A2 UNIT 3

Ch-5 : Oligopoly
5.1 Features

• The industry is dominated by a few large firms (high concentration

ratio, UK definition 5 firm concentration ratio more than 50%)
• Interdependence, each firm will be affected by how the others act
• Barriers to entry, e.g. brand loyalty
• Differentiated product
• Non price competition, e.g. high degree of advertising
• Possibility of collusion
• Supernormal profits in long run

E.g. car manufacturers, mobile telecom

Concentration ratio refers to the market share of the top ‘n’ firms in the
industry. For example, if the top three firms have 78% of the market
share, then we say that the three firm concentration ratio is 78%.

5.2 Collusion and Game Theory

Suppose there are two firms – A and B. Neither wants a price war, they
would rather collude and charge a high price.

Assume that each sells 100 units at $5 each. Therefore total revenue for
each firm is $500. Combined revenue is $1,000. Firm A could reduce its
price and charge $4, and sell 150 units. Its revenue will rise to $600. Firm
B will face a fall in demand, and can sell 60 units at $5, its revenue falls
to $300. Combined revenue is now $900, so even though one firm is
doing better, overall they are losing out.
Now firm B reacts, and reduces its price to $3. They can increase sales,
but it will reduce the combined revenue even further. This will continue
until the price war ends, and the two firms will be in a situation where
they are both worse off then originally.

Game theory suggests that the firms would be better off colluding, with
both charging higher prices, and earning higher revenues.
 There are three types of collusion:

• Overt collusion, where firms openly discuss their pricing strategy

with each other. This is illegal, and may only be practised by
countries, e.g. OPEC members can collude and charge high oil
prices.
• Covert collusion, where firms secretly meet and discuss pricing
and output decisions. This is quite common, despite the existence
of fines and jail sentences if caught
• Tacit collusion, where there is an implicit agreement between
firms, without actually directly communicating with each other.
This type of collusion is very difficult to control.

The possibility of collusion is greater, the lower the number of firms.

For example, it is easier for two or three firms to collude, compared
to five or six, as the possibility of a firm cheating is lower.

5.3 Kinked Demand Curve

Assumptions:

• Firms aim to maximise profits

• Demand is elastic if price increases, therefore revenue will fall.
This is because their price will be higher than their rivals, and
they will become less competitive
• Demand is inelastic if price falls, therefore revenue will fall.
This is because other firms will also reduce their prices, and
market share is unlikely to increase much.
• Prices are stable at P1