3.4.4a Characteristics and concentration ratios

Oligopoly Characteristics

1. A high concentration ratio is a defining feature, because just a few firms account for most sales.
2. Firms are interdependent, so each anticipates how rivals will react before it changes price or output.
3. Products are usually differentiated through branding, quality and marketing, which gives each firm some pricing power and encourages non-price competition.
4. High barriers to entry and exit protect established firms, which is why the leading firms can hold their market power over time.

Why interdependence matters

1. With only a few rivals, one firm's price cut or advertising push is large enough to pull custom away from the others, so it cannot be ignored.
2. Each firm must therefore judge how rivals will respond before it acts, and this uncertainty is what drives the strategic behaviour typical of oligopoly.

The concentration ratio

$$C{R}_n=S_1+S_2+\dots +S_n$$

1. The n-firm concentration ratio adds together the market shares of the largest n firms, so it measures how much of the market they control between them.
   1. The five-firm ratio is the most common, and the result is read against the whole market of 100%.

Significance of the ratio

1. A high ratio signals a concentrated, oligopolistic market where a few firms hold significant market power.
2. A low ratio suggests a more competitive market with many rivals and little dominance.
   1. The ratio therefore places a market on the spectrum of competition and can prompt scrutiny by the Competition and Markets Authority (CMA).

3.4.4b Collusion and game theory

Collusion and Game Theory

1. Because an oligopoly has a few large, interdependent firms (see 3.4.4a), each firm's best move depends on how its rivals are likely to react.
2. This gives firms two broad options: collude to raise joint profit and cut uncertainty, or compete, which risks price wars that erode profit.
   1. Even when firms collude, each still has a private incentive to cheat by undercutting the agreed price, which is what makes collusion unstable.

Overt and tacit collusion

1. A cartel restricts total output and shares the market, so price rises towards the monopoly level and joint profit increases.
2. Price leadership lets firms coordinate without any explicit agreement, as often seen in fuel retailing when a large chain moves its pump prices first.
   1. Cartels are illegal in the UK and investigated by the Competition and Markets Authority (CMA), which has fined firms in sectors such as construction, dairy and pharmaceuticals for price fixing.

Reasons to collude or compete

1. Firms collude to raise joint profits, reduce the uncertainty of interdependence and deter new entrants.
   1. Collusion holds best with few firms, similar cost structures, easy monitoring of rivals' prices and stable demand.
2. Firms compete non-collusively because of the incentive to cheat, legal penalties, mistrust between rivals and the desire to win market share.
   1. Collusion is harder to sustain where there are many firms, differentiated products or unstable demand, so firms may compete instead.

Game theory and the prisoner's dilemma

1. In a simple two-firm, two-outcome model each firm chooses either to hold the collusive high price or to cheat by cutting price.
2. Cutting price is the dominant strategy for both firms, because each earns more by cutting whatever its rival chooses to do.
3. So both cut and settle at the Nash equilibrium, even though both would have earned more by colluding: this is the prisoner's dilemma.
   1. The same logic that makes cheating individually rational is exactly why any cartel is fragile and hard to hold together.

Does collusion harm consumers?

1. It holds because collusion mimics monopoly: higher prices, restricted output and allocative inefficiency (P > MC), so consumers pay more and receive less.
2. It can also breed inefficiency, because with less competitive pressure colluding firms may innovate less and drift into x-inefficiency.
3. But there can be offsetting gains: stable prices reduce uncertainty, and the supernormal profit may fund research and dynamic efficiency.
4. On balance it depends on whether that profit is reinvested and whether collusion even survives, since the incentive to cheat and CMA enforcement often break cartels down and return gains to consumers.

3.4.4c Price and non-price competition

Competition in Oligopoly

Price competition

1. Oligopolists are interdependent, so one firm's price cut provokes a matched response; because the rival copies it, neither wins lasting market share and both end up with thinner margins, which is why open price competition is risky.
2. In a price war consumers gain lower prices in the short run, but as margins are squeezed weaker firms may exit, so choice can fall later; the UK grocery contests between Tesco, Asda and the discounters Aldi and Lidl show this pattern.
3. Predatory pricing works in two stages: the predator absorbs losses while price sits below cost until financially weaker rivals leave, then it raises price above the competitive level to recoup those losses and exploit the thinner market, so the early loss is an investment in future monopoly power.
4. Limit pricing sacrifices some short-run supernormal profit so that the low price signals to entrants that they could not cover costs at the scale they could achieve; it works only where the incumbent has a cost advantage from economies of scale, protecting long-run market power.

Non-price competition

1. Advertising and branding build awareness and a distinct image, as with Coca-Cola or Apple, raising the value customers place on the product.
2. Product differentiation through quality, design and features makes goods feel distinct and harder for rivals to imitate.
3. Loyalty schemes such as the Tesco Clubcard or Nectar reward repeat custom and raise the switching cost of moving to a rival.
4. After-sales service and innovation, such as warranties and new models, add value at the current price rather than cutting it.

Why non-price competition dominates

1. Because rivals are interdependent, a price cut is quickly matched so no firm wins lasting sales while margins shrink for all, and an open price war can be mutually destructive; firms therefore tend to hold price steady and shift their rivalry onto non-price methods instead.
2. Successful advertising shifts the firm's average revenue (AR) curve to the right and makes it steeper, so demand becomes more price-inelastic and the firm can hold a higher price without losing many sales.
3. Strong brands also act as a barrier to entry, since a new rival must spend heavily on advertising to match recognition; this spending is largely a sunk cost, which deters entry and defends long-run profit.

Is non-price competition in the consumer interest?

1. It can serve consumers well because advertising that informs, alongside genuine quality gains and innovation, raises choice and supports dynamic efficiency funded from oligopoly profit.
2. It also lets firms build stable revenue and market share without a damaging price war that might eventually force exit and reduce choice.
3. But persuasive advertising may create wants rather than inform, and its cost raises average cost, which can be passed on to consumers as higher prices while entrenched brands make entry harder.
4. On balance it depends on the type used: informative advertising and real quality improvements benefit consumers most, whereas purely persuasive spending that blocks entry mainly harms them.