3.4.4 Oligopoly – Edexcel Economics A notes

Contents

Definition and characteristics of oligopoly

An oligopoly is when a small number of producers dominate the market.

Oligopolistic markets have the following characteristics:

• A high concentration ratio:
  • A concentration ratio measures the sum of the market share of the largest firms in the industry.
  • If the five-firm concentration ratio of a market is over 60%, it is typically considered an oligopoly.
  • An example is for the electricity supply market in 2023, British Gas had a 20% market share, E.ON had a 17% market share, OVO/SSE 13%, EDF 11% and Scottish Power 9%. This gives a five firm concentration ratio of 70%, making electricity supply an oligopoly.
  • A higher percentage means the industry is more concentrated. So a concentration ratio reveals the extent of market power that the largest companies have in the industry.
• High barriers to entry and exit:
  • These barriers may stop new firms entering the market. 
  • Barriers to entry can include
    • Economies of scale
    • Regulations including patents 
    • High initial capital needs to start production. 
    • Limit pricing – price low such that the firm makes normal profit, in order to deter other firms from entering the market.
    • Advertising or other methods of non-price competition.
• Firm interdependence:
  • The actions of one firm in the industry depend on the actions of another firm.
  • Example: if one firm raises their price, other firms may follow by also raising the price. 
  • Alternatively, if one firm lowers the price, other firms may follow by cutting the price. This is called a price war.
• Product differentiation:
  • Firms may try to differentiate their products on factors other than price.
  • This includes advertising, quality, customer service or branding. 

Oligopoly diagram – game theory model

The standard model for oligopolistic firms is the game theory “prisoner’s dilemma” diagram shown below.

Assume there are two firms, firm A and firm B. Each firm chooses simultaneously whether to price high or low. 

The game theory diagram below shows the profits each firm makes depending on the pricing actions of each firm. 

For example, when firm A prices high and firm B prices low, the profits are £1 million for firm A and £5 million for firm B.

What does the game theory model predict for how oligopolistic firms will behave? This depends what we assume about whether firms can coordinate and trust each other.

• Suppose firms can coordinate and trust each other.
  • Both firms would set a high price to maximise total profit (£8 million total rather than £6m or £4m). 
  • This leads to higher total profits for both firms. 
  • This would be an example of collusion – the two firms working together to raise prices in this case.
  • However collusion is illegal.
    • If firms get caught colluding, they can receive a fine from the Competition and Markets Authority (CMA). 
    • An example of collusion is when Competition and Markets Authority has found evidence of collusion among construction supplier companies Vp and MGF.
    • According to the CMA, these firms were sharing information on future pricing strategies. This led to a total fine of £15 million. These companies supplied groundworks products such as those for building foundations or laying pipes for homes and roads.
    • The CMA has fined several cartels in the construction industry, where low profit margins may offer an incentive to collude for firm survival.

• Assume instead that these firms cannot coordinate on pricing strategies.
  • Both firms setting a high price is unsustainable. Firm A can change from high price to low price, and increase profits from £4m to £5m. 
  • That takes us to a situation in which firm A prices low and firm B prices high. This is also not optimal for firm B given firm A is pricing low. In this case, firm B prefers to make £2 million with low price rather than £1m with high price, given firm A is pricing low.
  • Therefore both firms end up pricing low. 
  • In other words, firms may engage in a price war. 
  • This would benefit consumers who would receive lower prices.
  • However each firm would only earn £2 million per firm. Profits are much lower compared to the outcome under collusion where both firms price high.
  • This is often referred to as the “Nash equilibrium”, one way of solving this game.

Reasons for collusive behaviour

• Collusion is when businesses work together to restrict competition.
  • This could include agreeing to raise prices or firms following each other’s price movements without a formal agreement.
• Reasons for collusion include:
  • Increase in profits as firms coordinate to set higher prices.
    • This is shown by the game theory diagram.
    • However this depends on the level of barriers to entry. Low barriers to entry would mean collusion cannot lead to supernormal profits, as other firms would enter the market and undercut the colluding firms on price.
  • Achieve market power
    • If two firms collude closely together, they can act as a monopoly power.
    • This allows the colluding firms to raise prices jointly in the future.
  • Preventing firm shutdown, for instance in a declining industry.
  • Firms can spend less on non-price competition when there are fewer competitors.
  • Stability for firms
    • An agreement on pricing for example allows firms to predict the prices of other firms. 
    • This reduces the risk of one firm being undercut by the other, in other words preventing price wars. 
    • This creates certainty for businesses. 
    • This certainty can benefit businesses, for instance, by making it easier to plan for the future, firms may be incentivised to invest more in improving their product.
  • However collusion may not work in practice.
    • Collusion is illegal. There can be fines or other legal penalties for colluding.
    • There is a risk of collusion failing if firms do not trust each other. In this case a price war could ensue, as in the game theory diagram when both firms price low.

See the section on price and non-price competition for reasons for non-collusive behaviour.

Overt versus tacit collusion

• Overt collusion occurs when there is a formal agreement. This type of collusion is likely to be more open.
  • This can include cartels – an agreement formed between two firms. They could choose to agree on prices, output or market shares for example.
  • There are risks of fines or other criminal sanctions for being caught in collusion, and colluding overtly makes it more likely that the colluding firms will be caught. 
  • However if the colluding firms do not get caught, they may be able to coordinate more closely than under tacit collusion (see below), leading to closer price coordination and higher profits from collusion.
• Tacit collusion is more secretive and implicit (understood but not necessarily put into words).
  • This often happens with price leadership. This is when one firm raises its price, and other firms follow in raising the price. 
  • Energy companies in the UK were investigated for price leadership although regulators did not find proof of this.
  • Firms may not know whether other firms would follow / whether to trust other firms.
  • However an advantage for firms (compared to overt collusion) is that the firms are less likely to get caught by regulators for colluding.

Types of and reasons for price and non-price competition

• Price competition and the reasons for this:
  • Price wars:
    • When multiple firms continue to undercut each other on price, leading to the price falling.
    • This is the (“Nash equilibrium”) outcome in the game theory model shown above, when firms cannot coordinate with each other.
    • Firms may engage in price wars to try to increase market share.
    • Alternatively it may be seen as a form of predatory or limit pricing, to force out other firms or prevent them from entering (see below).
  • Predatory pricing:
    • This occurs when a firm prices low, while making a loss.
    • One way of describing predatory pricing is when AR < AVC, in other words the firm is not able to cover its variable costs, making a loss in the short term.
    • This may force competing firms out of the market, so that the remaining firm can later raise prices and increase its profits.
    • However competition regulators may fine firms for conducting predatory pricing. This may disincentivise firms from using predatory pricing.
  • Limit pricing
    • This is when a firm prices low such that it makes zero supernormal profits.
    • This occurs when AR = ATC.
    • A firm may use limit pricing to discourage other firms from entering the market.
    • While other firms may not enter the market, the incumbent firm (the firm already in the market) only makes normal profit. So the incumbent firm has no supernormal profit to pay dividends to shareholders nor to reinvest into improving product quality.
    • However consumers may benefit from lower prices, increasing consumer surplus (compared to firms not engaging in limit pricing).
• Non-price competition and the reasons for this:
  • Firms may choose to compete on non-price factors, such as advertising, branding and packaging.
  • Firms may try to differentiate their products from those of other firms by investing in advertising, branding and packaging. 
  • In addition some firms issue loyalty cards.
    • Loyalty cards allow repeat customers to benefit from discounted prices.
    • This allows firms to increase brand loyalty, as customers are receiving discounts for continuing to purchase from the same firm. 
  • Non-price competition makes consumers less likely to switch to other firms, making demand more price-inelastic.
    • As a result firms can also increase market share by engaging in non-price competition.
  • Loyalty cards and advertising can be barriers to entry to other firms. Another firm wanting to enter the market may struggle to match the investment in advertising and to attract consumers away from other firms who have loyalty cards.
  • Evaluation for non-price competition:
    • The costs to the firm of investing in branding, quality or advertising may outweigh any benefit to the firm in the form of higher revenue.
    • Some advertising campaigns may not be effective or have uncertain returns.

Bonus section on the kinked demand curve

While Edexcel A does not require the use of the kinked demand curve (see Edexcel past training content on Year 2 Microeconomic themes 2) , explaining the kinked demand curve can also score points in the exam.

For an oligopoly cost-revenue diagram, the marginal cost (MC) and average total cost (ATC or AC) curves are the same as in monopoly.

However the average revenue curve is “kinked”, meaning the AR curve suddenly changes slope at price p*. Why is the AR curve kinked? This comes from firm interdependence.

AR:

• Start at price p* – price at the corner of the AR curve.
• Suppose one firm decides to lower price below p*.
  • Other firms would also lower their price, so as not to lose out on customers/profits.
  • So demand only rises by a little, as the firm lowering the price cannot attract customers from other firms. However as new customers enter the market and buy the product when the price falls, demand increases a little.
  • Note the AR curve is the demand curve for the individual firm’s product.
  • So below p*, AR is less price-elastic.
• Suppose one firms to raise its price above p*.
  • Other firms keep their price same, as more customers buy from their firm. 
  • Above p*, raising price leads to a larger fall in demand, as consumers switch quickly to other firms who are keeping their price the same.
  • So above p*, AR is more price-elastic.

MR:

• Just like in monopoly, the MR curve is twice as steep as the AR curve. 
• When AR is above p*, MR is twice as steep as the AR.
• When AR is below p*, the AR curve becomes steeper (less elastic) so the MR also becomes steeper.
• The MR curve is discontinuous at the same output level where there is a kink in the AR curve.
  • In other words the extra revenue for selling one more unit falls abruptly, as other  firms begin to match the falls in price and revenue does not rise as much.
  • Mathematically when there is a kink in the AR curve, it follows that the MR curve will be discontinuous. [Beyond the course].

So what does the kinked demand curve tell us?

• Assume the oligopoly firm maximises profit. This occurs where MC = MR. 
• Here MC = MR on the vertical part of the MR curve. So the firms make supernormal profit and price at p*.
• Generally the kinked demand curve theory predicts that the price is likely to be stable around p*, when the marginal cost intersects the vertical part of the MR curve.
• This is because increasing or decreasing price relative to p* is likely to lead to lower profits.
• Note this diagram does not assume collusion, but we know collusion exists in the real world.
  • The absence of collusion is a weakness of the kinked demand curve. 
  • Suppose the diagram would take collusion into account. How would the kinked demand curve change?
  • In this case, higher prices would lead to a small drop in demand, as other firms would also raise prices.
  • So the AR line could become less of a change in the slope or even become linear, with the same slope above and below p*.

Edexcel style practice question for oligopoly

I have written this practice question in the style of Edexcel A Economics A Level. It features a short extract and a 25 marker practice question.

The Competition and Markets Authority (CMA) has found cases of collusion in the construction industry, but states that difficult market conditions are no excuse to break competition law. The CMA, in 2020, fined Vp and MGF over £15 million for “sharing confidential information relating to current and future pricing and co-ordinating their commercial activities to reduce strategic uncertainty”.

Discuss the effects of collusion on firms and consumers (25 marks)

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