consumers may view collusion negatively and reduce their demand for the product, particularly if the PED is elastic. This may make firms less willing to collude.
The size of any fine or how strict any regulation is. If fines are small relative to total revenue or profit, it may still be worth it for firms to collude. The fines influence the payoffs in the game theory matrix. This itself may influence the outcomes firms choose.
Regulatory capture – oligopolies may lobby politicians and regulators. This may water down any regulation, entrenching oligopoly power and collusion.
Other evaluation points could include:
- How profits are allocated – to shareholders or reinvestment.
- Business objectives – profit maximisation versus sales maximisation or social welfare maximisation.
- Whether collusion could help prevent firm failure or the end of an industry.
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