Unit 2.

11(5) Market power – Oligopoly (HL)

What you should know by the end of this chapter:
• Definition of oligopoly
• Concentration ratio
• Assumptions of oligopoly
• Interdependent decision making
• Barriers to entry
• Collusive oligopoly
• Demand and revenue
• Non-collusive oligopoly
• Game theory
• Efficiency in oligopoly
• Evaluation of oligopoly

The nature of oligopoly

An oligopoly is a model of a market where a small number of large firms dominate the market. This
can be expressed as a situation where the total revenue of a small number of large firms accounts
for a high proportion of total market revenue. The rest of the market would be made up of smaller
firms.

Concentration ratio
Oligopolistic markets are described as highly concentrated. This means the concentration ratio for a
certain number of the largest firms in the market is a relatively high percentage of total market
revenue. For example, the market for sports clothing and footwear in an economy might be
dominated by four large firms. You would use a four-firm concentration ratio to measure the extent
to which this is an oligopolistic market. The ratio would be calculated as:

total revenue of the 4 largest firms in a market / total revenue of the market x 100

The annual total revenue figures might be:

$980m / $1210m = 81%

This means the four largest firms in the sportswear market account for 81 per cent of total market
revenue and we would describe this as an oligopolistic market.

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Assumptions of oligopoly
Small number of large firms
A small number of large firms account for a high proportion of total market revenue. The sportswear
market which is dominated by Nike, Adidas, Puma and Under Armour is an example of this.

Barriers to entry
Barriers to entry and exit exist in oligopolistic markets. This means there are costs and regulations
over and above the normal costs of entering or leaving a market. Barriers to entry in oligopolistic
markets are similar to those in monopoly markets. The different barriers to entry that exist in
markets are covered in Unit 2.11(3) on monopoly.

In the sportswear market, the economies of scale achieved by the four largest firms along with
brand loyalty and high expenditure on promotion all act as significant barriers to entry.

Differentiated products
Firms in oligopolistic markets sell a differentiated product that is different from the goods sold by
their competitors. This means oligopolistic firms face a downward sloping demand curve and are
price makers rather than price takers. For example, the training shoes sold by Nike and Adidas are
very similar but they are different in terms of design and brand image.

Interdependent decision making

Businesses in oligopolistic markets make interdependent decisions which means they make
decisions based on how they believe other firms in the market are going to react to their decisions.
This is unlike perfect and monopolistic competition where firms make decisions independently of
one and other. For example, if Nike chooses to cut its price to increase market share then Adidas,
Puma and Under Armour might respond by cutting their prices to protect their market share.

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Collusive oligopoly
Collusion occurs in a market where firms share information about their price and output
decisions. The most extreme form of collusion is a cartel where firms jointly decide to set price and
output and by doing this they effectively act as a monopoly. This means the colluding firms attempt
to maximise joint profits by setting price and output in the same way as a monopoly firm.

In an economy, for example, the cement market might be a cartel with 5 firms collectively agreeing
to fix their output and charge the same price. When firms collude, they effectively act as a monopoly
and the cement market can be analysed as if it was a monopoly. This means the firms in the market
jointly produce where marginal cost equals marginal revenue when marginal cost is rising and then
set price based on the demand curve.

This is shown in diagram 2.76. In this

example, the cartel in diagram 2.76 is
earning abnormal profits equal to the
yellow shaded area.

Conditions for collusion

For a collusive oligopoly to operate effectively the following conditions need to be in place:

• Firms are located closely together and there are good relationships between the producers
so that firms find it easy to work together.

• There are a small number of firms involved in a collusive agreement. When there are too
many firms in a cartel it is difficult to control output.

• Although there is product differentiation there are only small differences in the goods sold
by individual firms. This means consumers make their buying decisions based on price rather
than product quality. This means buyers are not attracted to one producer in the cartel
ahead of the others and this makes it easier for producers to jointly supply the market.

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The law and collusion
In most countries, collusive behaviour between firms is illegal because consumers pay a higher price
for a lower output than would exist in a competitive market. In the UK, for example, the
Competition Commission investigates and acts against collusive behaviour by firms.

Tacit collusion
Firms can use tacit collusion where they make decisions that influence price and output in a collusive
way, but do not involve a formal agreement. Tacit collusion can involve price leadership where firms
all change prices together but are led by one firm in the industry. For example, if there are six energy
businesses providing gas and electricity in a market they will react in an interdependent way when
setting prices by looking at each other's prices. Whilst they do not have a formal arrangement, they
may change their prices in line with each other, so they do not compete on price. If one energy firm
is the informal leader and they increase prices this will trigger an increase in price by other firms in
the market.

Non-collusive oligopoly
A non-collusive oligopoly is a market situation where the firms in the market do not enter into any
formal or informal agreements with other firms in the industry. The behaviour of firms in a non-
collusive oligopoly can be explained by using game theory.

Game theory
Game theory is a model of strategic behaviour that exists in an oligopolistic market. The model
explains how businesses react to each other decisions in interdependent decision-making situations.
The strategic element explains how firms plan their pricing decisions in response to their
competitors.

Game theory example

This is a game theory example where there are two firms selling cement in a market and making a
pricing decision.

Assumptions of this game theory example are:

• Two firms dominate the cement market in a duopoly situation – Firm A and Firm B

• Each firm has an equal market share

• Each firm has the same costs

• The products sold by each firm are very similar, so consumers are making their buying
decisions solely on price.

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 • The different decision-making options of each cement producer in the market are set out in
the table.

Firms A and B start with an initially high price with each firm charging $100 and making $8 million
profit each. Because of a fall in demand in the market, both firms are thinking about reducing their
prices.

• Firm A is deciding on whether to decrease its price to $80 or to leave it at $100. If Firm A
keeps its price the same and Firm B reduces its price, Firm A’s profits will fall to £1 million.
This outcome is the worst situation for firm A.

• If Firm A reduces its price and Firm B keeps its price the same Firm A’s profits will rise to $10
million. This is the best outcome for firm A.

• If Firm A reduces its price and Firm B reduces its price, then Firm A’s profits fall to $6 million
which is a fall in profit but not as much as the fall to $1 million so it is a better outcome.

• Given this matrix of outcomes, the least risk and the greatest return is for firm A to reduce
its price.

• The same outcomes apply to Firm B, its least risk and greatest return are for it to reduce its
prices.

• Given Firm A and Firm B's lowest risk outcome is to reduce price, both firms would reduce
price and this would lead to a fall in their profits.

• This game theory example can be used to explain why firms in oligopolistic markets would
like to collude and maintain their price at the current level. If the firms can use a formal or
tacit agreement to keep their cement prices at $100 then it reduces the risk associated with
pricing decisions and makes future planning easier for both forms.

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Price rigidity
There is evidence that in oligopolistic markets prices do not change as much as they do in other
markets in response to changes in demand and supply. This is known as price rigidity. The theory we
have considered so far in oligopoly goes some way to explaining why this might be the case:

• If firms collude in markets and agree not to compete on price, then price changes are less
likely when demand and supply change in the market. Oligopolistic firms that collude and act
as a monopoly can increase their collective profits by fixing price and output.

• Game theory can be used to explain how strategic decisions by firms can reduce price
changes. If firms make decisions on a ‘least risk’ basis then this will often mean not changing
prices.

• Price rigidity can be explained by businesses in oligopolistic markets wanting to avoid price
war situations where all firms in the market are reducing prices. The demand for an
individual firm’s product might be relatively elastic, but demand for the product in the whole
market is likely to be more inelastic. If the price of the product falls for all firms in the
market, then the total revenue of all the firms will decrease.

Non-price competition
Because firms in oligopolistic markets are often reluctant to compete on price they choose to
compete for customers through other activities that can attract consumers. Non-price competition
might involve:

• Firms improve the quality of their products in the market so it attracts buyers. This can be in
terms of product design, functionality, packaging and customer service. In the coffee shop
market firms such as Starbucks, Costa Coffee and Café Nero do not compete that much on
price, but they do compete on the quality of their shops, the coffee they serve and their
customer service.

• Promotion and advertising is the way many oligopolistic businesses try to attract customers.
The major sports goods firms, Nike and Adidas compete extensively in the market for sports
clothing and equipment through activities such as promotional campaigns, sponsorship and
product endorsement.

• Using a wide distribution network can give a firm a competitive advantage. The soft drinks
manufacturer, Coca-Cola tries to make its goods as accessible as possible to potential
buyers. This involves distributing their soft drinks through small shops, supermarkets,
transport hubs, bars and restaurants, places of entertainment and vending machines.

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Efficiency in oligopoly
In our graphical analysis of efficiency in oligopoly, we are going to use the collusive oligopoly
diagram to make judgements about allocative and productive efficiency.

Productive efficiency
Oligopolistic firms will not achieve
productive efficiency because they
produce on the downward-sloping
portion of the ATC curve at the profit
maximising output and do not achieve
the lowest possible average total cost.
This is shown in diagram 2.77. The
pressure of competition in oligopolistic
markets might make firms more
productively efficient than in a
monopoly.

Allocative efficiency
Similar to monopoly and monopolistic competition the firms in an Oligopoly fail to produce at the
point of allocative efficiency where marginal cost equals price which is shown in diagram 2.77. This
means the consumer pays a higher price for a lower output than under perfectly competitive market
conditions.

Oligopolistic markets also have price rigidity. This means prices do not change to reflect changes in
relative scarcity in the same way as monopolistic and perfect competition. This means that prices
may not fulfil their allocative and rationing functions as efficiently as they do in perfect and
monopolistic competition.

The benefits of oligopoly

Economies of scale

Because the firms in oligopolistic markets are generally large they do benefit from significant
economies of scale which generally makes their prices lower and output higher than in perfect and
monopolistically competitive markets. A large retailer like Walmart will sell its goods at much lower
prices than smaller retailers because of its economies of scale.

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Barriers to entry

The barriers to entry enjoyed by Oligopolies yield profits that can be re-invested back into the
business which gives consumers new products. In perfect and monopolistic competition abnormal
profits are competed away which takes away the funds for innovation and reduces the reward for
developing new products. Apple and Microsoft dominate their respective markets and they have
produced new and better products as a result of the huge profits they re-invest back in their
respective businesses.

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