Oligopoly – Economics Revision – The Tutor Academy
Oligopoly – Economics Revision – The Tutor Academy
Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes
Oligopoly
Oligopoly market structure exists where there are a small number of large firms dominating the market.
Examples:
- Supermarkets
- Retail banks
- Mobile phone networks
Characteristics of Oligopoly market structure
- High concentration ratio
- High barriers to entry
- Firms are interdependent (They make price and output decisions based on each others)
- Firms compete through non – price competition
- Product Differentiation
Kinked Demand Curve
The kinked demand curve explains how an oligopolistic market functions theoretically.
- In an Oligopolistic market firms have no incentive to charge higher prices then PE.
- If one firm was to try and charge a higher price of P1 for a good or service. This would lead to them losing market share as the other firm would keep its price lower at PE.
- Oligopolistic firms are also unable to charge lower prices than competitors at P2. This is because if one firm lowers its price. The other firm will also lower its price below its competitors. This will lead to a price war where both firms continue to decrease their prices competing away their profit margins.
- Therefore firms will generally constrain themselves from lowering or increasing prices from PE in an oligopolistic market.
- Competing firms will therefore keep their prices at the same point PE, QE. This is known as the point of sticky prices.
- They will opt to compete with each other through non-price competition e.g. advertising, branding, packaging, after sales service etc.
- Firms are also most likely to collude at point PE, QE. This is because they are both able to earn higher profits if they were to increase their prices together without getting caught by regulators.
Evaluation of the Kinked Demand Curve
- The model does not explain why prices are the way they are initially
- However, it does explain why markets are more complex and also a degree of stability
- The Kinked Demand Curve Model can be useful in explaining some simple Game Theory
- To explain cartels and collusions, a Pay-Off Matrix is more applicable instead of the Kinked Demand Curve Model as it provides a much wider range of possibilities
Advantages of an Oligopoly
1. Price Stability – this brings advantages to consumers and the economy as it allows them to plan ahead
2. Dynamic Efficiency – the supernormal profits gained may allow them to invest into innovation and R&D
3. Greater choice and better quality products – the investment into innovation allows the firm to produce better quality products and expand the range of services available
Disadvantages of an Oligopoly
1. Higher prices and lower output – collusion and cartel-like behaviour means firms are able to raise their prices, as well as restrict their output. This reduced competition and consumers pay more for less.
2. Allocatively and Productively Inefficient – price is above MC and output is less than the productively efficient output
3. Less consumer choice – higher concentration ratios and market share leads to less variety for consumers
4. Decision-Making Bias – lack of competiti0on in the market can lead to firms manipulating the choices made by consumers and irrational behaviour
5. Deliberate barriers to Entry – because firms have large market shares, they can enforce deliberate barriers to entry to deter other firms from entering the market
Collusion
Collusion occurs when two or more firms price fix and restrict their outputs to the detriment of customers welfare. There are two main types of Collusion, which are:
Tacit Collusion
This is the type of collusion that occurs through ‘unspoken’, ‘quite’, ‘hidden’ agreements between two parties. They are often implicit agreements that are extremely difficult for competition authorities to prove. Tacit collusion is illegal.
Overt Collusion
Overt means open or spoken collusion between firms. They will both be aware of each other’s price and output decisions and adjust accordingly to maximise profits. This type of collusion is easier to detect and is also illegal.
N-firm Concentration Ratios
This ratio measures the percentage of the total market that a particular number of firms possess. The N-firm concentration ratio indicates the concentration of supply in the industry
3 firm concentration ratio – shows the market share that the three biggest firms have
Formula for calculation Concentration Ratios:
(total sales of n firms / total size of the market) x 100
AQA Spec – Additional Content
The difference between collusive and non-collusive oligopoly
If firms decide to work together on something – for e.g. setting a price or fixing a quantity of output, they are engaging in collusive behaviour.
Collusion of firms results in higher prices, lower consumer surplus and greater profits earned by the companies
Firms in an oligopolistic market want to collude to deter entry of new firms and also reduce competition. By colluding, they are able to restrict output and charge higher prices to consumers, allowing them to maximise benefits
Non-collusive behaviour occurs when firms in an oligopoly are competing with each other.
Non-collusive behaviour occurs when:
- There are several firms in an oligopoly
- The products produced are homogenous
- One firm has a cost advantage
- The market is saturated
- Firms take market share from their rivals in order to grow
The difference between Cooperation and Collusion
Cooperation is allowed in a market and can be seen as beneficial, whereas, collusion is prohibited as it is conducted with an intention to exploit consumers
Cooperation can refer to how a firm is organised and how production is managed, whereas collusion refers to market variables
Quick Fire Questions – Knowledge Check
1. Identify the characteristics of an Oligopoly (3 marks)
2. Define ‘Interdependent’ (2 marks)
3. Draw a kinked demand curve (4 marks)
4. Explain the difference between a high concentration ratio and a low concentration ratio (4 marks)
5. Identify 4 examples of an oligopoly (4 marks)
6. Explain what the Kinked Demand Curve diagram shows (4 marks)
7. Define ‘Game Theory’ (2 marks)
8. Draw a game theory matrix showing advertising, R&D, Output, Pricing (4 marks)
9. Explain each game theory diagram (6 marks)
10. Explain tacit, overt, and covert collusion (6 marks)
11. Explain what the N-firm concentration ratio shows (4 marks)
12. Identify the formula for calculating the n-firm concentration ratio (2 marks)
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