Oligopoly
What you'll learn
- How oligopoly differs from monopoly, monopolistic competition and perfect competition.
- Why firms in oligopoly are interdependent and may avoid price competition.
- How the kinked demand curve explains price rigidity.
- How to calculate and evaluate concentration ratios in real markets.
Starting point: what is oligopoly?
A market structure describes the competitive environment in a market: how many firms there are, how much power they have, how easy entry is, and whether products are similar or different.
Oligopoly
An oligopoly is a market dominated by a small number of large firms, each with enough market power to affect rivals and the overall market outcome.
Examples often used in UK economics include supermarkets, mobile networks, energy suppliers, airlines, soft drinks and banking. Oligopoly does not mean “exactly four firms”; it means a few firms dominate.
Characteristics of oligopoly
Typical oligopoly markets have several of these features:
- High concentration: a large share of sales is controlled by a few firms.
- Barriers to entry: obstacles that make it hard for new firms to enter, such as high start-up costs, brand loyalty, patents, licences, network effects or sunk costs — costs that cannot be recovered if the firm exits.
- Interdependence: each firm’s decisions depend on how it expects rivals to react.
- Product differentiation: firms make products appear different from rivals’ products.
- Non-price competition: firms compete through features other than price.
- Possible collusion: firms may cooperate, explicitly or implicitly, to reduce competitive pressure.
The big idea
In oligopoly, firms are large enough to matter to each other. A price cut, advertising campaign or new product launch by one firm can trigger a reaction from rivals.
Product differentiation
Product differentiation
Product differentiation means making a product seem different from competitors’ products, either through real differences, such as quality and features, or perceived differences, such as branding and advertising.
In some oligopolies, products are quite similar: petrol, steel or electricity supply. In others, products are strongly differentiated: smartphones, supermarkets, streaming services or cars.
Differentiation helps firms build brand loyalty, meaning customers are less likely to switch when prices rise. This can make demand less price elastic — quantity demanded responds proportionately less to a price change.
Non-price competition
Non-price competition
Non-price competition is competition using methods other than changing price, such as advertising, loyalty schemes, customer service, product quality, delivery speed, warranties, apps or branding.
Oligopolists often prefer non-price competition because price cuts can be quickly matched by rivals, leading to a price war — repeated price reductions that reduce profit for the whole market.
UK supermarkets are a good example: Tesco Clubcard Prices, Sainsbury’s Nectar Prices, Aldi price-matching claims, delivery slots, store locations and own-brand ranges are all ways to compete without simply cutting every shelf price.
Choosing between price and non-price competition
- Suppose a mobile network cuts monthly prices by 10%. Rivals may match the cut quickly, so the firm gains only a small number of extra customers.
- If all firms match the price cut, total revenue in the market may fall while customer numbers barely change, reducing profits.
- The firm may instead improve 5G coverage or offer a streaming bundle, making its product more attractive without starting a damaging price war.
Assuming non-price competition is always good
Non-price competition can improve quality and choice, but it can also be wasteful if firms spend heavily on persuasive advertising that does little to improve the actual product.
Interdependence and the kinked demand curve
Interdependence
Interdependence means that a firm’s best decision depends on the expected reactions of rival firms.
This is the core of oligopoly. A supermarket, airline or petrol retailer cannot simply ask, “Should we cut price?” It must ask, “If we cut price, will rivals follow?”
The kinked demand curve is a model used to explain price rigidity, where prices remain stable even when costs or demand conditions change.
At the current price P1P_1P1 and output Q1Q_1Q1:
- If the firm raises price, rivals are assumed not to follow. The firm loses many customers, so demand above the kink is relatively price elastic.
- If the firm cuts price, rivals are assumed to follow. The firm gains few extra customers, so demand below the kink is relatively price inelastic.
- Marginal revenue is the extra revenue from selling one more unit.
- Marginal cost is the extra cost of producing one more unit.
- The marginal revenue curve has a gap, so a change in marginal cost within that gap may not change the profit-maximising price or output.
Predicting price rigidity after a cost increase
- Suppose an oligopolist is producing where marginal cost intersects the vertical gap in marginal revenue.
- If marginal cost rises slightly but still passes through the gap, the profit-maximising output remains Q1Q_1Q1 and the price remains P1P_1P1.
- The model therefore predicts sticky prices: the firm absorbs some cost changes rather than immediately changing price.
Limits of the kinked demand curve
The kinked demand curve explains why prices may be stable once a price exists, but it does not explain how the original price was chosen. It also struggles when there are large shocks, such as energy price spikes or major supply-chain disruption.
Collusion in oligopoly
Collusion
Collusion occurs when firms cooperate to reduce competition, often by keeping prices high, limiting output or dividing up markets.
The main types are:
| Type of collusion | Meaning |
|---|---|
| Overt collusion | An explicit agreement between firms, often illegal. |
| Cartel | A formal collusive agreement between firms, usually to fix prices or restrict output. |
| Tacit collusion | Firms coordinate without a formal agreement, for example by quietly following each other’s prices. |
| Price leadership | One firm sets a price and others follow. |
| Market sharing | Firms divide customers, regions or contracts between them. |
| Bid-rigging | Firms coordinate bids for contracts so the “winner” is pre-arranged. |
In the UK, anti-competitive agreements are investigated by the Competition and Markets Authority (CMA) under competition law. Firms can face large fines if they fix prices or rig bids.
Collusion is more likely when there are few firms, high barriers to entry, similar costs, stable demand and repeated interaction. However, collusion can be unstable because each firm has an incentive to cheat.
Why a cartel may break down
- If two firms both keep prices high, each may earn £50m profit.
- If one secretly cuts price while the other keeps the high price, the cheating firm may gain market share and earn £70m.
- But if both firms cheat and cut price, both may end up earning only £35m. Individually rational behaviour can make both firms worse off.
Concentration ratios: calculate and evaluate
Concentration ratio
A concentration ratio measures the percentage of total market sales accounted for by the largest firms in the market.
A four-firm concentration ratio, written as C4C_4C4, measures the market share of the largest four firms combined. It can be calculated using sales revenue or volume, but you must be consistent.
Cn=sales of largest n firmstotal market sales×100C_n = \frac{\text{sales of largest } n \text{ firms}}{\text{total market sales}} \times 100Cn=total market salessales of largest n firms×100Calculating a four-firm concentration ratio
- Suppose total market sales are £230bn. The four largest firms have sales of £62bn, £34bn, £29bn and £21bn.
- Add the sales of the largest four firms:
- Substitute into the formula:
- Interpret the result: the largest four firms control 63.5% of market sales, suggesting a concentrated market that may behave like an oligopoly.
Treating concentration ratios as proof
A high concentration ratio suggests oligopoly, but it does not prove weak competition. The market may still be competitive if entry is easy, imports are strong, or smaller firms are expanding quickly.
Concentration ratios also depend heavily on how the market is defined. “UK grocery retail” may look less concentrated than “large supermarkets in a particular town”. This matters for AO2 application and AO4 evaluation.
Advantages of oligopoly markets
Oligopoly can bring benefits, especially when large firms use their scale effectively.
Economies of scale
Economies of scale occur when average costs fall as output rises. Large firms may buy inputs cheaply, spread advertising costs across many customers, and invest in efficient logistics.
If cost savings are passed on, consumers may benefit from lower prices.
Innovation and dynamic efficiency
Dynamic efficiency means improving products or production processes over time. Oligopolists may earn supernormal profit, meaning profit above the minimum needed to keep resources in their current use. This can fund research and development.
For example, mobile networks invest in 5G infrastructure, while supermarkets invest in online ordering systems and automated warehouses.
Choice and quality
Product differentiation and non-price competition can improve variety, quality and convenience. Consumers may value faster delivery, better apps, loyalty rewards or stronger customer service.
Disadvantages of oligopoly markets
Oligopoly can also harm consumers and reduce economic efficiency.
Higher prices and lower output
If firms have market power, they may restrict output and charge prices above competitive levels. This can reduce consumer surplus and cause allocative inefficiency, where resources are not allocated to maximise society’s welfare.
Collusion and exploitation
Collusion can keep prices artificially high. Even tacit collusion can reduce competitive pressure if firms quietly avoid undercutting each other.
Barriers to entry
Strong brands, high sunk costs and economies of scale can protect incumbent firms. This may reduce pressure to cut costs or improve quality.
Wasteful non-price competition
Advertising and branding may inform consumers, but excessive persuasive advertising can raise costs without improving the product itself.
Judging whether consumers benefit
- In a supermarket oligopoly, large firms may achieve economies of scale and offer lower prices than many small independent shops.
- However, if the largest firms tacitly avoid aggressive price competition, prices may remain higher than they would be in a more competitive market.
- A balanced judgement depends on contestability, regulation, the strength of discounters such as Aldi and Lidl, and whether cost savings are passed to consumers.
Best evaluation line
Do not argue that oligopoly is automatically good or bad. The impact depends on firm conduct, barriers to entry, regulation, product type and how aggressively rivals compete.
Overall judgement
Oligopoly is a realistic and important market structure because many modern markets need large-scale investment, branding, networks or technology. It can deliver lower costs, innovation and better products.
But the same features that make oligopolists powerful can harm consumers if firms collude, raise prices, restrict output or use barriers to protect profits. In exam answers, your strongest judgement usually compares competitive oligopoly with collusive oligopoly.
In the exam
- Define oligopoly precisely, then apply it to the named market using market shares, brands, barriers or examples.
- For concentration ratios, show the formula, add the largest firms carefully, use the correct total market size, and state the result as a percentage.
- When using the kinked demand curve, explain rival reactions above and below the kink; do not just draw the diagram.
- Evaluate by asking whether the market is collusive or competitive, how strong entry barriers are, and whether regulation or new entrants discipline firms.
Check yourself
- Why might an oligopolist avoid cutting price even if it wants to gain market share?
- What does a four-firm concentration ratio measure, and why can it be misleading?
- In what circumstances might oligopoly benefit consumers rather than harm them?
