What you'll learn

• How to recognise an oligopolistic market and measure it using concentration ratios.
• Why oligopoly is built around interdependence: firms react to each other’s decisions.
• How price competition, non-price competition, price leadership, collusion and price wars work.
• How to use a simple game theory payoff matrix to find a Nash equilibrium.

Starting point: what is oligopoly?

An oligopoly sits between monopolistic competition and monopoly. There are a few large firms, each with enough market power to care about what the others are doing.

Examples often used in UK context include supermarkets, mobile networks, broadband providers, petrol retailing, airlines on particular routes, and some banking services.

Main features of oligopoly

Oligopolistic markets usually have:

• High concentration: a few firms hold a large share of total sales.
• Barriers to entry: obstacles that make it difficult for new firms to enter, such as high start-up costs, strong branding, patents, network effects or economies of scale.
• Product differentiation: firms may sell similar but branded products, such as mobile phone contracts or supermarket own-label ranges.
• Market power: firms can influence price rather than simply accept the market price.
• Interdependence: firms must predict rival reactions before changing price, output, advertising or product design.

Measuring market power: concentration ratios

A concentration ratio measures the combined market share of the largest firms in an industry. The most common is the four-firm concentration ratio, often written as CR4.

For example, if the four biggest firms in a market together account for 70% of sales, the CR4 is 70%. This suggests an oligopolistic market, although you should still consider barriers to entry and how fiercely firms compete.

Interdependence: the core feature

Interdependence means each firm’s best decision depends on what it expects rival firms to do.

Imagine a supermarket considering a 10% price cut on milk. If rivals do nothing, the supermarket may gain market share. But if all rivals match the price cut, market shares may barely change and every firm earns lower profit.

That is why oligopolists often compete carefully. They may avoid aggressive price cuts because retaliation can make everyone worse off.

Price competition and price rigidity

Price competition means firms compete by changing price, such as discounts, sales, cheaper tariffs or promotional offers.

However, oligopolies may show price rigidity, where prices do not change much even when costs or demand change. One explanation is the kinked demand curve model.

The idea is:

• If one firm raises price, rivals may keep their prices unchanged, so the firm loses many customers.
• If one firm cuts price, rivals may match the cut, so the firm gains few extra customers.
• Therefore, firms may avoid changing price unless they have a strong reason.

The kinked demand curve helps explain why oligopolists may prefer stable prices and focus on non-price competition.

Non-price competition

Non-price competition means firms try to increase demand without cutting price. This is extremely common in oligopoly because price wars can damage profits.

Examples include:

• Advertising and branding.
• Loyalty schemes, such as supermarket reward cards.
• Better customer service.
• Faster delivery.
• Product quality and design.
• Wider product range.
• Innovation, such as improved apps or online platforms.

Non-price competition can benefit consumers if it improves quality, choice and convenience. But it can also raise costs, create brand loyalty that acts as a barrier to entry, and make demand less price elastic.

Price leadership

Price leadership occurs when one firm, usually the largest or most influential, changes price and other firms follow.

This may happen because the dominant firm has lower costs, better market information or a larger customer base. Smaller firms may follow because undercutting could trigger retaliation, while charging more could lose customers.

Price leadership can create stable prices, but it may also reduce competitive pressure. If prices rise together without explicit agreement, regulators may investigate whether there is tacit coordination.

Collusion and cartels

Collusion occurs when firms coordinate their behaviour to reduce competition. This can be explicit or tacit.

A cartel is a formal agreement between firms to act like a monopoly. In the UK, price fixing and cartel behaviour are illegal under competition law and may be investigated by the Competition and Markets Authority (CMA).

Collusion can increase producer profits because firms may raise price and restrict output. For consumers, the likely effects are higher prices, less choice and reduced consumer surplus.

Price wars

A price war happens when firms repeatedly cut prices in response to each other.

In the short run, price wars can benefit consumers through lower prices. For example, supermarket petrol discounts may reduce household motoring costs during a cost-of-living squeeze.

But in the long run, price wars can reduce profits, weaken investment and force smaller firms out of the market. If weaker rivals exit, the surviving firms may later regain market power and raise prices.

Game theory: analysing interdependent behaviour

Game theory is the study of strategic decision-making where the outcome for each participant depends on the choices made by others.

In oligopoly, firms are “players”, their pricing or output decisions are “strategies”, and their profits are “payoffs”.

Payoff matrix example

The table below shows annual profit in £ millions. Each cell shows: Firm A profit, Firm B profit.

This is a classic prisoner’s dilemma outcome. Both firms would be better off if they both charged high prices and earned £10m each. But because each firm has an incentive to undercut, the market ends up at low price, low price.

Efficiency in oligopoly

Allocative efficiency

Allocative efficiency occurs where price equals marginal cost: $P=MC$. This means resources are allocated according to consumer preferences.

Oligopolies often charge a price above marginal cost, so they are usually allocatively inefficient. Consumers buy less than the socially efficient quantity, and there may be a welfare loss.

Productive efficiency

Productive efficiency occurs when firms produce at the lowest point on the average cost curve.

Oligopolies may be productively efficient if large firms benefit from economies of scale, which are cost advantages from producing on a larger scale. For example, large supermarkets can spread distribution and technology costs over millions of transactions.

However, oligopolies may also suffer from X-inefficiency, where lack of strong competition allows costs to drift above the minimum possible level.

Dynamic efficiency

Dynamic efficiency means improving products and production processes over time through investment and innovation.

This is where oligopoly can look more positive. Large firms may earn supernormal profits and use them for research and development, new technology, better logistics or improved digital services.

Costs and benefits of oligopoly

Potential benefits

Oligopoly may create:

• Lower average costs through economies of scale.
• Innovation funded by high profits.
• Strong brands and reliable quality.
• International competitiveness if dominant firms can compete in global markets.
• Wider product range and better customer experience through non-price competition.

Dominant firms can matter for the wider economy. Large technology, pharmaceutical, car or aerospace firms may support supply chains, exports, skilled jobs and national productivity growth.

Potential costs

Oligopoly may also lead to:

• Higher prices than in more competitive markets.
• Allocative inefficiency if price exceeds marginal cost.
• Collusion or tacit coordination.
• Less consumer choice if smaller firms are forced out.
• Barriers to entry that protect incumbent firms.
• X-inefficiency if firms become complacent.
• Supplier pressure, for example large retailers using bargaining power against farmers or small producers.

Evaluation: what does the impact depend on?

The effects of oligopoly depend on the market.

A highly concentrated market with strong barriers to entry, weak regulation and low consumer switching is more likely to exploit consumers.

But an oligopoly with active rivalry, low switching costs, strong competition policy and pressure from overseas firms may deliver low prices and innovation.

Time period matters too. A price war may help consumers in the short run but reduce competition in the long run if firms exit. High profits may harm consumers today but fund innovation that benefits consumers later.