13.4 - Oligopoly
Concentration ratios in markets
Concentration ratios measure the extent to which a small number of firms dominate a market, even if there are many smaller firms overall.
Calculating n-firm concentration ratios
An n-firm concentration ratio shows the combined market share of the largest n firms in a market.
Where:
- Total revenue of the largest n firms = Sum of revenues from the n biggest companies (£)
- Total market revenue = Overall value of the market (£)
A high concentration ratio, such as 85% for a 4-firm ratio, indicates that these firms control most of the market, which is common in oligopolistic structures.
Worked example - Calculating a 3-firm concentration ratio
In a market valued at £800 million, the three largest firms have revenues of £220 million, £190 million, and £170 million. Calculate the 3-firm concentration ratio.
Step 1: Identify the values
- Revenue of first firm = £220 million
- Revenue of second firm = £190 million
- Revenue of third firm = £170 million
- Total market revenue = £800 million
Step 2: Sum the revenues of the three largest firms
Total revenue of three firms = £220m + £190m + £170m = £580 million
Step 3: Apply the concentration ratio formula
Step 4: Interpretation
This means the three largest firms control 72.5% of the market, indicating a concentrated market structure.
Defining characteristics of oligopolies
Oligopolies are markets where a small group of firms hold significant influence. They can be defined by their structural features and the ways firms behave within them.
Market structure features
- Dominated by a few firms, leading to a high concentration ratio.
- High barriers to entry, making it difficult for new firms to enter and challenge existing ones, which helps maintain supernormal profits.
- Differentiated products, where goods or services from different firms are similar but have unique features to appeal to customers.
Conduct features
- Firms are interdependent, meaning the decisions of one firm, such as changing prices, directly affect the others.
- Firms adopt either competitive strategies, like aggressive pricing, or collusive strategies to manage interdependence and maximise advantages.
Competitive and collusive behaviours in oligopolies
In oligopolies, firms must choose long-term strategies to maximise profits, influenced by the actions of interdependent rivals. Unlike perfect competition or monopolies, there is no one-size-fits-all approach, leading to either competition or cooperation.
Competitive behaviour
Firms engage in rivalry, often focusing on price cuts to gain market share.
This is more likely when:
- One firm enjoys lower production costs than competitors.
- There is a larger number of significant firms in the market.
- Products are highly similar, making price a key differentiator.
- Barriers to entry are not excessively high, allowing potential new competitors.
Collusive behaviour
Firms cooperate, particularly on pricing, to avoid damaging competition.
Types of collusion:
- Formal collusion - Involves explicit agreements, such as forming a cartel to set prices, which is typically illegal.
- Informal collusion - Tacit cooperation without agreements, where firms recognise that avoiding price wars benefits everyone.
This is more likely when:
- Firms have comparable costs.
- The market has few firms.
- Strong brand loyalty reduces customer switching, even if prices differ.
- High barriers to entry protect the group from new rivals.
In collusive setups, some firms may act as price leaders, setting prices that others follow.
Similarities between collusive oligopolies and monopolies
Collusive oligopolies often mirror monopolistic outcomes, as cooperating firms act like a single entity to control the market.
Economic impacts
- Higher prices and limited output, leading to underconsumption where demand is not fully met.
- Allocative inefficiency, as resources are not distributed to match consumer needs.
- Productive inefficiency, with firms not always motivated to minimise costs.
- Potential for dynamic efficiency through investment in better methods, though the incentive may be low without competition.
- Supernormal profits earned at consumers' expense, as prices stay elevated despite lower possible costs.
Strategies in collusive oligopolies
Colluding firms might agree on a profit-maximising price and output level, then divide production quotas among themselves.
Even when colluding on price, firms may compete in other areas:
- Differentiating products through improvements or strong branding.
- Using sales promotions, such as loyalty schemes for repeat buyers.
- Expanding into new export markets to grow without direct rivalry.
These tactics allow non-price competition while maintaining collusive stability.
Potential benefits and instability of oligopolies
Despite criticisms, some economists view oligopolies, especially collusive ones, as not entirely negative and often short-lived due to inherent instability.
Arguments for the benefits of oligopolies
- Collusive oligopolies encourage strong non-price competition, fostering dynamic efficiency through innovations and product enhancements that benefit consumers.
- In competitive oligopolies, high efficiency levels are common, leading to effective market performance.
- Firms avoid excessively high prices to prevent attracting new entrants, even with barriers.
Instability in collusive oligopolies
- Formal collusion is rare and unstable because it is usually illegal.
- Informal collusion tends to be temporary, as one firm may cheat by cutting prices for first-mover advantage, sparking price wars and lower prices overall.