economics oligopoly essay

Essay on Oligopoly: Top 8 Essays on Oligopoly | Markets | Microeconomics

Here is a compilation of essays on ‘Oligopoly’ for class 9, 10, 11 and 12. Find paragraphs, long and short essays on ‘Oligopoly’ especially written for school and college students.

Essay on Oligopoly

Essay Contents:

• Essay on Payoff (Profit) Matrix

Essay # 1. Introduction to Oligopoly:

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Two extreme market forms are monopoly (characterised by the existence of a single seller) and perfect competition (characterised by a large number of sellers). Competition is of two types- perfect competition and monopolistic competition. In perfect competition, all sellers sell ho­mogeneous products while in monopolistic competition they sell heterogeneous products. In monopoly there is no rival.

So the monopolist is not concerned with the effect of his actions on rivals. In both types of competition, the number of firms is so large that the actions of any one seller have little, if any, effect on its competitors. An industry with only a few sellers is known as an oligopoly, a firm in such an industry is known as an oligopolist.

Although car-wash is a million rupee business, it is not exactly a product familiar to most consumers. However, often many familiar goods and services are supplied only by a few com­peting sellers, which means the industries we are talking about are oligopolies. An oligopoly is not necessarily made up of large firms. When a village has only two medi­cine shops, service there is just as much an oligopoly as air shuttle service between Mumbai and Pune.

Essentially, oligopoly is the result of the same factors that sometimes produce monopoly, but in somewhat weaker form. Honestly, the most important source of oligopoly is the exist­ence of economies of scale, which give better producers a cost advantage over smaller ones. When these economies of scale are very strong, they lead to monopoly, but when they are not that strong they lead to competition among a small number of firms.

Since an oligopoly con­tains a small number of firms, any change in the firms’ price or output influences the sales and profits of competitors. Each firm must, therefore, recognise that changes in its own policies are likely to elicit changes in the policies of its competitors as well.

As a result of this interdependence, oligopolists face a situation in which the optimal deci­sion of one firm depends on what other firms decide to do. And so there is opportunity for both conflict and cooperation. Oligopoly refers to a market situation in which the number of sellers is few, but greater than one. A special case of oligopoly is monopoly in which there are only two sellers.

Essay # 2. Characteristics of Oligopoly:

The notable characteristics of oligopoly are:

1. Price-Searching Behaviour :

An oligopolist is neither a price-taker (like a competitor) nor a price-maker (like a monopolist). It is a price-searcher. An oligopolist is neither a big enough part of the market to be able to act as a monopolist, nor a small enough part of the market to be able to act as a competitor. But each firm is a dominant part of the market.

In such a situation, competition among buyers will force all the sellers to charge a uniform price for a product. But each firm is sufficiently so large a part of the market that its actions will have noticeable effects upon his rivals. This means that if a single firm changes its output, the prices charged by all the firms will be raised or lowered.

2. Product Characteristics :

In oligopoly, there may be product differentiation as in monopolistic competition (called differ­entiated oligopoly) or a homogeneous product may be traded by all the few dominant firms (as in pure oligopoly).

3. Interdependence and Uncertainty :

In oligopoly no firm can take decision on price independently. It is because the decision to fix a new price or change an existing price will create reactions among the rival firms. But rivals’ reactions cannot be predicted accurately. If a firm reduces its price its rivals may reduce their prices or they may not. So there is lack of symmetry in the behaviour of rival firms.

This type of reaction of rivals is not found in perfect competition or monopolistic competition where all firms change their price in the same direction and by the same magnitude in order to remain competitive and survive in the long run. So the outcome of a firm’s decision is uncertain.

For this reason it is difficult to predict the total demand for the product of an oligopolistic industry. It is still more difficult, and in some situations virtually impossible, to estimate the share of an individual firm in industry’s output.

It is true that the consequences of attempted price variations on the part of an individual seller are uncertain. His rivals may follow his change, or they may not, but they will, in all likelihood, notice it. The results of any action on the part of an oligopolist or even a duopolist depend upon the reactions of his rivals. In short, it is not possible to define general price- quantity relations for an individual firm, since reaction patterns of rivals are highly uncertain and almost completely unknown.

4. Different Reaction Patterns and Use of Models :

It is not true to say that, in oligopoly, profit is always maximised. It is because an oligopolist does not have control over all the variables which affect his profit. Moreover, a variety of possible reaction patterns is possible in this market—there is a conjectural variation in this market.

Just as firm A’s profit depends on the output of firm B also, firm B’s profit, in its turn, depends on firm A’s output. This is why various models are used to describe the diverse behaviour of oligopoly markets where a variety of outcomes is possible.

5. Non-Price Competition :

As in monopolistic competition there is not only price competition but non-price competition as well in oligopoly (and, to some extent, in duopoly). For example, advertising is often a life and death question in this type of market due to strategic behaviour of all firms. In most oligopoly situations we find intermediate outcomes. Economists are yet to emerge with a definite behaviour pattern in oligopoly.

Essay # 3. Scope of Study of Oligopoly :

Here we study a few of the many possible reaction patterns in duopoly and oligopoly situa­tions. The focus is on pure oligopoly. Here we assume that all firms produce a homogeneous product. We do not discuss the case of differentiated oligopoly and the issue of selling cost (advertising) separately. Of course, we discuss briefly Baumol’s sales maximisation hypoth­esis—without and with advertising.

The focus here is on the interdependence of the various sellers’ reactions, which is the essential distinguishing feature of oligopoly. If the influence of one seller’s quantity decision from the profit of another, δπ i /δq j , is negligible, the industry must be either perfectly competi­tive or monopolistically competitive. If δπ i /δq j , is perceptible, the industry is duopolistic or oligopolistic.

The optimum quantity and maximum profit of a duopolist or oligopolist depend upon the actions of the firms belonging to the industry. He can control only his own output level (or price, if his product is differentiated), but he has no direct control over other variables which are likely to (or do) affect his profits. In truth, the profit of each oligopolist is the result of the interaction of the decisions of all players in the market.

Since there are no generally accepted behavioural assumptions for oligopolists and duopolists as is found in other market forms, there are diverse patterns of behaviour and many different solutions for oligopolistic and duopolistic markets. Each solution is based on different types of models and each model is based on a different behavioural assumption or a set of assumptions.

Here we start with one or two simple duopoly models. The same analysis (solution) can be extended to cover any oligopolistic market. The earliest model of duopoly behaviour is the Cournot model, with which we may start our review of different oligopoly models. We end with the game theoretic treatment of oligopoly which shows decision-making under conflict.

Essay # 4. Models of Oligopoly:

1. the cournot model :.

The Cournot model (presented in 1838) is based on the analysis of a market in which two firms produce a homogeneous product. Augustin Cournot (a French economist) noticed that only two firms were producing mineral water for sale. He argued that each firm would choose quan­tity that would maximise profit, taking the quantity marketed by its competitor as given.

Two main features of the model are:

(i) Each firm chooses a quantity of output instead of price; and

(ii) In choosing its output each firm takes its rival’s output as given.

In Cournot’s model, then, strategies are quantities of output. Here we assume that firms produce a homoge­neous good and know the market demand curve.

Each firm must decide how much to produce, and the two firms make their decisions at the same time. When taking its production decision, each duopolist takes into consideration its competitor. It knows that its competitor is also de­ciding how much to produce, and the market price will depend on the total output of both firms.

The essence of the Cournot model is that each firm treats the output level of its competitor as fixed and then decides how much to produce. Each Cournot’s duopolist believes that the other’s quantity will not change. In Fig. 1 when I produces Q M , II maximises its profit by producing 1/4Q C . In order to sell Q M plus Q c , the price must fall to P 1 . Here Q M is the mo­nopoly output which is half the competitive output Q c .

The inverse demand function, stating price as a function of the aggregate quantity sold, is expressed as:

P =f (q 1 ) + q 2 … (1)

where q 1 and q 2 are the output levels of the duopolists. The total revenue of each duopolist depends upon his own output level as also as that of his rival:

R 1 = q 1 f 1 (q 1 + q 2 ) = R 1 (q 1 , q 2 )

R 2 = q 2 f 2 (q 1 + q 2 ) = R 2 (q 1 , q 2 ) … (2)

The profit of each equals his total (sales) revenue, less his cost, which depends upon his output level above:

π 1 = R 1 (q 1 , q 2 ) – C 1 (q 1 )

π 2 = R 2 (q 1 , q 2 ) – C 2 (q 2 ) … (3)

The basic behavioural assumption of the Cournot model is that each duopolist maximises his profit on the assumption that the quantity produced by his rival is invariant with respect to his own decision regarding output quantity. Duopolist I maximises π 1 with reference to q 1 , treating q 2 as a parameter, and duopolist II maximises π 2 , with reference to q 2 , treating q 1 as a parameter. Setting the partial derivatives of (3) equal to zero, we get:

The solution of (7) is

Here OM is the marginal cost of producing the commodity. The second firm’s price is p 2 . The first firm’s profit function is composed of three segments. When p 1 < p 2 , the first firm captures the entire mar­ket, and its profit increases as its price increases. When p 1 > p 2 , the two firms split the total profits equal to distance CA, and each makes a profit equal to CB. When p 1 >p 2 , the first firm’s profit is zero because it sells nothing when its price exceeds the second firm’s price.

Criticisms:

The Bertrand model has been criticised on two main grounds. First, when firms produce a homogeneous good, it is more natural to compete by setting quantities rather than prices. Second, even if firms do set prices and choose the same price (as the model predicts), what share of total sales will go to each one? The model assumes that sales would be divided equally among the firms, but there is no reason why this must be the case.

However, despite these shortcomings, the Bertrand model is useful because it shows how the equilibrium out­come in an oligopoly can depend crucially on the firms’ choice of strategic variable.

3. The Stackelberg Model :

The Stackelberg model (presented by the German economist Heinrich von Stackelberg) is a modified version of the Cournot model. In the Cournot model, we assume that two duopolists make their output decisions at the same time. The Stackelberg model examines what happens if one of the firms can set its output first. The Stackelberg model of duopoly is different from the Cournot model, in which neither firm has any opportunity to react.

The model is based on the assumption that the profit of each duopolist is a function of the output levels of both:

π 1 = g 1 (q 1 , q 2 ) π 2 = g 2 (q 1 , q 2 ) … (1)

The Cournot solution is found out by maximising π 1 with reference to q 1 , assuming q 2 to be constant and π 2 with reference to q 2 , assuming q 1 to be constant. In general, each firm might make some other assumption about the response (reaction) of its only rival. In such a situation, profit-maximisation by the two duopolists requires the fulfillment of the following two condi­tions:

Since the firm’s demand curve is kinked, its combined marginal revenue curve is discon­tinuous. This means that the firm’s cost can change without leading to price change. In this figure, marginal cost could increase but would still equal marginal revenue at the original out­put level. This means that price remains the same.

The kinked demand curve model fails to explain oligopoly pricing. It says nothing about how marginal revenue firms arrived at the original price P̅ to start with. In fact, some arbitrary price is taken as both the starting and end point of our journey. Why firms did not arrive at some other price remains an open question. It just describes price rigidity but cannot explain it. In addition, the model has not been supported by empirical tests. In reality, rival firms do match price increases as well as price cuts.

Market-sharing Price Leadership :

Oligopolists often collude—jointly restrict supply to raise price and cooperate. This strategy can lead to higher profits. Collusion is, however, illegal. Moreover, one of the main impedi­ments to implicitly collusive pricing is the fact that it is difficult for firms to agree (without talking to each other) on what the price should be.

Coordination becomes particularly problem­atic when cost and demand conditions—and, thus, the ‘correct’ price—are changing. However, benefits of cooperation can be enjoyed without actually colluding. One way of doing this is through price leadership. Price leadership may be provided by a low-cost firm or a dominant firm.

In this context, we may draw a distinction between price signalling and price leadership. Price signalling is a form of implicit collusion that sometimes gets around this problem. For example, a firm might announce that it has raised its price with the expectation that its competi­tors will take this announcement as a signal that they should also raise prices. If competitors follow, all of the firms (at least, in the short run) will earn higher profits.

At times, a pattern is established whereby one firm regularly announces price changes and other firms in the industry follow. This type of strategic behaviour is called price leadership— one firm is implicitly recognised as the ‘leader’. The other firms, the ‘price followers’, match its prices. This behaviour solves the problem of coordinating price: Everyone simply charges what the leader is charging.

Price leadership helps to overcome oligopolistic firms’ reluctance to change prices—for fear of being undercut. With changes in cost and demand conditions, firms may find it increas­ingly necessary to change prices that have remained rigid for some time. In that case, they wait for the leader to signal when and by how much price should change.

Sometimes a large firm will naturally act as a leader; sometimes different firms will act as a leader from time to time. In this context, we may discuss the dominant Firm model of leadership. This is known as market- sharing price leadership.

6. The Dominant Firm Model :

In some oligopolistic markets, one large firm has a major share of total sales while a group of smaller firms meet the residual demand by supplying the remainder of the market. The large firm might then act as a dominant firm, setting a price that maximises its own profits.

The other firms, which individually could exert little, if any, influence over price, would then act as perfect competitors; they all take the price set by the dominant firm as given and produce accordingly. But what price should the dominant firm set? To maximise profit, it must take into account how the output of the other firms depends on the price it sets.

Fig. 5 shows how a dominant firm sets its prices. A dominant firm is one with a large share of total sales that sets price to maximise profits, taking into account the supply response of smaller firms. Here D is the market demand curve and S F is the supply curve (i.e., the aggregate marginal cost curves of the smaller firms, called competitive fringe firms). The dominant firm must determine its demand curve D D .

This curve is just the difference between market demand and the supply of fringe firms. For example, at price P 1 , the supply of fringe firms is just equal to market demand. This means that the dominant firm can sell nothing at this price. At a price P 2 or less, fringe firms will not supply any of the good, in which case, the dominant firm faces the market demand curve. If price lies between P 1 and P 2 , the dominant firm faces the demand curve D D .

The marginal cost curve of the dominant firm corresponding to D D is MR D . The dominant firm’s marginal cost curve is MC D . In order to maximise its profit, the dominant firm produces quantity Q D at the interaction of MR D and MC D . From the demand curve D D , we find P 0 . At this price, fringe firms sell a quantity Q F , thus the total quantity sold is Q T = Q D + Q F .

7. Collusive Oligopoly: The Cartel Model :

Various models have been formulated to explain the strategic behaviour of firms in an oligopolistic market. A price (cut-throat) competition exists among the rivals who try to oust the others from the market. Sometimes there ex­ists a dominant firm that acts as the leader in the market while the others just follow the leader.

As a result, there happens to be a clear possibil­ity of the formation of a cartel by the rival firms in an oligopolistic market in order to eliminate competition among themselves. This is termed as “collusive oligopoly” because the firms some­how manage to combine together in order to be­have collectively as a single monopoly.

Now let us see graphically what incentives the firms get for forming a cartel. In Fig. 6, the market demand curve is given by the D M the total supply curve is the horizontal summation of the marginal cost curves of all existing firms in the industry, which is denoted by MC M .

The market equilibrium is attained at the point of intersection between the D M (demand curve) and the marginal cost curve MC M , if the firms compete with each other. OP M is the equilibrium price at which the total output of the industry is OQ M .

In order to determine its own quantity, each firm equates this price to its marginal cost. The sum of the quantities of the firms is OQ. If the firms form a cartel in order to act as a monopolist, the price rises to OP ‘ M and the quantity is reduced to OQ ‘ M to be in equilibrium. Now, when the quantity is being reduced by Q M Q’ M , then all the firms together save the cost represented by the area below the MC M curve which is Q M E M F M Q ‘ M .

Thus, a rise in price due to a reduction in the quantity is followed by a decrease in the total revenue represented by the area below the MR M curve, i.e., area Q M G M F M Q’ M . This, in turn, shows that the cost saved exceeds the loss in revenue and, so, all the firms taken as a whole can increase their profit represented by the area E M F M G M . The prospect of earning this extra profit actually acts as the incentive to form a cartel in the oligopoly market structure.

Since the cartel is formed, all firms agree together to produce the total quantity OQ’ M . In order to carry this out, each and every firm is allotted a quota or a certain portion of production such that the sum of all quotas is equal to OQ M . For this, the best way of quota allotment would be to treat each firm as a separate entity (plant) under the same monopolist. Thus, all the firms have the same marginal cost (MC) such that MC = MR (marginal revenue).

Finally, the total profit is maximised because the total output is produced at the minimum cost.

Each and every firm can increase its profit by reducing the profits of other firms, simply by increasing its output quantity above the allotted quota. The system of cartel formation must guard against the desire of individual firms to violate the quota and the cartel breaks down when the cost of guarding against quota violation is very high.

The OPEC is an example of collusive oligopoly or cartel in which members (producers) explicitly agree to cooperate in setting prices and output levels. All the producers in an industry need not and often do not join the cartel. But if most producers adhere to the cartel’s agree­ments, and if market demand is sufficiently inelastic, the cartel may drive prices well above competitive levels.

Two conditions for success:

Two conditions must be fulfilled for cartel success. First, a stable cartel organisation must be formed whose members agree on price and production levels and both adhere to that agreement. The second condition is the potential for monopoly power. A cartel cannot raise price much if it faces a highly elastic demand curve. If the potential gains from cooperation are large, cartel members will have more incentive to share their organisa­tional problems.

Analysis of Cartel Pricing:

Cartel pricing can be analysed by using the dominant firm model of oligopoly. It is because a cartel usually accounts for only a portion of total production and must take into account the supply response of competitive (non-cartel) producers when it sets price. Here we illustrate the OPEC oil cartel.

Fig. 7 illustrates the case of OPEC. Total demand TD is the world demand curve for crude oil, and S c is the competitive (non-OPEC) supply curve. The demand for OPEC oil D 0 is the difference between total demand (TD) and competitive supply (SC), and MR 0 is the corresponding marginal revenue curve.

MC 0 is OPEC’s marginal cost curve; OPEC has much lower production costs than do non-OPEC producers. OPEC’s marginal revenue and marginal cost are equal at quantity Q 0 , which is the quantity that OPEC will produce. Here we see from OPEC s demand curve that the price will be P 0 .

Since both total demand and non-OPEC supply are inelastic, the demand for OPEC oil is also fairly inelastic; thus the cartel has substantial monopoly. In the 1970s, it used that power to drive prices well above competitive levels.

In this context, it is important to distinguish between short-run and long-run supply and demand curves. The total demand and non-OPEC supply curves in Fig. 7 apply to short-or intermediate-run analysis. In the long run, both demand and supply will be much more elastic, which means that OPEC’s demand curve will also be much more elastic.

We would thus expect that, in the long run, OPEC would be unable to maintain a price that is so much above the competitors’ level. In truth, during 1982-99, oil prices fell steadily, mainly because of the long- run adjustment of demand and non-OPEC supply.

However, cartel is not an unmixed blessing. No doubt cartel members can talk to one an­other in order to formalize an agreement. But it is not that easy to reach a consensus. Different members may have different costs, different assessments of market demand, and even different objectives, and they may, therefore, want to set prices at different levels.

Furthermore, each member of the cartel will be tempted to “cheat” by lowering its price slightly to capture a larger market share than it was allotted. Most often, only the threat of a long-term return to competi­tive prices deters cheating of this sort. But if the profits from cartelization are large enough, that threat may be sufficient.

Essay # 5. Sales (Revenue) Maximisation :

W.J. Baumol presented an alternative hypothesis to profit maximisation, viz., sales (revenue) maximisation. He has suggested that large oligopolistic firms do not maximise profit, but rather maximise sales revenue, subject to the constraint that profit equals or exceeds some minimum accepted level. Various empirical studies support Baumol’s hypothesis. And it accurately cap­tures some aspects of oligopolistic firms’ behaviour.

Most important, when firms are uncertain about their demand curve they actually face, or, when they cannot accurately estimate the marginal costs of their output (due to uncertainty about factor prices, or when they produce more than one product), the decision to try to maximise sales appears to be consistent with their long-term survival. This is why many oligopolist firms seek to maximise their market share in order to protect themselves from the adverse effects of uncertain market environment.

Graphical Analysis :

A revenue-maximising oligopolist would choose to produce that level of output for which MR = 0. When MR = 0, TR is maximum. That is, the oligopolist should proceed to the point at which selling any extra unit(s) actually leads to a fall in TR. This choice is illustrated in Fig. 8.

For the firm which faces the demand curve D, TR is maximum when output is q s . For q < q s , MR is positive. This means that selling more units increases TR (though not necessarily profit). For q > q s , however, MR is negative. So further sales actually reduce TR because of price cuts that are necessary to induce consumers to buy more. We know that

MR = P(1 – 1/e p ) … (1)

MR = 0 if e p = 1, in which case TR will be maximum. TR is constant in a small neighbourhood of that output quantity at M 1 P = 0, TR is maximum, and when TR is maximum, e p = 1.

We may now compare the revenue-maximisation choice with the profit-maximising level of output, q s . At q p , MR equals marginal cost MC in Fig. 8. Increasing output beyond q p would reduce profits since MR < MC. Even though TR continues to increase up to q s , units of output beyond q p bring in less than they cost to produce. Since marginal revenue is positive at q p , equation (1) shows that demand must be elastic (e p > 1) at this point.

Essay # 6. Constrained Revenue Maximisation :

A firm that chooses to maximise TR is neither taking into account its costs nor the profitabil­ity of the output that it is selling. And it is quite possible that the output level q s in Fig. 8 yields negative profit to the firm. However, it is not possible to any firm to survive for ever with negative profits. So it may be more realistic to assume that firms do meet some mini­mum level (target rate) of profit from their activities.

Thus, even though oligopolists may be prompted to produce more than q p with a view to maximising revenue, they may produce less than q p units in order to ensure an acceptable level of profit. They will, therefore, behave as constrained revenue maximises and will choose to produce an output level which lies between q p and q s .

Mathematical Analysis :

How firms in Oligopoly compete

Oligopoly is a market structure in which a few firms dominate the industry; it is an industry with a five firm concentration ratio of greater than 50%.

In Oligopoly, firms are interdependent; this means their decisions (price and output) depend upon how the other firms behave:

• Barriers to entry are likely to be a feature of Oligopoly
• There are different models to explain how firms may behave

The kinked demand curve model suggests firms will be profit maximisers.

Kinked Demand Curve Diagram

At p1 if firms increased their price, consumers would buy from the other firms. Therefore, they would lose a large share of the market and demand will be elastic. Therefore, firms will lose revenue by increasing the price.

If firms cut price then they would gain a big increase in market share. However, it is unlikely that firms will allow this. Therefore, other firms follow suit and cut-price as well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut and revenue would fall.

This model suggests price will be rigid because there is no incentive for firms to change the price

If prices are rigid and firms have little incentive to change prices they will concentrate on non-price competition . This occurs when firms seek to increase revenue and sales by various methods other than price.

For example, a firm could spend money on advertising to raise the profile of their product and try and increase brand loyalty, if successful this will increase market sales. Advertising is a big feature of many oligopolies such as soft drinks and cars. Alternatively, they could introduce loyalty cards or improve the quality of their after sales service. When buying a plane ticket price is not the only factor consumers look at, they may prefer airlines with more leg room, air miles e.t.c.

Non-price competition depends upon the nature of the product. For example, advertising is very important for soft drinks but less important for petrol.

However, in reality, this model doesn’t always occur. Often the objectives of firms are not to maximise profit. For example, they may wish to increase the size of their firm and maximise sales. If this is the case, they may be willing to take part in a price war, even if this does lead to lower profits. Price wars involve firms selling goods at very low prices to try and gain market share. For example, newspapers such as the Times and the Sun have recently been sold very cheaply. Price wars are more likely if:

• 1. Large firms are able to cross subsidise one market from profits elsewhere
• 2. In a recession, markets are more competitive as firms seek to retain customers

However, price wars may only be short-term

A firm may engage in predatory pricing ; this occurs when the incumbent firm seeks to force a new firm out of business by selling at a very low price so that it cannot remain profitable.

Using game theory

Game theory looks at different possible outcomes of oligopoly – depending on how firms react to different decisions.

If the firms in oligopoly seek to increase market share the most likely outcome is that they both set low prices and make a low profit (£3m each) However if the firms could come to some agreement either formal or tacit collusion – they could both agree to raise prices. This will require the firms to reduce output and stick to the more limited supply. If they set high prices, then they will both be able to make monopoly profits (£8m each)

However, when prices are high, there is a temptation to undercut your rival and benefit from both high market prices and high output. This enables higher profit – £10m, but if firms start to cheat – then rivals are likely to retaliate by cutting prices too.

Collusion is possible in oligopoly, but it depends on several factors. Collusion is more likely if

1. There are a small number of firms, who are well known to each other – this makes it easier to stick to output quotas 2. A dominant firm, who is able to have a lot of influence in setting the price. 3. Barriers to entry, this is important to stop other firms entering to take advantage of the high profits 4. Effective communication and monitoring of output and costs 5. Similar production costs and therefore will want to raise prices at the same rate 6. Effective punishment strategies for firms who cheat 7. No effective government legislation, e.g. collusion is illegal in the UK.

Conclusion:

There is no certainty in how firms will compete in Oligopoly; it depends upon the objectives of the firms, the contestability of the market and the nature of the product. Some oligopolies compete on price; others compete on the quality of the product.

Examples of Competition in oligopoly

Petrol is a homogenous product and so is likely to be quite stable in prices. Firms often move petrol prices in response to changes in the oil price. However, the introduction of the supermarket own brand petrol has changed the market. Tesco and Sainsbury’s are more willing to sell cheaper petrol to attract customers to shop at their supermarket.

Coffee market

This takeaway coffee at 99p is quite cheap – suggesting a competitive oligopoly. However, for many customers, the price of coffee is secondary to the quality and environment of the coffee shop. Traditional coffee shops like Costa and Starbucks use more non-price competition to attract customers – as much as offering cheap prices.

In fact, there is a danger selling cheap coffee – may indicate to consumers lower quality.

How firms compete in general

See more – How firms compete

• Pricing strategies

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Chapter 10. Monopolistic Competition and Oligopoly

10.2 Oligopoly

Learning objectives.

• Explain why and how oligopolies exist
• Contrast collusion and competition
• Interpret and analyze the prisoner’s dilemma diagram
• Evaluate the tradeoffs of imperfect competition

Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. Oligopolies are typically characterized by mutual interdependence where various decisions such as output, price, advertising, and so on, depend on the decisions of the other firm(s). Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.

Why Do Oligopolies Exist?

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.

Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.

Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly for large passenger aircraft.

The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.

Collusion or Competition?

When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide up the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion . A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel . See the following Clear It Up feature for a more in-depth analysis of the difference between the two.

Collusion versus cartels: How can I tell which is which?

In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.

The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.

The desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits has been well understood by economists. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. Indeed, a small handful of oligopoly firms may end up competing so fiercely that they all end up earning zero economic profits—as if they were perfect competitors.

The Prisoner’s Dilemma

Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.

The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. The story behind the prisoner’s dilemma goes like this:

Two co-conspiratorial criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. So your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.

The game theory situation facing the two prisoners is shown in Table 3 . To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A ought to confess, too, so as to not get stuck with the eight years in prison. But if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. Confess is considered the dominant strategy or the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up doing a total of 10 years of jail time between them.

The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have had to serve a total of four years of jail time between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer jail terms.

The Oligopoly Version of the Prisoner’s Dilemma

The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits. Table 4 shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly . If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.

Can the two firms trust each other? Consider the situation of Firm A:

• If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in Table 4 ) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
• If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).

Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions.

The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits . The following Clear It Up feature discusses one cartel scandal in particular.

What is the Lysine cartel?

Lysine, a $600 million-a-year industry, is an amino acid used by farmers as a feed additive to ensure the proper growth of swine and poultry. The primary U.S. producer of lysine is Archer Daniels Midland (ADM), but several other large European and Japanese firms are also in this market. For a time in the first half of the 1990s, the world’s major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of Investigation (FBI), however, had learned of the cartel and placed wire taps on a number of their phone calls and meetings.

From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:

I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us … money. … And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.

The price of lysine doubled while the cartel was in effect. Confronted by the FBI tapes, Archer Daniels Midland pled guilty in 1996 and paid a fine of $100 million. A number of top executives, both at ADM and other firms, later paid fines of up to $350,000 and were sentenced to 24–30 months in prison.

In another one of the FBI recordings, the president of Archer Daniels Midland told an executive from another competing firm that ADM had a slogan that, in his words, had “penetrated the whole company.” The company president stated the slogan this way: “Our competitors are our friends. Our customers are the enemy.” That slogan could stand as the motto of cartels everywhere.

How to Enforce Cooperation

How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.

Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC) , have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.

Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself.

Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.

One example of the pressure these firms can exert on one another is the kinked demand curve , in which competing oligopoly firms commit to match price cuts, but not price increases. This situation is shown in Figure 1 . Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.

If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price , and share a monopoly level of profits even without any legally enforceable agreement.

Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.

Tradeoffs of Imperfect Competition

Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.

Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffeted by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Monopoly and Antitrust Policy discusses the delicate judgments that go into this task.

The Temptation to Defy the Law

Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, which sometimes lasted more than four hours, complex pricing structures were established. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.

How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region; there were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.

Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

Key Concepts and Summary

An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.

The prisoner’s dilemma is an example of game theory. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.

Self-Check Questions

• Suppose the firms collude to form a cartel. What price will the cartel charge? What quantity will the cartel supply? How much profit will the cartel earn?
• Suppose now that the cartel breaks up and the oligopolistic firms compete as vigorously as possible by cutting the price and increasing sales. What will the industry quantity and price be? What will the collective profits be of all firms in the industry?
• Compare the equilibrium price, quantity, and profit for the cartel and cutthroat competition outcomes.

Review Questions

• Will the firms in an oligopoly act more like a monopoly or more like competitors? Briefly explain.
• Does each individual in a prisoner’s dilemma benefit more from cooperation or from pursuing self-interest? Explain briefly.
• What stops oligopolists from acting together as a monopolist and earning the highest possible level of profits?

Critical Thinking Questions

• Would you expect the kinked demand curve to be more extreme (like a right angle) or less extreme (like a normal demand curve) if each firm in the cartel produces a near-identical product like OPEC and petroleum? What if each firm produces a somewhat different product? Explain your reasoning.
• When OPEC raised the price of oil dramatically in the mid-1970s, experts said it was unlikely that the cartel could stay together over the long term—that the incentives for individual members to cheat would become too strong. More than forty years later, OPEC still exists. Why do you think OPEC has been able to beat the odds and continue to collude? Hint: You may wish to consider non-economic reasons.
• Mary and Raj are the only two growers who provide organically grown corn to a local grocery store. They know that if they cooperated and produced less corn, they could raise the price of the corn. If they work independently, they will each earn $100. If they decide to work together and both lower their output, they can each earn $150. If one person lowers output and the other does not, the person who lowers output will earn $0 and the other person will capture the entire market and will earn $200. Table 6 represents the choices available to Mary and Raj. What is the best choice for Raj if he is sure that Mary will cooperate? If Mary thinks Raj will cheat, what should Mary do and why? What is the prisoner’s dilemma result? What is the preferred choice if they could ensure cooperation? A = Work independently; B = Cooperate and Lower Output. (Each results entry lists Raj’s earnings first, and Mary’s earnings second.)

The United States Department of Justice. “Antitrust Division.” Accessed October 17, 2013. http://www.justice.gov/atr/.

eMarketer.com. 2014. “Total US Ad Spending to See Largest Increase Since 2004: Mobile advertising leads growth; will surpass radio, magazines and newspapers this year. Accessed March 12, 2015. http://www.emarketer.com/Article/Total-US-Ad-Spending-See-Largest-Increase-Since-2004/1010982.

Federal Trade Commission. “About the Federal Trade Commission.” Accessed October 17, 2013. http://www.ftc.gov/ftc/about.shtm.

Answers to Self-Check Questions

• Pc > Pcc. Qc < Qcc. Profit for the cartel is positive and large. Profit for cutthroat competition is zero.
• Firm B reasons that if it cheats and Firm A does not notice, it will double its money. Since Firm A’s profits will decline substantially, however, it is likely that Firm A will notice and if so, Firm A will cheat also, with the result that Firm B will lose 90% of what it gained by cheating. Firm A will reason that Firm B is unlikely to risk cheating. If neither firm cheats, Firm A earns $1000. If Firm A cheats, assuming Firm B does not cheat, A can boost its profits only a little, since Firm B is so small. If both firms cheat, then Firm A loses at least 50% of what it could have earned. The possibility of a small gain ($50) is probably not enough to induce Firm A to cheat, so in this case it is likely that both firms will collude.

Principles of Economics Copyright © 2016 by Rice University is licensed under a Creative Commons Attribution 4.0 International License , except where otherwise noted.

Oligopoly Notes & Questions (A-Level, IB)

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Oligopoly Definition: An Oligopoly is a market structure where only a few sellers dominate the market.

Oligopoly Examples & Explanation: Because there are only a few firms (players) in an Oligopoly, they tend to be highly interdependent of one another – meaning they will take in account each others’ actions when trying to compete in the market. Another characteristic is these markets also exhibit high barriers to entry, such that new firms cannot easily enter into the market. This characteristic is shared with Monopolies (one firm dominating) and Duopolies (two-firms dominating), explaining how they can dominate the market with large amounts of market share. If we consider the oil & gas industry, they tend to be an Oligopoly in most countries (think Shell, BP, Exxon) due to the huge capital investment required for oil exploration/mining, making it difficult for new producers to enter into the market. When a large oil/gas producer sells their oil at a lower price to increase their sales volume, other producers are likely to lower their prices as well to protect their share of the market. As a result, Oligopolies tend to keep market prices stable and focus on non-price competition, so that firms can avoid a price war. However, the negative oil prices from the coronavirus pandemic is also caused by other factors, including a lack of storage capacity for oil producers forcing them to sell, and a global lack of demand for oil during the crisis. In general, oil producers in OPEC agree on an amount of output to maintain a relatively high price for oil, meaning higher profits for the industry.

Oligopoly Economics Notes with Diagrams

Oligopoly video explanation – econplusdal.

The left video explains oligopoly and the kinked-demand curve, the right looks at competition and cartels in the oligopoly market structure.

Oligopoly Multiple Choice Questions (A-Level)

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10 Oligopoly

10.1 theory of the oligopoly, why do oligopolies exist.

Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firm(s)’ decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.

Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.

Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.

The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.

The existence of oligopolies can lead to the combination of many firms into larger firms. This is discussed next.

Types of Firm Integration

Conglomerate.

From: Wikipedia: Conglomerate (company)

A  conglomerate  is a combination of multiple  business entities  operating in entirely different industries under one  corporate group , usually involving a  parent company  and many  subsidiaries . Often, a conglomerate is a  multi-industry company . Conglomerates are often large and  multinational .

Horizontal Integration

From: Wikipedia: Horizontal integration

Horizontal integration  is the process of a  company  increasing  production  of goods or services at the same part of the  supply chain . A company may do this via internal expansion,  acquisition or merger . [1] [2] [3]

The process can lead to  monopoly  if a company captures the vast majority of the market for that product or service. [3]

Horizontal integration contrasts with  vertical integration , where companies integrate multiple stages of production of a small number of production units.

Benefits of horizontal integration to both the firm and society may include  economies of scale  and  economies of scope . For the firm, horizontal integration may provide a strengthened presence in the reference market. It may also allow the horizontally integrated firm to engage in  monopoly pricing , which is disadvantageous to society as a whole and which may cause regulators to ban or constrain horizontal integration. [5]

An example of horizontal integration in the food industry was the  Heinz  and  Kraft Foods  merger. On March 25, 2015, Heinz and Kraft merged into one company, the deal valued at $46 Billion. [8] [9]  Both produce processed food for the consumer market.

On November 16, 2015,  Marriott International  announced that it would purchase  Starwood Hotels  for $13.6 billion, creating the world’s largest hotel chain once the deal closed. [11]  The merger was finalized on September 23, 2016. [12]

AB-Inbev acquisition of SAB Miller for $107 Billion which completed in 2016, is one of the biggest deals of all time. [13]

Vertical Integration

From: Wikipedia: Vertical integration

In  microeconomics  and  management ,  vertical integration  is an arrangement in which the  supply chain  of a company is owned by that company. Usually each member of the supply chain produces a different  product  or (market-specific) service, and the products combine to satisfy a common need. It is contrasted with  horizontal integration , wherein a company produces several items which are related to one another. Vertical integration has also described  management styles  that bring large portions of the supply chain not only under a common ownership, but also into one  corporation  (as in the 1920s when the  Ford River Rouge Complex  began making much of its own steel rather than buying it from suppliers).

Vertical integration and expansion is desired because it secures the supplies needed by the firm to produce its product and the market needed to sell the product. Vertical integration and expansion can become undesirable when its actions become anti-competitive and impede free competition in an open marketplace. Vertical integration is one method of avoiding the  hold-up problem . A monopoly produced through vertical integration is called a  vertical monopoly .

Vertical integration is often closely associated to vertical expansion which, in  economics , is the growth of a business enterprise through the  acquisition  of companies that produce the intermediate goods needed by the business or help market and distribute its product. Such expansion is desired because it secures the supplies needed by the  firm  to produce its product and the market needed to sell the product. Such expansion can become undesirable when its actions become  anti-competitive  and impede free competition in an open marketplace.

The result is a more efficient business with lower costs and more profits. On the undesirable side, when vertical expansion leads toward  monopolistic  control of a product or service then regulative action may be required to rectify anti-competitive behavior. Related to vertical expansion is  lateral expansion , which is the growth of a business enterprise through the acquisition of similar firms, in the hope of achieving  economies of scale .

Vertical expansion is also known as a vertical acquisition. Vertical expansion or acquisitions can also be used to increase scales and to gain market power. The acquisition of  DirecTV  by  News Corporation  is an example of forward vertical expansion or acquisition. DirecTV is a  satellite TV  company through which News Corporation can distribute more of its media content: news, movies and television shows. The acquisition of  NBC  by  Comcast  is an example of backward vertical integration. For example, in the United States, protecting the public from communications monopolies that can be built in this way is one of the missions of the  Federal Communications Commission .

One of the earliest, largest and most famous examples of vertical integration was the  Carnegie Steel  company. The company controlled not only the mills where the  steel  was made, but also the mines where the  iron ore  was extracted, the coal mines that supplied the  coal , the ships that transported the iron ore and the railroads that transported the coal to the factory, the  coke  ovens where the coal was cooked, etc. The company focused heavily on developing talent internally from the bottom up, rather than importing it from other companies. Later, Carnegie established  an institute  of higher learning to teach the steel processes to the next generation.

Oil companies , both multinational (such as  ExxonMobil ,  Royal Dutch Shell ,  ConocoPhillips  or  BP ) and national (e.g.,  Petronas ) often adopt a vertically integrated structure, meaning that they are active along the entire supply chain from  locating deposits , drilling and extracting  crude oil , transporting it around the world,  refining  it into petroleum products such as  petrol/gasoline , to distributing the fuel to company-owned retail stations, for sale to consumers.

Lateral Integration

Lateral expansion , in  economics , is the growth of a business enterprise through the acquisition of similar companies, in the hope of achieving  economies of scale  or  economies of scope . Unchecked lateral expansion can lead to powerful  conglomerates  or  monopolies .

Lateral integration differs from horizontal integration as the integration is not exact. For example, one of the examples of horizontal integration was one hotel chain buying another. This did not enhance the company’s product offerings other than having more hotel options.

On the other hand, Parker Hannifin acquired Lord Corporation. While the two companies make similar types of products, their product offerings were distinct. There was not much overlap with the types of products offered. Instead, Parker Hannifin was not able to provide a far greater product offering in the given sectors.

The Strength of an Oligopoly

From: Wikipedia: Concentration ratio

The most common concentration ratios are the CR 4  and the CR 8 , which means the market share of the four and the eight largest firms. Concentration ratios are usually used to show the extent of market control of the largest firms in the industry and to illustrate the degree to which an industry is  oligopolistic . [1]

N-firm concentration ratio is a common measure of market structure and shows the combined market share of the N largest firms in the market. For example, the 5-firm concentration ratio in the UK pesticide industry is 0.75, which indicates that the combined market share of the five largest pesticide sellers in the UK is about 75%. N-firm concentration ratio does not reflect changes in the size of the largest firms.

Concentration ratios range from 0 to 100 percent. The levels reach from  no, low  or  medium  to  high  to “total” concentration

Perfect competition

If there are  N  firms in an industry and we are looking at the top  n  of them, equal market share for all of them means that CR n  =  n/N . All other possible values will be greater than this.

No concentration

If CR n  is close to 0%, (which is only possible for quite a large number of firms in the industry  N ) this means  perfect competition  or at the very least  monopolistic competition . If for example CR 4 =0 %, the four largest firm in the industry would not have any significant market share.

Low concentration

0% to 40%. [5]  This category ranges from perfect competition to an oligopoly.

Medium concentration

40% to 70%. [5]  An industry in this range is likely an oligopoly.

High concentration

70% to 100%. [5]  This category ranges from an oligopoly to monopoly.

Total concentration

100% means an extremely concentrated  oligopoly . If for example CR 1 = 100%, there is a  monopoly .

10.2 Game theory

Game theory basics, dominant versus non-dominant strategies.

From: Wikipedia: Cooperative game theory

In game theory , a cooperative game (or coalitional game ) is a game with competition between groups of players (“coalitions”) due to the possibility of external enforcement of cooperative behavior (e.g. through contract law ). Those are opposed to non-cooperative games in which there is either no possibility to forge alliances or all agreements need to be self-enforcing (e.g. through credible threats ). [1]

Cooperative games are often analysed through the framework of cooperative game theory, which focuses on predicting which coalitions will form, the joint actions that groups take and the resulting collective payoffs. It is opposed to the traditional non-cooperative game theory which focuses on predicting individual players’ actions and payoffs and analyzing Nash equilibria . [2] [3]

Cooperative game theory provides a high-level approach as it only describes the structure, strategies and payoffs of coalitions, whereas non-cooperative game theory also looks at how bargaining procedures will affect the distribution of payoffs within each coalition. As non-cooperative game theory is more general, cooperative games can be analyzed through the approach of non-cooperative game theory (the converse does not hold) provided that sufficient assumptions are made to encompass all the possible strategies available to players due to the possibility of external enforcement of cooperation. While it would thus be possible to have all games expressed under a non-cooperative framework, in many instances insufficient information is available to accurately model the formal procedures available to the players during the strategic bargaining process, or the resulting model would be of too high complexity to offer a practical tool in the real world. In such cases, cooperative game theory provides a simplified approach that allows the analysis of the game at large without having to make any assumption about bargaining powers.

Types of Strategies

General strategy.

This is simply any rule that a player uses. These strategies can be “good” or “bad.” For example, if you have to choose heads or tails for a coinflip, you may use the strategy “tails never fails” and always pick tails even though there is no advantage to this strategy. Additionally, when playing the game of Blackjack, you may have a rule that you always hit when you have a score of 20. If you do not know how to play Blackjack, I will simply state that this is generally a very, very bad idea! Even though it is a poor strategy, it is still a strategy nonetheless.

Dominant Strategy

From: Wikipedia: Strategic dominance

In game theory , strategic dominance (commonly called simply dominance ) occurs when one strategy is better than another strategy for one player, no matter how that player’s opponents may play. Many simple games can be solved using dominance.

Nash Equilibrium

From: Wikipedia: Nash equilibrium

In terms of game theory, if each player has chosen a strategy, and no player can benefit by changing strategies while the other players keep theirs unchanged, then the current set of strategy choices and their corresponding payoffs constitutes a Nash equilibrium.

Stated simply, Alice and Bob are in Nash equilibrium if Alice is making the best decision she can, taking into account Bob’s decision while his decision remains unchanged, and Bob is making the best decision he can, taking into account Alice’s decision while her decision remains unchanged. Likewise, a group of players are in Nash equilibrium if each one is making the best decision possible, taking into account the decisions of the others in the game as long as the other parties’ decisions remain unchanged.

Informally, a strategy profile is a Nash equilibrium if no player can do better by unilaterally changing his or her strategy. To see what this means, imagine that each player is told the strategies of the others. Suppose then that each player asks themselves: “Knowing the strategies of the other players, and treating the strategies of the other players as set in stone, can I benefit by changing my strategy?”

If any player could answer “Yes”, then that set of strategies is not a Nash equilibrium. But if every player prefers not to switch (or is indifferent between switching and not) then the strategy profile is a Nash equilibrium. Thus, each strategy in a Nash equilibrium is a best response to all other strategies in that equilibrium. [13]

The Nash equilibrium may sometimes appear non-rational in a third-person perspective. This is because a Nash equilibrium is not necessarily Pareto optimal . [Note: We do not talk about Pareto optimality in this class, but you can think of it as a best-case for everyone situation.]

The Prisoner’s Dilemma

From: Wikipedia: Prisoner’s dilemma

The prisoner’s dilemma is a standard example of a game analyzed in game theory that shows why two completely rational individuals might not cooperate, even if it appears that it is in their best interests to do so. It was originally framed by Merrill Flood and Melvin Dresher while working at RAND in 1950. Albert W. Tucker formalized the game with prison sentence rewards and named it “prisoner’s dilemma”, [1] presenting it as follows:

Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of communicating with the other. The prosecutors lack sufficient evidence to convict the pair on the principal charge, but they have enough to convict both on a lesser charge. Simultaneously, the prosecutors offer each prisoner a bargain. Each prisoner is given the opportunity either to betray the other by testifying that the other committed the crime, or to cooperate with the other by remaining silent. The offer is: If A and B each betray the other, each of them serves two years in prison If A betrays B but B remains silent, A will be set free and B will serve three years in prison (and vice versa) If A and B both remain silent, both of them will serve only one year in prison (on the lesser charge).

It is implied that the prisoners will have no opportunity to reward or punish their partner other than the prison sentences they get and that their decision will not affect their reputation in the future. Because betraying a partner offers a greater reward than cooperating with them, all purely rational self-interested prisoners will betray the other, meaning the only possible outcome for two purely rational prisoners is for them to betray each other. [2] The interesting part of this result is that pursuing individual reward logically leads both of the prisoners to betray when they would get a better individual reward if they both kept silent. In reality, humans display a systemic bias towards cooperative behavior in this and similar games despite what is predicted by simple models of “rational” self-interested action. [3] [4] [5] [6] This bias towards cooperation has been known since the test was first conducted at RAND; the secretaries involved trusted each other and worked together for the best common outcome. [7]

The prisoner’s dilemma game can be used as a model for many real world situations involving cooperative behavior. In casual usage, the label “prisoner’s dilemma” may be applied to situations not strictly matching the formal criteria of the classic or iterative games: for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it difficult or expensive—not necessarily impossible—to coordinate their activities.

Game Tables

In the game above, we need some way to display all of the information in a condensed format. To accomplish this, we use a game table. For the sake of displaying the game tables in an accessible manner, I will use the following format:

You will see that the information is exactly the same as the information presented. For example, if A stays silent, but B betrays, we would be in the top, right payout cell (which is -3,0).

The next question is what the “best” outcome is. We will examine that but going back to the two strategies discussed earlier.

Solving Prisoner’s Dilemma with Dominant Strategy

The iterated elimination (or deletion) of dominated strategies (also denominated as IESDS or IDSDS) is one common technique for solving games that involves iteratively removing dominated strategies. In the first step, at most one dominated strategy is removed from the strategy space of each of the players since no rational player would ever play these strategies. This results in a new, smaller game. Some strategies—that were not dominated before—may be dominated in the smaller game. The first step is repeated, creating a new even smaller game, and so on. The process stops when no dominated strategy is found for any player. This process is valid since it is assumed that rationality among players is common knowledge , that is, each player knows that the rest of the players are rational, and each player knows that the rest of the players know that he knows that the rest of the players are rational, and so on ad infinitum (see Aumann, 1976).

There are two versions of this process. One version involves only eliminating strictly dominated strategies. If, after completing this process, there is only one strategy for each player remaining, that strategy set is the unique Nash equilibrium [2] . This will be discussed next.

You can use the following set of steps:

• Pick one person (it doesn’t matter).
• If their opponent picks choice A, what will your person pick?
• If their opponent picks choice B, what will your person pick?
• If you choose the same thing for both of your opponent’s choices, then that is the dominant strategy. We say that choice strictly dominates the other choice and you can cross off the strictly dominated strategy.
• Repeat for the opponent (this should be easier).
• If the choices are different, there is no dominant strategy

Let us return to the prisoner’s dilemma game table. Let us act as player A and decide what player A would do in a variety of situations.

If player B stays silent, what should we do as player A? If we stay silent, then we would lose 1 (meaning one year in prison.) If we betray, we earn 0. In this case we should betray as no prison is better than one year in prison.

If player B betrays, what should we do as player A? If we stay silent, then we get three years in prison. If we betray, we get two years in prison. In this case, we should betray as two years in prison is better than 3 years in prison.

Therefore, the dominant strategy for player A is to betray. This is because regardless of what player B chooses to do, player A’s best choice is to betray. We can therefore eliminate “A-stay silent” since player A will not stay silent.

We can now move to player B to see if there is a dominant strategy for player B. It should be noted that, in theory, there does not need to be, but with our games there will be (if player A has one.) So, now let us play our modified game as player B.

If player A chooses to stay silent – STOP! – what did we just discuss? Player A will not choose to stay silent, so we do not need to worry about this. So, if player A chooses to betray, what should we do as player B? If we stay silent, we get three years in prison whereas we only get two years in prison if we betray. Therefore, player B should betray.

Thus, the dominant strategy for this game is (A,B)=(Betray,Betray).

There are additional exercises in the companion. Each player can have either 0 or 1 dominant strategies.

Solving Prisoner’s Dilemma with Nash Equilibrium

As mentioned earlier, we are looking for a stable solution. That is, a situation where neither player has an incentive to change their choice based on the other player’s choice. To find the Nash Equilibrium, you can follow these steps:

• Choose a player (again, it doesn’t matter which).
• Pick a choice (it doesn’t matter which).
• Based on your choice, what will the opponent pick?
• Based on what your opponent picks, what would you pick?
• If it is the same as your original choice, it is a Nash Equilibrium. If not, it is not a Nash Equilibrium.
• Repeat for the other choice(s).

So, let us return to our game. Without loss of generality, let us play as player A. It should be noted that playing as player B will yield the same exact results.

As player A, let us begin by staying silent. What will player B do? Player B can either stay silent (one year in prison) or betray (0 years in prison.) Player B will betray. Now, since we know that player B will betray, what should player A do? If player A stays silent, we get 3 years in prison but if we betray we only get two years in prison. Thus, we, as player A, should betray. But this is different from where we started, thus we do not have a Nash Equilibrium. The chain for this event is:

A: Silent >> B: Betray >> A: Betray — A has changed their choice, not a Nash Equilibrium.

Now, as player A, let us start by betraying. If we betray, player B can either stay silent (3 years in prison) or betray (2 years in prison.) Thus, player B will betray. When player B betrays, what should we do? We can either stay silent (3 years in prison) or betray (2 years in prison.) Thus, we betray. This is exactly where we started, thus, we have a Nash Equilibrium. In fact, we could continue to do this forever and the chain would stay exactly the same. The chain for this scenario is:

A: Betray >> B: Betray >> A: Betray — A has kept their choice the same, so A:Betray, B:Betray is a Nash Equilibrium.

10.3 Cartels and Collusion

Game theory and oligopolies.

So what was the foray into game theory for? It allows us to explore how individual firms in oligopolies want to act. Let us consider two firms that each produce widgets. They can each choose to either produce at a high price level or low price level. Remember, for a firm to produce more (and sell it) they have to charge less. And if a firm restricts its output, they can charge more. Recall, a monopolist is able to make an additional profit because it restricts output and charges more whereas a firm in a perfectly competitive market may sell more, but at a lower price, and therefore earns a lower profit.

Let us use the following game table showing each firms’ profits:

First, let us step back and just look at the game table. What should each firm do? It seems like each firm should just set their price high. But, is that what will happen?

Let us look for the dominant strategy. As player A, if player B chooses to set a high price, we should should charge a low price (70>65). If player B chooses to set a low price, we should choose low price (40>20). Therefore, as player A, we should always choose to set our price low. The same applies for player B as setting their price low is always better than setting their price high regardless of what player A does (100>90 and 60>40).

So, even though it “makes sense” for both firms to set their prices high, both firms will set their prices low. The same would apply to the Nash Equilibrium.

What does this mean in the real world? If the two firms could cooperate and fully trust each other, they would each set their prices high. This is what we call collusion and will be discussed shortly. But, whether it is due to laws or just human nature, firms are never able to collude too long. Eventually, firms will move to the dominant strategy. While firms would like to keep their prices high, there are typically forces that prevent this.

From: Wikipedia: OPEC

The Organization of the Petroleum Exporting Countries ( OPEC , / ˈ oʊ p ɛ k / OH-pek ) is an intergovernmental organization of 14 nations, founded in 1960 in Baghdad by the first five members ( Iran , Iraq , Kuwait , Saudi Arabia , and Venezuela ), and headquartered since 1965 in Vienna, Austria . As of September 2018, the then 14 member countries accounted for an estimated 44 percent of global oil production and 81.5 percent of the world’s “proven” oil reserves , giving OPEC a major influence on global oil prices that were previously determined by the so called “ Seven Sisters ” grouping of multinational oil companies.

The stated mission of the organization is to “coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil markets, in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.” [4] The organization is also a significant provider of information about the international oil market. The current OPEC members are the following: Algeria , Angola , Ecuador , Equatorial Guinea , Gabon , Iran , Iraq , Kuwait , Libya , Nigeria , the Republic of the Congo , Saudi Arabia (the de facto leader), United Arab Emirates , and Venezuela . Indonesia and Qatar are former members.

The formation of OPEC marked a turning point toward national sovereignty over natural resources , and OPEC decisions have come to play a prominent role in the global oil market and international relations . The effect can be particularly strong when wars or civil disorders lead to extended interruptions in supply. In the 1970s, restrictions in oil production led to a dramatic rise in oil prices and in the revenue and wealth of OPEC, with long-lasting and far-reaching consequences for the global economy . In the 1980s, OPEC began setting production targets for its member nations; generally, when the targets are reduced, oil prices increase. This has occurred most recently from the organization’s 2008 and 2016 decisions to trim oversupply.

Economists often cite OPEC as a textbook example of a cartel that cooperates to reduce market competition , but one whose consultations are protected by the doctrine of state immunity under international law . In December 2014, “OPEC and the oil men” ranked as #3 on Lloyd’s list of “the top 100 most influential people in the shipping industry”. [5] However, the influence of OPEC on international trade is periodically challenged by the expansion of non-OPEC energy sources, and by the recurring temptation for individual OPEC countries to exceed production targets and pursue conflicting self-interests.

At various times, OPEC members have displayed apparent anti-competitive cartel behavior through the organization’s agreements about oil production and price levels. [26] In fact, economists often cite OPEC as a textbook example of a cartel that cooperates to reduce market competition, as in this definition from OECD ‘s Glossary of Industrial Organisation Economics and Competition Law : [1]

International commodity agreements covering products such as coffee, sugar, tin and more recently oil (OPEC: Organization of Petroleum Exporting Countries) are examples of international cartels which have publicly entailed agreements between different national governments.

OPEC members strongly prefer to describe their organization as a modest force for market stabilization, rather than a powerful anti-competitive cartel. In its defense, the organization was founded as a counterweight against the previous “ Seven Sisters ” cartel of multinational oil companies, and non-OPEC energy suppliers have maintained enough market share for a substantial degree of worldwide competition. [27] Moreover, because of an economic “ prisoner’s dilemma ” that encourages each member nation individually to discount its price and exceed its production quota, [28] widespread cheating within OPEC often erodes its ability to influence global oil prices through collective action . [29] [30]

OPEC has not been involved in any disputes related to the competition rules of the World Trade Organization , even though the objectives, actions, and principles of the two organizations diverge considerably. [31] A key US District Court decision held that OPEC consultations are protected as “governmental” acts of state by the Foreign Sovereign Immunities Act , and are therefore beyond the legal reach of US competition law governing “commercial” acts. [32] [33] Despite popular sentiment against OPEC, legislative proposals to limit the organization’s sovereign immunity, such as the NOPEC Act, have so far been unsuccessful. [34]

Cartel Theory

From: Wikipedia: Cartel

A cartel is a group of apparently independent producers whose goal is to increase their collective profits by means of price fixing , limiting supply, or other restrictive practices . Cartels typically control selling prices, but some are organized to force down the prices of purchased inputs. Antitrust laws attempt to deter or forbid cartels. A single entity that holds a monopoly by this definition cannot be a cartel, though it may be guilty of abusing said monopoly in other ways. Cartels usually arise in oligopolies —industries with a small number of sellers—and usually involve homogeneous products .

A survey of hundreds of published economic studies and legal decisions of antitrust authorities found that the median price increase achieved by cartels in the last 200 years is about 23 percent. [4] Private international cartels (those with participants from two or more nations) had an average price increase of 28 percent, whereas domestic cartels averaged 18 percent. Less than 10 percent of all cartels in the sample failed to raise market prices.

In general, cartel agreements are economically unstable in that there is an incentive for members to cheat by selling at below the agreed price or selling more than the production quotas set by the cartel (see also game theory ). This has caused many cartels that attempt to set product prices to be unsuccessful in the long term . Empirical studies of 20th-century cartels have determined that the mean duration of discovered cartels is from 5 to 8 years [5] . However, once a cartel is broken, the incentives to form the cartel return and the cartel may be re-formed. Publicly known cartels that do not follow this cycle include, by some accounts, the Organization of the Petroleum Exporting Countries (OPEC).

Price fixing is often practiced internationally. When the agreement to control price is sanctioned by a multilateral treaty or protected by national sovereignty, no antitrust actions may be initiated [6] . Examples of such price fixing include oil, whose price is partly controlled by the supply by OPEC countries, and international airline tickets, which have prices fixed by agreement with the IATA , a practice for which there is a specific exception in antitrust law.

Prior to World War II (except in the United States), members of cartels could sign contracts that were enforceable in courts of law. There were even instances where cartels are encouraged by states. For example, during the period before 1945, cartels were tolerated in Europe and were promoted as a business practice in German-speaking countries. [7] This was the norm due to the accepted benefits, which even the U.S. Supreme court has noted. In the case, the U.S. v. National Lead Co. et al. , it cited the testimony of individuals, who cited that a cartel, in its protean form, is “a combination of producers for the purpose of regulating production and, frequently, prices, and an association by agreement of companies or sections of companies having common interests so as to prevent extreme or unfair competition.” [8]

Today, however, price fixing by private entities is illegal under the antitrust laws of more than 140 countries. Examples of prosecuted international cartels are lysine , citric acid , graphite electrodes , and bulk vitamins . [9] This is highlighted in countries with market economies wherein price-fixing and the concept of cartels are considered inimical to free and fair competition, which is considered the backbone of political democracy. [10] The current condition makes it increasingly difficult for cartels to maintain sustainable operations. Even if international cartels might be out of reach for the regulatory authorities, they will still have to contend with the fact that their activities in domestic markets will be affected. [11]

For a cartel to be successful, some or all of the following conditions are necessary:

• A small number of firms.
• Products are relatively undifferentiated from one firm to the next.
• Prices are easily observable.
• Prices show little variation over time.

Introduction to Microeconomics Copyright © 2019 by J. Zachary Klingensmith is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License , except where otherwise noted.

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An oligopoly is a market in which a few firms dominate, and an oligopolist is one of these dominant firms. While 'a few' is an imprecise number, economists generally look at the market shares of the top three, four or five firms - if these firms control most of the market, then the firms are oligopolists.

How is the degree of oligopoly measured?

Concentration ratios.

Concentration ratios (or CRs) can be used to help identify whether the firm operates under conditions of oligopoly. Concentration refers to the extent to which market power is in the hands of a small number of firms. Concentration ratios show the combined market shares of the top few firms as a ratio of the total market size, expressed as a percentage.

When markets are highly concentrated the conduct of firms and their efficiency is likely to be sub-optimal. [Read more on market structure and conduct .]

For example, the global music shares of the top producers are:

Universal Music, 31% Sony Music, 21% Warner Music, 18% Independents, 27% Artists Direct, 3% Source: MIDIA (2019),

This makes the three-firm CR 70% - indicating oligopoly conditions.

The H-H Index

he Herfindahl–Hirschman Index (HH-Index) is an alternative measure of market concentration in an industry. It is calculated by adding the squared market shares of the top few firms in a market. The higher the number, the greater the degree of concentration.

The maximum figure possible is for a single monopolist, which is 100 (%) x 100 (%) = 10,000 .

For example, let's assume that the market shares of the largest three firms in a hypothetical market are: Firm A = 35%, Firm B = 25%, and Firm C = 20%.

The H-H Index would give 35 2 + 30 2 + 25 2 , which equals:

1,225 + 625 + 400 = 2350 .

Example - UK Supermarkets

The top four UK supermarkets in 2022 by market share were Tesco, with 26.9%, Sainsbury, with 14.6%, ASDA with 14.1%, and Morrisons, with 9.1%. 

The H-H Index for the top four supermarkets in the UK in 2022 was 1222.

Generally, an H-H Index of more than 1200 indicates a high degree of concentration and suggests the market is an oligopoly.

Read more: Changing concentration in the UK electricity market

Key characteristics and features of oligopoly

Firms are interdependent.

As there are only a few other competitors in the market, the profit available to a single oligopolist is constrained by the actions and decisions taken by the other firms in the market.

For example, if one oligopolist - firm A - decides to reduce its price in the hope of gaining market share, and the two other firms in the market - B and C - also reduce their prices in response, firm A's strategy will have been thwarted.  An oligopolist needs to anticipate and respond to the actions and behaviour of rivals. The need to take rivals into account when making decisions is referred to as mutual interdependence .

Uncertainty

Given the importance of interdependence, oligopolists face high levels of uncertainty, perhaps never being able to fully predict the behaviour of close rivals. This explains the temptation to reduce competition and the attempt to co-operate with close rivals to reduce uncertainty.

The importance of strategy

As a result of interdependence, oligopolists must try to anticipate the likely response of rivals to any change in policy concerning price or to non-price decisions. Non-price decisions include decisions about the product itself, how it is distributed, how it is marketed and advertised.

Strategy is especially important for oligopolies that cannot easily differentiate their good or service, such as petrol retailers. If they can differentiate, they become less interdependent and more able to act independently.

Differentiated or undifferentiated?

Oligopolists may operate in markets where differentiation is difficult - such as the market for refined white sugar, or where differentiation is much easier - such as oligopolists in the motor manufacturing industry.

Competition or collusion?

It follows that a key feature of oligopolies is that key decisions must be made about whether firms actively compete with each other, or whether they limit competition. Competition can be reduced when firms collude with each other and act jointly to enable all firms to reduce uncertainty and increase the level of profits (or other benefits) available to the 'group' of firms.

Types of collusion

Oligopolists can engage in overt (open) collusion by establishing an agreement to reduce competition or to collaborate in some way. For example, members of cartels may create agreements to fix output or price, or other aspects of the market. While 'overt' collusion to fix prices is clearly anti-competitive, and therefore unlawful in most countries, other forms of collusion may be hidden and difficult to legislate for, and to police.

Covert collusion arises when oligopolists conspire to 'rig' a market by having agreements which are hidden and secret. In some cases, members may 'whistle-blow' in the hope that they may avoid any punishment if the collusion is discovered by the relevant competition authority. This is more likely if authorities offer incentives to whistle-blow.

Tacit collusion arises when firms appear to adopt a similar policy on price or non-price aspects of their business, but there is no agreement between them. This may not involve any collusion in the legal sense, and need not involve communication between firms. However, the outcomes (such as higher prices or reduced output) may well resemble those that arise from explicit collusion.

Tacit collusion may arise when firms follow rules which are understood rather than written down. For example, in an oligopoly market with three firms, it may be understood that firm A takes the lead in making a change to price, or to a non-price activity, and firms B and C simply follow the lead. This arrangement is not written and there may be no conscious attempt to rig the market. Price leadership is arguably the commonest form of tacit collusion - in this case, there is no conspiracy to act unlawfully.

From a legal perspective, anti-trust law is concerned with the process of collusion, rather than the outcome, and there must be a conscious commitment to achieve an unlawful outcome.

Types of competition

Oligopolists may prefer to compete, rather than collude, especially if the penalties for anti-competitive behaviour are significant (such as fines, being forced to wind-up, or loss of reputation if discovered.)

Competition can either involve competing on price - price competition - or competing in non-price ways - non-price competition .

For the oligopolist, price competition is risky as it can lead to retaliation, and to a price-war which can lead to falling profits for all firms in the industry. This explains the preference for non-price competition . For example, rather than compete on the price of their core product (petrol/'gas'), petrol retailers may compete through special promotions, through advertising, and by developing a respected brand.

Pricing strategies can also be introduced that reduce competition, such as cost-plus pricing . Cost-plus pricing exists when the oligopolist sets a selling price as a fixed mark-up above average production costs.

For example, insurance companies may set a fixed 20% mark-up above all their costs, including all the predicted claims costs. If all insurance companies share similar costs, then any sudden change in costs - such as following a particularly harsh winter, will result in all insurance companies raising their prices (called premiums) by the same or a very similar amount.

Barriers to entry

Oligopolists can maintain their relative dominance by benefitting from barriers to entry. These include expenditure on advertising and the strength of the brand in deterring entry; the benefit of economies of scale ; collusion between oligopolists; and pricing strategies to deter entry, such as limit pricing - setting a low price to limit the entry of new firms.

Read more on barriers to entry

Price-stickiness - the oligopolists kinked-demand curve

Prices in oligopolistic markets tend to 'stick' - often for lengthy periods - even when market conditions change. This can be explained though the kinked-demand curve .

The oligopolist faces two demand scenarios:

Firstly, when demand is elastic following a price rise , and secondly when demand is inelastic in response to a price drop .

In both scenarios, the firm is worse off - at least in terms of revenue. Raising price creates an elastic reaction, and lowering price creates an inelastic reaction. In both case, revenue is less than achieved at the original price.

Profits will also be maximised at the original price

Profit maximisation occurs where marginal cost (MC) cuts marginal revenue (MR). For the oligopolist, this may occur in the vertical section of the MR curve, between A and B. The level of profit depends upon the position of the ATC curve.

Once price is set, the kinked demand curve implies that the price sticks at P.

Even when we factor in the possibility of cost changes, the price will stick at its original level. Changes in costs have no effect at all if MC remains between A and B (the discontinuous portion of the oligopolist's MR curve). Even when MC moves outside of this range, price hardly changes.

Price stickiness and interdependence can also be explained through Game Theory .

Integration

Oligopolists tend to emerge over time through integration with other firms.

Integration can either be horizontal - between firms at the same stage of production (such as two airlines merging) - or vertical, which involves the integration of firms from different stages in production.

Vertical integration can be in one of two directions - backward, where one firm integrates with a firm which is nearer to the source of supply (such as a TV company purchasing a soccer team) or forward, which is where a producer integrates with a firm nearer to the final consumer (such as a farmer acquiring a grocery store.)

Numerical example

Why the oligopolist's demand curve is 'kinked' is a question that can be appreciated by considering a cost-revenue schedule.

Here we can see that the firm's average revenue curve falls with quantity, but because there are two different reactions to price - elastic for a rise, and inelastic for a fall - there is a kink in the demand (AR) curve and the MR curve will have a discontinuous portion (between output 6 and 7, as highlighted in the schedule).

The elastic response to the price rise results from rivals not changing their price in response, whereas the inelastic response to a price drop results in rivals being forced to 'follow suit' given that rivals would experience a considerable fall in market share if they did not reduce price.

If we transfer the figures to a graph we arrive at the classic kinked demand curve. Profits are maximised at output 6 (and price 75), which is where marginal cost (MC) equals marginal revenue (MR).

The area for super-normal profits is also highlighted.

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Oligopoly – Economics Revision – The Tutor Academy

• Revision Notes

Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes 

Oligopoly market structure exists where there are a small number of large firms dominating the market.

• 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 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)

Next Revision Topics

• Perfect Competition
• Monopolistic Competition
• Natural Monopoly

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What Is an Oligopoly?

Understanding oligopolies, special considerations.

• Characteristics
• Game Theory
• Pros and Cons

The Bottom Line

• Government & Policy

Oligopoly: Meaning and Characteristics in a Market

• Antitrust Laws: What They Are, How They Work, Major Examples
• Understanding Antitrust Laws
• Federal Trade Commission (FTC)
• Clayton Antitrust Act
• Sherman Antitrust Act
• Robinson-Patman Act
• How and Why Companies Become Monopolies
• Discriminating Monopoly
• Price Discrimination
• Predatory Pricing
• Bid Rigging
• Price Maker
• Monopolistic Markets
• Monopolistic Competition
• What Are the Characteristics of a Monopolistic Market?
• Monopolistic Market vs. Perfect Competition
• What are Some Examples of Monopolistic Markets?
• A History of U.S. Monopolies
• What Are the Most Famous Monopolies?
• Monopoly vs. Oligopoly
• Oligopoly CURRENT ARTICLE
• What are Current Examples of Oligopolies?

An oligopoly is a type of market structure in which a small number of firms control the market. Where oligopolies exists, producers can indirectly or directly restrict output or prices to achieve higher returns. A key characteristic of an oligopoly is that no one firm can keep the others from having significant influence over the market. An oligopoly differs from a monopoly, in which one firm dominates a market.

Key Takeaways

• An oligopoly is a market structure wherein a small number of producers work to restrict output or fix prices so they can achieve above-normal market returns.
• Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution, of oligopolies.
• The major difficulty that oligopolies face is the prisoner's dilemma that each member faces, which encourages each member to cheat.
• Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to limit competition.

Investopedia / Ellen Lindner

Market structures come in different forms and sizes. The term is used to describe the distinctions between industries, which are made up of different companies that sell their products and services. Most market structures aim for perfect competition , which is a theoretical construct that doesn't actually exist.

These market structures are made up of a small number of companies within an industry that controls the market. Firms in an oligopoly set prices , whether collectively—in a cartel —or under the leadership of one firm, rather than taking prices from the market. Profit margins are thus higher than they would be in a more competitive market. 

Some of the barriers to entry (that prevent new players from entering the market) in an oligopoly include economies of scale , regulatory barriers, accessing supply and distribution channels, capital requirements, and brand loyalty.

Oligopolies in history include steel manufacturers, oil companies, railroads, tire manufacturing, grocery store chains, and wireless carriers. The economic and legal concern is that an oligopoly can block new entrants, slow innovation, and increase prices, all of which harm consumers.

Governments sometimes respond to oligopolies with laws against price- fixing and collusion. Yet, a cartel can price fix if they operate beyond the reach or with the blessing of governments. Oligopolies that exist in mixed economies often seek out and lobby for favorable government policy to operate under the regulation or even direct supervision of government agencies.

The main problem that firms in an oligopoly face is that each firm has an incentive to cheat. if all firms in the oligopoly agree to jointly restrict supply and keep prices high, then each firm stands to capture substantial business from the others by breaking the agreement and undercutting the others. Such competition can be waged through prices, or through simply the individual company expanding its own output brought to market. 

Companies in an oligopoly benefit from price-fixing, setting prices collectively, or under the direction of one firm in the bunch, rather than relying on free-market forces to do so.

Oligopoly Characteristics

Oligopolies are considered stable. One of the main reasons why they are is because participating firms need to see the benefits of collaboration over the costs of economic competition, then agree to not compete and instead agree on the benefits of cooperation.

The firms sometimes find creative ways to avoid the appearance of price-fixing , such as using phases of the moon. Price-fixing is the act of setting prices, rather than letting them be determined by the free-market forces. Another approach is for firms to follow a recognized price leader so that when the leader raises prices, the others will follow .

The conditions that enable oligopolies to exist include high entry costs in capital expenditures , legal privilege (license to use wireless spectrum or land for railroads), and a platform that gains value with more customers, such as social media.

The global tech and trade transformation has changed some of these conditions. For instance, offshore production and the rise of mini-mills have affected the steel industry. In the office software application space, Microsoft ( MSFT ) was targeted by Google Docs, which Google funded using cash from its web search business.

Oligopolies and Game Theory

Game theorists have developed models for these scenarios, which form a sort of prisoner's dilemma . When costs and benefits are balanced so that no firm wants to break from the group, it is considered the Nash equilibrium  state for oligopolies. This can be achieved by contractual or market conditions, legal restrictions, or strategic relationships between members of the oligopoly that enable the punishment of cheaters.

Maintaining an oligopoly and coordinating action among buyers and sellers in general on the market involves shaping the payoffs to various prisoner's dilemmas and related coordination games that repeat over time.

As a result, many of the same institutional factors that facilitate the development of market economies by reducing prisoner's dilemma problems among market participants, such as secure enforcement of contracts, cultural conditions of high trust and reciprocity, and laissez-faire economic policy, might also potentially help encourage and sustain oligopolies.

Advantages and Disadvantages of an Oligopoly

One of the main benefits of having an oligopoly is that competition is very limited. That's because there are very few players in the market. Since there are few competitors, an oligopoly allows those who participate to net a higher amount of profits .

Disadvantages

Oligopolies come with higher barriers to entry for new participants. This means that it can be difficult to enter the market because of the high costs associated with doing business, the regulatory environment, and the problems that arise when it comes to accessing supply and distribution channels .

Because of the lack of competition, there may be very little incentive to innovate product and service offerings. With no diversity in offerings, consumers remain loyal to what they know best.

Limited competition

Higher profits for companies

Greater consumer demand

High barriers to entry for new participants

Lack of innovation

Very little choice for consumers

Example of an Oligopoly

There are many examples of oligopolies in the market. But one of the major examples of a global oligopoly is the Organization of the Petroleum Exporting Countries (OPEC) . The organization was founded in Baghdad in 1960 with five countries but expanded to 13 oil-producing countries in 1975.

One of the main reasons why OPEC is considered an oligopoly is because it has no overarching authority. Every member nation within the group also has a substantial portion of the group's market share. These countries also have a great deal of power together (not separately) when it comes to supply and demand issues and pricing. So when the group lowers its supply as demand drops, prices rise. The opposite is true when demand rises.

What Are Some Negative Effects of an Oligopoly?

An oligopoly is when a few companies exert significant control over a given market. Together, these companies may control prices by colluding with each other, ultimately providing uncompetitive prices in the market. Among other detrimental effects of an oligopoly include limiting new entrants in the market and decreased innovation. Oligopolies have been found in the oil industry, railroad companies, wireless carriers, and big tech.

What Is an Example of a Current Oligopoly?

One measure that shows if an oligopoly is present is the concentration ratio, which calculates the size of companies in comparison to their industry. Instances where a high concentration ratio is present include mass media. In the U.S., for example, the sector is dominated by just five companies: NBC Universal; Walt Disney; Time Warner; Viacom CBS; and News Corporation—even as streaming services like Netflix and Amazon Prime begin to encroach on this market. Meanwhile, within big tech, two companies control smartphone operating systems: Google Android and Apple iOS.

Is the U.S. Airline Industry an Oligopoly?

With just four companies controlling nearly two-thirds of all domestic flights in the U.S. as of 2021, it has been purported that the airline industry is an oligopoly . These four companies are Delta Airlines, United Airlines Holdings, Southwest Airlines, and American Airlines. According to a report compiled by the White House, "reduced competition contributes to increasing fees like baggage and cancellation fees. These fees are often raised in lockstep, demonstrating a lack of meaningful competitive pressure, and are often hidden from consumers at the point of purchase." Interestingly, in 1978, The Airline Deregulation Act was imposed, which stripped away the Civil Aeronautics Board the ability to regulate the industry. Prior to this time, the airline industry operated much like a public utility, while fare prices had declined 20 years before the deregulation was introduced. 

There is no such thing as perfect competition in the market. But there are different market structures, including oligopolies. These types of markets are characterized by a small number of participating firms, which may work together to set prices.

Organization of Petroleum Exporting Countries. " Brief History ."

The White House. " Fact Sheet for Executive Order on Promoting Competition in the American Economy ."

Congress.gov. " S.2493 - Airline Deregulation Act ."

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Oligopolies

An oligopoly is an industry which is dominated by a few firms.

Characteristics of oligopoly

• A few firms with a high concentration ratio and significant price-setting power.
• Supernormal profit in the short-run and long-run.
• Barriers to entry are relatively high.
• Product differentiation.
• Interdependence between firms. But they can often implement collusive strategies.
• Oligopoly can be defined through either its conduct (collusive or competitive), or its structure.

Concentration ratios

• If there are four firms in an oligopoly that take up 76% of the market, then the four-firm concentration ratio is 76%.
• E.g If the top 3 firms control 80% of a market, the 3-firm concentration ratio is 0.8.

Collusive oligopoly

• Firms in an oligopoly are interdependent. Their pricing and product strategies depend on the behaviour of the other firms.
• The prisoners' dilemma shows us that firms can receive a greater payoff by colluding.
• Formal collusion: a spoken agreement between firms to keep prices high.
• Tacit collusion: an unspoken agreement between firms. Tacit collusion often works through price leadership. Here, it is in both firms best interest not to change prices.

Non-collusive oligopoly

• In a non-collusive oligopoly, firms compete with each other on a number of factors, including price.
• Non-collusive oligopolies are a common type of market structure.

Likelihood of types of oligopoly

• Low entry barriers, a high number of firms, and different marginal costs.
• High entry barriers, low number of firms, and similar marginal costs.

Features of an Oligopoly

The nature of the oligopoly can have an impact on the firms within it, as well as the consumers.

• Firms in an oligopoly may engage in a price war.
• By fiercely cutting prices (sometimes called 'predatory pricing'), firms are trying to gain market share.
• The idea is that by aggressively cutting prices, you will drive other firms out of the market because they can no longer compete.
• New firms will be discouraged to enter because of the low profits being made.
• Once firms have been driven out of the market, non-price competition can be used to maintain market share.

Advantages of oligopoly

• Informal collusion is less likely than it may appear, as one firm tends to defect, which brings down the entire cartel.
• This could lead to price wars, which are good for consumers due to the lower prices.
• Collusive oligopolies can achieve dynamic efficiency through non-price competition and product development.
• Competitive oligopolies also have the potential to be very efficient.

Examples of Oligopolies

Due to their size and the fact that they often spend large amount on advertising, many firms and oligopoly industries are well-known:

Coca-Cola and Pepsi

• Technically, a market with two dominant sellers is called a duopoly.
• However, the interdependence and behaviour of these firms would be the same with three or more sellers and so Coca-Cola and Pepsi could be considered here.
• They have such strong brands that barriers to entry are very high and they also have strong price-setting power.
• Coca-Cola and Pepsi are also very dependent on each other in terms of their price and promotion levels.

'Big Six' energy companies

• Although this has since reduced, the 'Big Six' UK energy providers controlled virtually all of the gas and electricity markets.
• They have been accused of price fixing by politicians and made such large profits that there were calls for a special, one-off tax on these.
• The CMA has investigated this industry recently and it is under constant scrutiny.
• There are high barriers to entry and brand loyalty, mainly due to customers not switching to cheaper suppliers when this is possible.

Mobile phone networks

• There are several main mobile phone service providers in the UK, including Vodafone, EE, O2, etc.
• There are high barriers to entry due to the need to have a licence to operate and these firms spend heavily on marketing and promotions to gain customers.
• BT bought EE for £12.5bn after the CMA approved the deal, deciding that it would not cause there to be a substantial reduction in the level of competition.

1 Introduction to Markets

1.1 Nature of Economics

1.1.1 Economics as a Social Science

1.1.2 Positive & Normative Economic Statements

1.1.3 The Economic Problem

1.1.4 Resources

1.1.5 Production Possibility Frontiers

1.1.6 Specialisation & Division of Labour

1.1.7 Types of Economies

1.1.8 End of Topic Test - Nature of Economics

1.1.9 Application Questions - Nature of Economics

1.2 How Markets Work

1.2.1 Rational Decision Making

1.2.2 Demand

1.2.3 Elasticities of Demand

1.2.4 Elasticities of Demand 2

1.2.5 Elasticity & Revenue

1.2.6 Supply

1.2.7 Elasticity of Supply

1.2.8 Price Determination

1.2.9 Price Mechanism

1.2.10 Consumer & Producer Surplus

1.2.11 Indirect Taxes & Subsidies

1.2.12 A-A* (AO3/4) - Taxing Prices or Quantities?

1.2.13 Alternative View of Consumer Behaviour

1.2.14 End of Topic Test - Markets

1.2.15 A-A* (AO3/4) - Markets

2 Market Failure

2.1 Market Failure

2.1.1 Types of Market Failure

2.1.2 Externalities

2.1.3 The Deadweight Welfare Loss of Externalities

2.1.4 A-A* (AO3/4) - The Externalities of Education

2.1.5 Public Goods

2.1.6 Information Gaps

2.1.7 End of Topic Test - Market Failure

2.1.8 Application Questions - Market Failure

2.2 Government Intervention

2.2.1 Government Intervention in Markets

2.2.2 Subsidies & Price Controls

2.2.3 Pollution Permits & Regulation

2.2.4 A-A* (AO3/4) - European Emissions Trading

2.2.5 State Provision & Information Provision

2.2.6 Government Failure

2.2.7 End of Topic Test - Government Intervention

2.2.8 A-A* (AO3/4) - Government Intervention

3 The UK Macroeconomy

3.1 Measures of Economic Performance

3.1.1 Measuring Economic Growth

3.1.2 National Income Data

3.1.3 Inflation

3.1.4 Causes of Inflation

3.1.5 Consequences of Inflation

3.1.6 Employment & Unemployment

3.1.7 Causes & Impact of Unemployment

3.1.8 A-A* (AO3/4) - Hysteresis

3.1.9 Balance of Payments

3.1.10 Current Account Deficit & Imbalances

3.1.11 End of Topic Test - Economic Performance

3.1.12 Application Questions Macroeconomy

3.2 Aggregate Demand

3.2.1 Aggregate Demand

3.2.2 Consumption

3.2.3 Investment

3.2.4 Government Expenditure

3.2.5 Net Trade

3.2.6 End of Topic Test - Aggregated Demand

3.2.7 Application Questions - AD

3.3 Aggregate Supply

3.3.1 Aggregate Supply

3.3.2 End of Topic Test - Aggregated Supply

3.3.3 A-A* (AO3/4) -Aggregate Supply

3.4 National Income

3.4.1 National Income

3.4.2 Injections & Withdrawals

3.4.3 Equilibrium Level of Real National Output

3.4.4 Multiplier Effect

3.4.5 End of Topic Test - National Income

3.4.6 Application Questions - National Income

3.5 Economic Growth

3.5.1 Causes of Economic Growth

3.5.2 Output Gaps

3.5.3 Business Cycle

3.5.4 Impact of Economic Growth

3.5.5 End of Topic Test - Economic Growth

3.5.6 A-A* (AO3/4) - Growth

4 The UK Economy - Policies

4.1 Macroeconomic Objectives & Policies

4.1.1 Possible Objectives

4.1.2 Demand-Side Policies - Monetary

4.1.3 Demand-Side Policies - Monetary 2

4.1.4 A-A* (AO3/4) - The Future of Interest Rates

4.1.5 Demand-Side Policies - Fiscal

4.1.6 Demand-Side Policies in 2007-08

4.1.7 Strengths & Weaknesses of Demand Side

4.1.8 Supply-Side Policies

4.1.9 Supply-Side Policies 2

4.1.10 Conflicts Between Objectives

4.1.11 A-A* (AO3/4) - Conflicting Incentives

4.1.12 Phillips Curve

4.1.13 End of Topic Topic - Policies & Objectives

4.1.14 Application Questions - UK Policies

5 Business Behaviour

5.1 Business Growth

5.1.1 Size & Types of Firms

5.1.2 Business Growth

5.1.3 Pros & Cons of External Expansion

5.1.4 Demergers

5.1.5 End of Topic Test - Business Growth

5.1.6 A-A* (AO3/4) - Business Growth

5.2 Business Objectives

5.2.1 Business Objectives

5.2.2 End of Topic Test - Business Objectives

5.2.3 Application Questions - Business Objectives

5.3 Revenues, Costs & Profits

5.3.1 Revenue

5.3.2 Costs

5.3.3 Economies & Diseconomies of Scale

5.3.4 Profits

5.3.5 Profits 2

5.3.6 End of Topic Test - Revenue, Costs & Profits

5.3.7 A-A* (AO3/4) - Revenue, Costs & Profit

6 Market Structures

6.1 Market Structures

6.1.1 Efficiency

6.1.2 Perfect Competition

6.1.3 Perfect Competition 2

6.1.4 Monopolistic Competition

6.1.5 Oligopolies

6.1.6 The Prisoner's Dilemma

6.1.7 Collusion in Oligopolistic Markets

6.1.8 A-A* (AO3/4) - Which Factors Affect Collusion?

6.1.9 Monopolies

6.1.10 Price Discrimination

6.1.11 Monopsony

6.1.12 A-A* (AO3/4) - Models in Economics

6.1.13 Contestability

6.1.14 Benefits of Contestability

6.1.15 End of Topic Test - Market Structures

6.1.16 Application Questions - Market Structures

6.1.17 A-A* (AO3/4) - Cereal Collusion

6.2 Labour Market

6.2.1 Demand for Labour

6.2.2 Supply of Labour

6.2.3 Labour Market Imperfections

6.2.4 A-A* (AO3/4) - Labour Productivity & Unemployment

6.2.5 A-A* (AO3/4) - What Level of Unionisation is Good?

6.2.6 Wage Determination

6.2.7 Elasticity of Labour Supply & Demand

6.2.8 Intervention in Setting Wages

6.2.9 End of Topic Test - Labour Market

6.2.10 A-A* (AO3/4) - Labour Markets

6.3 Government Intervention

6.3.1 Reasons for Government Intervention

6.3.2 Government Promotion of Competition

6.3.3 Usefulness of Competition Policy & Examples

6.3.4 A-A* (AO3/4) - Modern Competition Policy

6.3.5 Privatisation

6.3.6 Government Regulation

6.3.7 A-A* (AO3/4) - Nationalisation vs Privatisation

6.3.8 Government Protection of Suppliers and Employees

6.3.9 Impact of Government Intervention

6.3.10 End of Topic Test - Government Intervention

6.3.11 Application Questions - Government Intervention

7 A Global Perspective

7.1 International Economics - Globalisation & Trade

7.1.1 Globalisation

7.1.2 Globalisation for LEDCs

7.1.3 Globalisation for MEDCs

7.1.4 Specialisation & Trade

7.1.5 Pattern of Trade

7.1.6 Terms of Trade

7.1.7 Trading Blocs

7.1.8 UK, EU & WTO

7.1.9 End of Topic Test - Globalisation & Trade

7.1.10 A-A* (AO3/4) - Globalisation & Trade

7.2 International Economics - Currency

7.2.1 Merged Currency

7.2.2 Restrictions on Free Trade

7.2.3 Arguments for Protectionism

7.2.4 Arguments Against Protectionism

7.2.5 Balance of Payments

7.2.6 Balance of Payments 2

7.2.7 Floating Exchange Rates

7.2.8 Fixed Exchange Rate

7.2.9 International Competitiveness

7.2.10 End of Topic Test - International Economy

7.2.11 Application Questions - International Economics

8 Finance & Inequality

8.1 Poverty & Inequality

8.1.1 Absolute & Relative Poverty

8.1.2 Inequality

8.1.3 Inequality 2

8.1.4 Lorenz Curve

8.1.5 Government Policy on Poverty

8.1.6 End of Topic Test - Poverty & Inequality

8.1.7 A-A* (AO3/4) - Inequality & Poverty

8.2 Emerging & Developing Economies

8.2.1 Measures of Development

8.2.2 Factors Influencing Growth & Development

8.2.3 Barriers to Development

8.2.4 Barriers to Development 2

8.2.5 A-A* (AO3/4) - The Bottom Billion

8.2.6 Development Strategies

8.2.7 Interventionist Strategies

8.2.9 International Institutions

8.2.10 International Institutions 2

8.2.11 End of Topic Test - Emerging & Developing

8.2.12 Application Questions - Developing Countries

8.3 The Financial Sector

8.3.1 Role of Financial Markets

8.3.2 Market Failure in the Financial Sector

8.3.3 Role of Central Banks

8.3.4 End of Topic Test - The Financial Sector

8.3.5 A-A* (AO3/4) - Financial Sector

8.4 Role of the State in the Macroeconomy

8.4.1 Public Expenditure

8.4.2 Taxation

8.4.3 Public Sector Finances

8.4.4 End of Topic Test - Role of the State

8.4.5 Application Questions - Role of the State

9 Examples of Global Policy

9.1 International Policies

9.1.1 Global Debt & Deficit Policies

9.1.2 Poverty & Inequality Policies

9.1.3 Changes in Interest Rates

9.1.4 Competitiveness Policies

9.1.5 End of Topic Test - International Policies

9.1.6 A-A* (AO3/4) - International Policies

9.2 Policy Responses to Shocks

9.2.1 International Tax Policies

9.2.2 Problems for Policymakers

9.2.3 End of Topic Test - Policy Responses

9.2.4 Application Questions - Policy Responses

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Characteristics of oligopoly

Few large dominant firms There are a small number of dominant firms within the market and therefore the market is likely to have a high concentration ratio.

High barriers to entry and exit

There are high barriers to entry and exit within oligopolistic industries. This is often due to high startup costs which can be seen in oligopolistic industries such as the airline industry. For example, it costs hundreds of millions of pounds to buy several airplanes and therefore this is a massive barrier to entry for firms trying to enter the market. In addition to this, there is a high level of sunk costs for firms if they were to leave the market, thus acting as a barrier to exit. For example, in the smartphone industry lots of money is spent on advertising, product development and market research. When a phone company exits the market, these cost cannot be recovered. Therefore, phone companies tend to stay in the market for as long as possible which would be in contrast to a company in an industry with lower sunk costs.

High concentration ratio There are several types of concentration ratio depending upon the number of firms included within the calculation. For example. A 4-firm concentration ratio takes the combined market share of the 4 biggest firms within the industry which is then expressed in relation to the overall market share. Therefore it can be concluded that a higher concentration ratio reflects lower levels of competition and a lower concentration ratio reflects higher levels of competition. A 5-firm concentration ratio would a similar calculation but instead would include the top 5 firms and 4-firm concertation ratio would be a similar calculation but would include only the top 4 firms etc etc. Oligopolistic industries such as the airline industry have high concentration ratios as they are dominated by only a small number of firms.

Interdependence of firms Firms changing their prices within an oligopoly market structure need to consider the reaction of competitors. For example, firms within the market often lower their prices as soon as another firm does and therefore the overall revenue gained by firms within the market fall. As a result of this interdependence, prices within the market are often very rigid.

Product differentiation As there is product differentiation within the oligopoly market structure, firms have the ability to set prices. Therefore both average revenue and marginal revenue are downwards sloping on the oligopoly diagram.

Non-price competition Firms operating within an oligopoly market structure tend to compete through non-price mediums such as advertising. This can be seen in the mobile phone industry by big companies such as Samsung and Apple. Although both phones may be more expensive than similar alternatives, the strong brand they’ve created gives them a competitive advantage.

Firm’s profits maximize Firms operate at the point where marginal cost is equal to marginal revenue.

Kinked demand curve

Firm’s within an oligopoly are profit maximizers and therefore produce at the point where marginal cost is equal to marginal revenue. This gives a price level of P1 and a quantity of Q1. The kink in the demand curve shows the price rigidity and interconnectedness of firms within an oligopoly market structure. Above the price level of P1 the demand/average revenue curve turns more elastic. This means that if firms were to increase their prices above P1, the change in quantity demand would be greater than the change in price level. Therefore, the firm’s total revenue and profit would decrease. On the other hand, the demand/average revenue curve becomes slightly inelastic below the price level P1. This is due to the interconnectedness of firms within oligopolistic markets, meaning that if one firm reduces their prices, so will all of the other firms within the market. Therefore, demand is relatively inelastic below P1 as they would gain no price advantage as competitors would also drop their prices (the percentage change in quantity will be less than proportional to the change in price). This means by doing so all firms suffer a decrease in total revenue and profit As a result of this, the market price tends to be very rigid and instead, firms compete through non price means such as advertisement.

Another key characteristic of the kinked demand diagram is the discontinuity that occurs in the marginal revenue curve. As a result of this discontinuity, firms will still keep a price of P1 regardless of a marginal cost increase given that it is within the vertical discontinuity. This is shown on the diagram where marginal cost increases from MC1 to MC2 whilst firms still operate at a price level of P1. Again this shows the price rigidity of oligopolistic markets as well as the disincentive for firms to raise or lower their prices given the elasticity changes before and after the kink in AR.

Calculation of n-firm concentration ratios

4-firm concentration ratio example:

Find the top 4 biggest firms

Firm A – 20%

Firm B – 14%

Firm C – 6%

Firm D – 15%

Firm E – 4%

Firm F – 16%

Firm G – 3%

Add the market share of the four firms together

Firm D -15%

Firm B – 14%

4-firm concentration ratio = 65%

This figure tells us that the top 4 firms within the industry make up 65% of the total market share. A 4-firm concentration ratio of around 60% usually indicates that the industry is oligopolistic. A 4-firm concentration ratio of 0-50% usually indicates a perfectly competitive market. If a single firm has a concentration ratio of 100% then this is considered a pure monopoly. However, in the UK any single firm that has a market share of 25% or more is considered a monopoly.

Simple game theory

Game theory is used to demonstrate the interdependence of firms and price rigidity within an oligopoly market structure. It does this by showing a firm’s decision given the expected reaction of a competitor.

For example, firm A and firm B both have a choice whether to increase their prices, or decrease them. The figures in the box represent the profit that each firm will make given their choice. Firm B’s profit is represented by the value on the right hand side, whereas firm A’s decision is on the left hand side.

If firm B decided to raise its prices and firm A reacts by raising their prices also, then both firms would make £20 million profit.

If firm B decided to raise its price and firm A reacted by lowering their price, firm B would make £10 million, whereas Firm A would make £24 million.

On the other hand, if firm A were to raise their price and Firm B where to lower their price then Firm A would make £10 million and firm B would make £24 million.

Furthermore, if Firm A were to lower their price and Firm B were to also lower their price, both firm’s would make £15 million.

Given the fact that the reaction to either firm increasing their price would be the competitor lowering their price, the best outcome for both of them given their expected reactions would be £15 million each. This is known as the nash equilibrium. Although £15 million is the best outcome for them both given their expected reactions, the most efficient outcome for both firms would be for both of them to raise their prices. By doing so they could both earn £20 million each. However, for this to occur there needs to be collusion from both firms in order to stop the competitor from lowering their prices given the firm’s decision to raise their price. Collusion often results in monopoly outcomes for consumers as they can now charge whatever they want without having to worry about competitors offering lower prices. Therefore, overt collusion is illegal. Although this is the case, tacit collusion is still legal. Both of these forms of collusion are explained below.

Types of collusion

Tacit collusion

This is known as informal collusion and often originates from price leadership. If there is a dominant firm within the market then other firms will follow their prices. This is because the dominant firm benefits from large economies of scale and therefore cannot be beaten price wise by the smaller firms. Therefore, all the smaller firms follow the prices that the price leader sets.

Overt collusion

This occurs when firms within the market get together in order to formally set the market price for a good/service. As a result of this, firms are able to set prices similar to those within a monopoly market structure and therefore make large amounts of profit. Due to the extortionate prices and uncompetitive outcomes (poor quality goods, poor customer service etc) that this leads to, overt collusion is banned within the UK as well as in many other countries.

Reasons for collusive behavior

Small number of firms

If there are only a small number of firms within the market, it is easy for firms to get together with the intention to collude.

Similar costs

If firms within the market have similar costs then it is less likely that one firm will have an advantage over another firm. Therefore, all firms within the market have more incentive to collude than to try and get ahead of competitors through means such as price wars. In addition to this, it is much easier for firms to agree on the fixed price that is to be set. This is because firms within the market have very similar profit margins.

High entry barriers

If there are high barriers to entry within a market then firms do not have to worry about firms entering the market in the long run due to the large amounts of supernormal profit that they make. As potential new entrants in to the market will be put off by the high entry barriers, firms are able to keep making supernormal profits within the long run. Therefore, there is more incentive to collude knowing that they will be able to maintain the supernormal profit made through collusion in the long run.

Ineffective competition policy

If the competition policy is ineffective and less stringent, then firms within the market are more likely to get away with collusion. Therefore, there is more incentive for firms to collude.

Consumer loyalty

Firms are less likely to cheat on a collusive deal if consumer loyalty is high. This is because regardless of the lower price level offered by the competitor that broke the deal, customers will continue to shop at their existing firm. This means that little revenue will be made by the firm through undercutting the fixed price agreed upon. Therefore any collusive deals made are more likely to stay intact.

Reasons for non-collusive behavior

Large number of firms

When there are a large number of firms within the market it can be difficult to organize collusion.

Low barriers to entry

Market structures that have low barriers to entry usually don’t make supernormal profits in the long run due to the fact that other firms see these supernormal profits and enter the market, removing supernormal profit in the long run. This is the same reason why firms that are in markets with low barriers to entry are less likely to collude. The large amounts supernormal profit that would be made by firms through collusion will be removed in the long run as more firms enter the market.

Cost advantage

If one competitor has a large cost advantage then there is no need for them to collude. This is because they… Read more

• Past Papers
• Theme 1: Introduction to markets and market faliure
• Theme 2: The UK economy – performance and policies
• Theme 3: Business behaviour and the labour market
• Theme 4: A global perspective
• Revision Guides

Learning Objectives

• Explain why and how oligopolies exist
• Contrast collusion and competition
• Interpret and analyze the prisoner’s dilemma diagram
• Evaluate the tradeoffs of imperfect competition

Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. Oligopolies are typically characterized by mutual interdependence where various decisions such as output, price, advertising, and so on, depend on the decisions of the other firm(s). Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.

Why Do Oligopolies Exist?

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.

Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.

Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly for large passenger aircraft.

The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.

Collusion or Competition?

When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide up the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion . A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel . See the following Clear It Up feature for a more in-depth analysis of the difference between the two.

Collusion versus cartels: How can I tell which is which?

In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.

The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.

The desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits has been well understood by economists. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. Indeed, a small handful of oligopoly firms may end up competing so fiercely that they all end up earning zero economic profits—as if they were perfect competitors.

The Prisoner’s Dilemma

Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.

The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. The story behind the prisoner’s dilemma goes like this:

Two co-conspiratorial criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. So your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.

The game theory situation facing the two prisoners is shown in Table 1 . To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A ought to confess, too, so as to not get stuck with the eight years in prison. But if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. Confess is considered the dominant strategy or the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up doing a total of 10 years of jail time between them.

The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have had to serve a total of four years of jail time between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer jail terms.

The Oligopoly Version of the Prisoner’s Dilemma

The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits. Table 2  shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly . If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.

Can the two firms trust each other? Consider the situation of Firm A:

• If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in Table 2 ) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
• If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).

Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions.

The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits . The following Clear It Up feature discusses one cartel scandal in particular.

What is the Lysine cartel?

Lysine, a $600 million-a-year industry, is an amino acid used by farmers as a feed additive to ensure the proper growth of swine and poultry. The primary U.S. producer of lysine is Archer Daniels Midland (ADM), but several other large European and Japanese firms are also in this market. For a time in the first half of the 1990s, the world’s major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of Investigation (FBI), however, had learned of the cartel and placed wire taps on a number of their phone calls and meetings.

From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:

I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us … money. … And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.

The price of lysine doubled while the cartel was in effect. Confronted by the FBI tapes, Archer Daniels Midland pled guilty in 1996 and paid a fine of $100 million. A number of top executives, both at ADM and other firms, later paid fines of up to $350,000 and were sentenced to 24–30 months in prison.

In another one of the FBI recordings, the president of Archer Daniels Midland told an executive from another competing firm that ADM had a slogan that, in his words, had “penetrated the whole company.” The company president stated the slogan this way: “Our competitors are our friends. Our customers are the enemy.” That slogan could stand as the motto of cartels everywhere.

How to Enforce Cooperation

How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.

Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC) , have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.

Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself.

Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.

One example of the pressure these firms can exert on one another is the kinked demand curve , in which competing oligopoly firms commit to match price cuts, but not price increases. This situation is shown in Figure 1 . Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.

If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price , and share a monopoly level of profits even without any legally enforceable agreement.

Figure 1. A Kinked Demand Curve. Consider a member firm in an oligopoly cartel that is supposed to produce a quantity of 10,000 and sell at a price of $500. The other members of the cartel can encourage this firm to honor its commitments by acting so that the firm faces a kinked demand curve. If the oligopolist attempts to expand output and reduce price slightly, other firms also cut prices immediately—so if the firm expands output to 11,000, the price per unit falls dramatically, to $300. On the other side, if the oligopoly attempts to raise its price, other firms will not do so, so if the firm raises its price to $550, its sales decline sharply to 5,000. Thus, the members of a cartel can discipline each other to stick to the pre-agreed levels of quantity and price through a strategy of matching all price cuts but not matching any price increases.

Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.

Tradeoffs of Imperfect Competition

Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.

Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffeted by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Monopoly and Antitrust Policy discusses the delicate judgments that go into this task.

The Temptation to Defy the Law

Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, which sometimes lasted more than four hours, complex pricing structures were established. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.

How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region; there were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.

Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.

The prisoner’s dilemma is an example of game theory. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.

The United States Department of Justice. “Antitrust Division.” Accessed October 17, 2013. http://www.justice.gov/atr/.

eMarketer.com. 2014. “Total US Ad Spending to See Largest Increase Since 2004: Mobile advertising leads growth; will surpass radio, magazines and newspapers this year. Accessed March 12, 2015. http://www.emarketer.com/Article/Total-US-Ad-Spending-See-Largest-Increase-Since-2004/1010982.

Federal Trade Commission. “About the Federal Trade Commission.” Accessed October 17, 2013. http://www.ftc.gov/ftc/about.shtm.

when a few large firms have all or most of the sales in an industry

economic conditions in the industry, for example, economies of scale or control of a critical resource, that limit effective competition

the total number of units of a good or service consumers are willing to purchase at a given price

when firms act together to reduce output and keep prices high

a group of firms that collude to produce the monopoly output and sell at the monopoly price

a branch of mathematics often used by economists that analyzes situations in which players must make decisions and then receive payoffs based on what decisions the other players make

a game in which the gains from cooperation are larger than the rewards from pursuing self-interest

an oligopoly with only two firms

a perceived demand curve that arises when competing oligopoly firms commit to match price cuts, but not price increases

Oligopoly Copyright © 2020 by Rice University; Dean, Elardo, Green, Wilson, Berger. All Rights Reserved.

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Principles of microeconomics, unit 5: monopoly and oligopoly.

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Up to this point, we have analyzed the operation of firms in a perfectly competitive market. However, there are many markets that are not competitive: either there is only one firm operating (a monopoly), or a small number of firms are present (an oligopoly). Firm behavior in the context of a monopoly or an oligopoly can be very different. In this unit, you will learn how to model the decisions made by firm in a monopoly and an oligopoly, and the implications of these alternate structures for consumer welfare.

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1 Competitive markets: Demand and supply

• Markt equilibrium
• The role of the price mechanism
• Market efficiency

2 Elasticity

• Price elasticity of demand (PED)
• Cross price elasticity of demand (XED)
• Income elasticity of demand (YED)
• Price elasticity of supply (PES)

3 Government intervention

• Indirect taxes
• Price controls

4 Market failure

• The meaning of market failure
• Types of market failure

11 Supply-side policies

• The role of supply-side policies
• Interventionist supply-side policies
• Market-based supply-side policies
• Evaluation of supply-side policies

Assumptions of the model

Game theory, open/formal collusion, tactic/informal collusion, non-collusive oligopoly.

Oligopoly ( AQA A Level Economics )

Revision note.

Economics & Business Subject Lead

Characteristics of Oligopolistic Markets

• E.g. Banks, insurance companies, department stores, supermarkets, petrol retailers, sport stores etc.

Diagram: The Level of Market Power in an Oligopoly

Firms in an oligopoly market experience a higher degree of market power and the market share is more concentrated  

Characteristics of an Oligopoly Market

Concentration Ratios

• The most commonly used ones in the UK are the five-firm, ten-firm, and twenty-firm concentration ratios  
• A five-firm concentration ratio of around 60% is considered to be an oligopoly  
• They act to prevent mergers or acquisitions from taking place, which would give one firm more than 25% of the market share

Worked example

The following table shows the value of UK supermarket sales for the 3 months to March 31st, 2022.

Calculate the five-firm concentration ratio. Show your working.

Step 1: Identify the top five firms by value of sales and add the value of their sales together

      Tesco (136.5) + Asda (77.5) + Sainsbury's (75) + Morrisons (55) + Aldi (44)

Step 2: Calculate the percentage of total sales of the top five firms

The Distinction Between Collusive & Non-collusive Oligopolies

• They cease to compete as vigorously as they can
• The incentive to collude in these markets is high  
• Price wars may break out occasionally between competitors
• Little is to be gained as competitors can quickly follow each others actions, resulting with very little change in market share but a significant loss in profits, due to the lower prices generated by the price war

Diagram: A Collusive Oligopoly

When firms join together in collusion, they agree on a price and act like a monopoly in the industry by removing competition  

Diagram analysis

•  Five firms with a concentration ratio of 80% meet secretly and agree to fix prices at a particular level
• The five firms present in the market as a single firm
• At this level, AR (P 1 ) > AC (C 1 )
• The collusive oligopoly is making higher levels of ab normal profit

Types of collusion

• The net effect of collusion is that a group of firms end up acting more like a monopoly in the market  
• A cartel is the most restrictive form of collusion and is illegal in most countries
• Higher prices for consumers
• Less output in the market
• Poor quality products and/or customer service
• Less investment in innovation  
• Price fixing
• Setting output quotas, which limit supply and naturally result in price increases
• Agreements to block new firms from entering the industry
• Price leadership occurs when a dominant firm sets the price for its products or services, and other smaller firms in the industry typically follow suit
• This dominant firm, known as the price leader, often has a significant market share or holds a strategic position in the industry
• Tacit collusion requires firms to monitor the price of the largest firm in the industry and then adjust their prices to match
• It is difficult for regulators to prove that collusion has occurred

The Distinction Between Cooperation & Collusion

• Cooperation is a legal agreement between rival firms to share resources and expertise to achieve a specific goal
• It allows firms to increase sales and market share without violating antitrust (anti monopoly) laws  
• This leads to increased innovation , greater choice, and potentially lower prices for consumers 
• E.g In 2023, Sony and Honda established a collaborative venture to produce an electric vehicle. They benefited from shared brand recognition and technologies  
• Collusion is an illegal agreement between rival firms to control price or output
• Firms effectively act like a monopoly to maximise profits
• Regulatory authorities have to monitor and regulate this behaviour to ensure fair outcomes for consumers   

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Study Notes

3.4.4 Oligopoly (Edexcel)

Last updated 20 Sept 2023

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This Edexcel study note covers Oligopoly

a) Characteristics of Oligopoly:

• High Barriers to Entry and Exit: Oligopolistic markets often have significant barriers that prevent new firms from entering the industry or existing firms from easily exiting. These barriers can include high capital requirements, economies of scale, patents, and government regulations.
• High Concentration Ratio: Oligopolies are characterized by a small number of large firms dominating the market. The concentration ratio measures the market share held by the largest firms in the industry, and in oligopolistic markets, this ratio is typically high.
• Interdependence of Firms: Oligopolistic firms are highly aware of the actions and decisions of their competitors. They must consider how their own choices, such as pricing and marketing strategies, will affect the behavior and reactions of rival firms.
• Product Differentiation: Oligopolistic firms often engage in product differentiation to distinguish their offerings from competitors. This can include branding, quality variations, and advertising to create brand loyalty.

b) Calculation of n-Firm Concentration Ratios and Their Significance:

The n-firm concentration ratio measures the combined market share of the largest n firms in an industry. It is calculated by summing the market shares of these firms. Significance:

• Higher concentration ratios indicate a more concentrated industry with fewer dominant firms.
• Lower concentration ratios suggest a more competitive industry with a greater number of smaller firms.
• It can provide insights into the degree of market power held by the largest firms and potential antitrust concerns.

c) Reasons for Collusive and Non-Collusive Behavior: Collusive Behavior:

• Maintaining High Prices: Firms in an oligopoly may collude to set high prices and limit competition, increasing their profits collectively.
• Stability: Collusion can provide market stability, reducing uncertainty for firms and consumers.
• Avoiding Price Wars: Collusion helps firms avoid destructive price wars.

Non-Collusive Behavior:

• Competition: Firms may choose to compete aggressively to gain market share and increase profits individually.
• Legal Constraints: Antitrust laws and regulations prohibit collusion, encouraging firms to compete independently.
• Differences in Objectives: Firms may have differing goals and incentives that make collusion difficult.

d) Overt and Tacit Collusion; Cartels and Price Leadership:

• Overt Collusion: Occurs when firms openly agree to cooperate and set prices or output levels. This can lead to the formation of cartels, which are explicit agreements among firms to coordinate their actions.
• Tacit Collusion: Involves firms behaving in a manner that resembles collusion without any explicit agreement. Firms may follow observed pricing patterns set by competitors or engage in price leadership, where one dominant firm sets the price and others follow suit.

e) Prisoner's Dilemma in a Two-Firm Model:

The prisoner's dilemma is a classic game theory scenario where two rational players, in this case, two firms, make decisions that result in suboptimal outcomes. In an oligopolistic context, if both firms choose to compete aggressively, they may trigger a price war and both suffer lower profits. However, if both firms collude and set high prices, they both earn higher profits. The dilemma arises because each firm has an incentive to betray the collusion agreement to gain a larger share of the profits, but if both firms do this, they both end up worse off.

f) Types of Price Competition:

• Price Wars: Fierce competition where firms continuously lower prices to gain market share, often resulting in reduced profits for all.
• Predatory Pricing: Occurs when a firm sets very low prices with the intent of driving competitors out of the market, after which it can raise prices.
• Limit Pricing: A strategy where a dominant firm sets prices low enough to discourage new entrants from the market.

g) Types of Non-Price Competition:

• Product Differentiation: Firms emphasize the unique qualities and features of their products through branding, quality, design, or advertising.
• Advertising and Marketing: Firms engage in extensive advertising and marketing campaigns to create brand loyalty and awareness.
• Innovation: Competing through the development of new products, technologies, or processes.
• Customer Service: Offering exceptional customer service and support as a competitive advantage.
• Distribution Channels: Establishing efficient distribution networks to reach customers faster and more conveniently.

Download this PowerPoint

• Kinked Demand Curve
• Non-Price Competition

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