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Assumptions of Oligopolies
Assumptions of Oligopolies
Few Dominant Firms (Concentration Ratio)
Firms are Interdependent (Game Theory)
Firms produce homogeneous or differentiated products
High Barriers to enter and exit
Determining whether a market is Oligopolistic (Concentration Ratio)
Determining whether a market is Oligopolistic (Concentration Ratio)
In order to understand whether or not a market is oligopolistic, we need to look at how much of the market share the top 4 firms have. To measure this, we use something called the concentration ratio (CR).
To calculate the concentration ratio, we total up the market share of the top 4 (CR4) or top 8 (CR8) firms to see how much of the market share is held by those firms. To calculate the market share, we take the total revenues of all firms in the market and then calculate as a % of the Total, what each firm makes in revenue as a % of the total.
In this example, we can see that the top 4 firms have a 90.37% of the total market share. This tells us that this market is heavily concentrated on the top 4 firms, making these 4 firms the dominant firms in the industry. Generally, the higher the percentage, the more concentrated the market is on the top 4 or 8 firms.
Understanding why firms are Interdependent (Game Theory)
Understanding why firms are Interdependent (Game Theory)
The video discusses the Prisoners Dilemma. This model helps us understand the interdependence of oligopolistic firms. When faced with a similar pay off matrix to the one presented in the prisoners dilemma, firms must make a choice. However, the outcome of that choice is not just dependent on their own choice, but how others also act.
Lets look at the Pay off Maxtrix below for 2 firms and a pricing strategy, with the profits made with each decision.
We can see there are two firms. Airline A and Airline B. Both firms are presented with a choice of what to do with their price; Raise Price or Lower Price.
As we can see, if both firms choose to raise their prices, each firm will make £10m profit. However, if A chooses to Raise the price and B chooses to lower their price, Airline A will only earn £3m, whereas Airline B will earn £12m.
Similarly, if Airline A chooses to lower its price and B raises its price, then A will earn £12m and B will only earn £3m
If both firms choose to lower their prices, they will each only earn £6m in profit each.The best outcome for both Airlines is if both airlines chose to raise their prices, allowing both firms to earn £12m. However neither airline is aware of the decision the other will take. Take for example, if Airline A knows that Airline B will raise the price, then Airline A should lower its price to earn £12m. Therefore, this poses a dilemma for both firms. Despite the best option being to raise the price, knowing the other firm may lower its price means that both firms are likely to choose to lower their prices, making both firms worse off earning £6m in profit.
Therefore, firms may choose to try to cooperate by forming collusive oligopolies, or choosing to compete not on price but instead using non-price competition.
Collusive Oligopolies
Collusive Oligopolies
As we have seen above, due to their interdependence, Oligopolies competing on price are made worse off. Therefore, firms may discuss with each other and agree to limit competition and agree to fix their prices to maximise their own outcomes. This process is called Collusion.
Cartels (Formal Collusion)
Cartels (Formal Collusion)
One form of Collusion is for firms to create a Cartel. Cartels may agree on fixing the quantity produced by each firm, fixing the price a good is sold at or dividing up markets by, for example, geographical location. Similarly, firms could create barriers for other firms to enter the market. By doing this, the firms who are part of the cartel essentially form a Monopoly, allowing all members to maximise their profits. As we can see, by limiting the output to Qpm and selling the good for a price of P1, the firms are able to make abnormal profits (represented by the yellow box).
These factors benefit the firms by:
Increasing market power of firms
Higher Profits
Elimination of Competition and the problems presented by the Prisoners Dilemma.
One example of a legal Cartel is the Organisation of Petroleum Exporting Countries (OPEC). Each of the 13 member countries has a quota they can produce. If the Cartel wishes to raise the price, quotas on output will be decreased, decreasing the supply and increasing the price. If the Cartel wishes to lower the price, quotas will increase, increasing supply and therefore lowering the price.
In most countries however, Cartels and collusion are illegal, as they are seen as anti competitive behaviour, making consumers worse off. Therefore, most cartels happen less formally as any evidence of the formation of a cartel is usually met with fines or other consequences by governments.
It is because of this, cartels tend to be unstable over the longer term. That is to say if a cartel is formed and despite the benefits, members have the incentive to cheat the Cartel. Referring back to the payoff matrix above, if both Airlines A & B agreed to Raise the Price, both members of the cartel would earn £10m. However, if airline B knows that Airline A is going to raise the price, then Airline B should lower its own price, making Airline B £12m.
Therefore whilst firms may agree on a particular decision, there is always an incentive to cheat the other firm in order to benefit. What usually follows this is a "Price War". Since airline B lowered its price, airline A has no choice but to lower its prices, giving an outcome of £6m for each firm. However, in order to keep gaining, firms will continue to lower their prices in order to gain over the other firm. To avoid this, Oligopolistic firms may focus on competing on Non-Price Competition (see below)
On top of this, as firms all have different costs, the price set may not always benefit all firms and therefore the Cartel may not continue over the long term. Similarly, the more firms are members of the cartel, the more difficult it is to maintain as agreements on quotas etc are more difficult to agree on.
Informal Collusion
Informal Collusion
As cartels are illegal in most countries, firms may collude through more informal methods. For example, smaller firms may follow the prices set by the largest firm in the market. This form of collusion limits competition and keeps prices high for consumers. However, this type of collusion is more difficult to prove by governments as compared to Formal Collusion.
OPEC - A formal Cartel for Oil Prices
OPEC - A formal Cartel for Oil Prices
Non Collusive Oligopolies and the Kinked Demand Curve
Non Collusive Oligopolies and the Kinked Demand Curve
Oligopoly is characterised by a small number of interdependent firms. In such markets, firms must take into account not only consumer behaviour but also the strategic responses of rivals when making decisions about price and output. The kinked demand curve model offers an explanation for price rigidity in non-collusive oligopolies, a situation where firms do not formally agree on prices, but instead act independently while recognising their mutual interdependence.
The model was first proposed by Paul Sweezy in the 1930s and remains a useful framework for explaining why prices in oligopolistic markets tend to be sticky in the face of cost or demand fluctuations.
The kink in the firm's average revenue (AR) curve, which is equivalent to its demand curve, emerges from the asymmetric expectations firms hold regarding their rivals' reactions to price changes. The model assumes:
If a firm raises its price, its rivals are unlikely to follow, fearing loss of market share. As a result, the firm’s demand becomes highly price elastic above the current price. Consumers can easily switch to cheaper substitutes offered by competitors.
Conversely, if the firm lowers its price, competitors are expected to match the cut to protect their market share. In this case, the firm gains little or no increase in quantity demanded, making the demand price inelastic below the current price.
This results in a kink at the prevailing market price, where the slope of the AR curve becomes steeper below the kink and flatter above it.
The kink reflects strategic interdependence: each firm must consider not just the direction of its own price change, but the expected response of competitors. Since the potential loss from a price rise (due to elastic demand) is greater than the potential gain from a price cut (due to inelastic demand), firms are discouraged from changing price in either direction.
Marginal Revenue and the Discontinuity
Marginal Revenue and the Discontinuity
The MR (marginal revenue) curve, which lies beneath the AR curve, will also exhibit an unusual feature due to the kink, a vertical discontinuity at the level of output where the kink occurs.
Why does this happen?
MR is derived from AR. Where AR changes slope abruptly (i.e. at the kink), MR becomes undefined over a range of output, because there is no single, continuous tangent to the AR curve at that point.
The discontinuity represents a range over which marginal revenue is not defined. It is essentially a vertical gap, where no marginal revenue corresponds to the output at the kink.
This discontinuity has important implications for price and output decisions. A firm maximises profit where MC = MR. If the MC curve passes through the discontinuity, the firm will still profit-maximise at the same level of output and price — even if marginal cost changes within that range.
The Role of Cost Changes
The Role of Cost Changes
In standard models of firm behaviour, a change in marginal cost would typically lead to a change in profit-maximising price and output. However, in the kinked demand curve model, this is not necessarily the case.
The existence of a vertical discontinuity in MR allows for multiple marginal cost (MC) curves, both above and below the original MC , that still result in the same equilibrium. As long as the new MC curve intersects MR within the discontinuity, the profit-maximising output and price remain unchanged.
The firm has no incentive to change price, because any upward movement will reduce revenue significantly (due to the elastic upper demand curve), and any downward movement will reduce revenue without increasing quantity sufficiently (due to the inelastic lower demand curve). This creates a zone of price rigidity, where even changes in cost conditions (within limits) do not alter the optimal pricing decision.
Therefore, two MC curves, say, MC₁ and MC₂, can both intersect the MR curve within the discontinuous region and imply no change in either price or output.
This is not arbitrary. It reflects the idea that in the real world, especially in oligopolies like petrol, banking, or airline industries, prices often remain unchanged despite variations in cost. Firms do not wish to trigger a price war or lose customers, and this risk-averse behaviour is captured well by the kinked demand framework.
Strategic Implications of the Model
Strategic Implications of the Model
The kinked demand curve reflects a fundamental tension in oligopoly: the desire to avoid price competition while remaining alert to competitors’ moves. The model shows that:
Price stability is a rational outcome, not just an observational coincidence.
Firms behave conservatively with respect to pricing, avoiding moves that could destabilise the market.
Even in the absence of explicit collusion, firms may reach a stable price through mutual expectations.
The model provides a microeconomic foundation for tacit coordination or tacit collusion a key feature of real-world oligopolies. Firms align their behaviour not through agreements, but through shared incentives and common knowledge of rivals’ likely strategies.
The Importance of Non-Price Competition in Oligopolies
The Importance of Non-Price Competition in Oligopolies
In oligopolistic markets, where a small number of large firms dominate, non-price competition plays a crucial role in shaping firm behaviour and market outcomes. Unlike in perfect competition, where price is the primary competitive tool, firms in an oligopoly are highly interdependent and therefore cautious about using price as a competitive weapon. A price cut by one firm is likely to be matched by rivals, eliminating any potential gain in market share and potentially triggering a damaging price war. Conversely, a price increase might not be followed, resulting in lost customers. Because of this strategic uncertainty, firms often prefer to compete using non-price methods that are less likely to provoke direct retaliation and that can help build longer-term customer loyalty.
This reliance on non-price competition is reinforced by the kinked demand curve model, which predicts that firms face a relatively elastic demand curve above the current price (due to the likelihood that rivals will not match price increases) and a relatively inelastic demand curve below it (because rivals are expected to match price cuts). This creates a strong disincentive to alter prices. As a result, firms seek alternative ways to make their products more attractive, leading to a focus on value-based competition rather than price-based competition.
Firms engage in non-price competition in various forms, all aimed at differentiating their product or enhancing the overall customer experience. These methods include:
Product differentiation – changing the design, quality, or features of a product to stand out from competitors.
Branding and advertising – creating a strong brand image and investing in marketing to increase brand awareness and loyalty.
Customer service and after-sales care – offering better support, warranties, or return policies to add value beyond the product itself.
Loyalty schemes and promotional incentives – rewarding repeat customers with points, discounts, or exclusive offers.
Innovation and R&D – investing in technological improvements or new product development to stay ahead of rivals.
The economic rationale behind these strategies is clear: by increasing product differentiation, firms can make demand for their product more price inelastic. This allows them to maintain higher prices without losing significant market share. Non-price competition also helps establish barriers to entry, since new firms may struggle to match the brand recognition, customer relationships, or technological sophistication of established players. In many cases, these strategies lead to dynamic efficiency, as firms are incentivised to innovate and improve quality over time in order to sustain their competitive edge.
However, non-price competition is not without its costs. High levels of spending on advertising or research and development can raise a firm’s average costs, which may be passed on to consumers in the form of higher prices. In some cases, firms may also engage in excessive or superficial differentiation, offering marginally different versions of the same product in a way that confuses rather than benefits consumers. Even so, these costs are often viewed by firms as acceptable compared to the risks associated with price competition.
Evaluating Oligopolies
Evaluating Oligopolies
Potential Benefits to Oligopolies
Potential Benefits to Oligopolies
Economies of Scale: Oligopolistic firms often have substantial market share and production capacity. This enables them to benefit from economies of scale, which can lead to lower average costs of production. Lower costs can translate into lower prices for consumers, increased profitability for firms, and overall market efficiency.
Technological Advancements: Oligopolistic firms, due to their size and financial resources, have the ability to invest heavily in research and development (R&D) and technological advancements. This can lead to product innovations, process improvements, and the development of new technologies. These advancements can benefit consumers by offering better-quality products, increased efficiency, and improved living standards.
Product Differentiation: Oligopolies often engage in product differentiation to compete and gain market share. This can lead to a wider variety of products and choices for consumers. Product differentiation allows firms to cater to different consumer preferences, leading to more personalized products and increased customer satisfaction.
Strategic Behavior and Competition: Oligopolistic firms engage in strategic behavior, such as pricing strategies, marketing campaigns, and product innovation, to gain a competitive advantage. This intense competition among dominant firms can drive innovation, efficiency, and responsiveness to consumer needs. Firms may also engage in non-price competition, such as advertising or customer service, which can improve overall product quality and customer experience.
Increased Investment and Growth: Oligopolies, due to their market power and profitability, have the financial resources to invest in capital-intensive projects and long-term growth initiatives. These investments can lead to job creation, economic growth, and improved productivity in the economy. Oligopolistic firms' ability to make substantial investments can positively impact industries and local economies.
Potential Drawbacks to Oligopolies
Potential Drawbacks to Oligopolies
Limited Competition: Oligopolies feature a small number of dominant firms, which can lead to limited competition. The reduced competition may result in higher prices for consumers, as firms may engage in tacit or explicit collusion to maintain their market power. This can lead to reduced consumer welfare and hinder market efficiency.
Barrier to Entry: Oligopolistic markets often have high barriers to entry, making it difficult for new firms to enter and compete. Existing dominant firms may have significant advantages such as economies of scale, established brand recognition, or strong distribution networks. The lack of new entrants can stifle innovation, restrict consumer choice, and limit market dynamics.
Price Rigidity: Oligopolistic firms may engage in price rigidity, meaning they are reluctant to change prices in response to changes in costs or demand. This behavior can lead to price inflexibility and slower adjustments to market conditions, reducing efficiency and responsiveness. It can also result in price stability at higher levels, potentially disadvantaging consumers.
Collusion and Anti-Competitive Behavior: Oligopolistic firms may engage in collusive practices to maintain market power and control prices. This can lead to anti-competitive behavior, such as price-fixing, market allocation, or bid rigging, which harm consumers and restrict market competition. Such practices are generally illegal and undermine the principles of fair competition.
Lack of Consumer Sovereignty: In oligopolistic markets, the limited number of dominant firms may have significant influence over product choices and availability. This can limit consumer sovereignty—the power of consumers to shape the market through their preferences and demand. The dominance of a few firms may reduce consumer options and result in a lack of diversity in the marketplace.
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