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Study Notes

3.4.4 Oligopoly (Edexcel)


Last updated 20 Sept 2023

This Edexcel study note covers Oligopoly

a) Characteristics of Oligopoly:

  1. 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.
  2. 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.
  3. 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.
  4. 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:

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

Non-Collusive Behavior:

  1. Competition: Firms may choose to compete aggressively to gain market share and increase profits individually.
  2. Legal Constraints: Antitrust laws and regulations prohibit collusion, encouraging firms to compete independently.
  3. 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.

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