11.4 - Oligopoly
Concentration ratios and market dominance
Concentration ratios measure how much of a market is controlled by the largest firms, highlighting the level of market dominance even in industries with many companies overall. High concentration indicates a concentrated market where a few big players hold significant power.
Calculating concentration ratios
The n-firm concentration ratio is found by adding the market shares of the top n firms and expressing this as a percentage of the total market.
Where:
- Total revenue of top n firms = Sum of revenues from the largest n companies (£)
- Total market revenue = Overall value of the market (£)
For example, if the top three firms have revenues of £12m, £8m, and £5m in a market worth £40m, the 3-firm concentration ratio is (12 + 8 + 5) ÷ 40 × 100 = 62.5%.
Worked example - Calculating a concentration ratio
A market is valued at £60m. The three leading firms have revenues of £18m, £10m, and £8m. Calculate the 3-firm concentration ratio.
Step 1: Identify the values
- Revenue of first firm = £18m
- Revenue of second firm = £10m
- Revenue of third firm = £8m
- Total market revenue = £60m
Step 2: Sum the revenues of the top three firms
Total revenue of top three = £18m + £10m + £8m = £36m
Step 3: Apply the concentration ratio formula
Defining oligopolies by structure and conduct
Oligopolies are markets dominated by a small number of firms, leading to unique behaviours and strategies. They can be defined in two main ways: by their structural features or by how firms interact.
Structural features of oligopolies
An oligopoly exists when:
- A few firms dominate the market, shown by a high concentration ratio.
- High barriers to entry prevent new firms from easily joining and competing for profits.
- Firms sell differentiated products that are similar but not identical, allowing for branding and slight variations.
Conduct features of oligopolies
An oligopoly can also be identified by firm behaviour, where:
- Firms are interdependent, meaning one firm's actions affect others in the market.
- Firms adopt either competitive or collusive strategies to leverage this interdependence for their benefit.
Competitive and collusive behaviours in oligopolies
In oligopolies, firms do not follow a single profit-maximising strategy like in perfect competition or monopolies. Instead, they choose between competition and collusion, influenced by how other firms respond, leading to varied market scenarios.
Factors influencing competitive behaviour
Competitive behaviour, where firms rival each other (often on price), is more common when:
- One firm enjoys lower costs than rivals.
- There are many large firms, making it hard to monitor others' actions.
- Products are highly similar, encouraging price-based rivalry.
- Barriers to entry are low, allowing new competitors to enter.
Factors influencing collusive behaviour
Collusive behaviour, where firms cooperate (especially on pricing), is more likely when:
- Firms have similar cost structures.
- There are few firms, simplifying oversight of others' prices.
- Strong brand loyalty keeps customers loyal even if prices differ.
- High barriers to entry protect existing firms from new threats.
Types of collusion
- Formal collusion - Firms form a cartel with explicit agreements, often illegal, to control prices or output.
- Informal collusion - Tacit cooperation without agreements, where firms avoid competition knowing it benefits all if everyone follows suit.
- Price leadership - One firm sets prices, and others follow to keep levels similar.
Effects of collusion on prices, output, and efficiency
Collusion in oligopolies can mimic monopoly outcomes, often leading to market failures through higher prices and inefficiencies, though firms may still compete in non-price ways.
Similarities to monopoly outcomes
Colluding firms often restrict output to keep prices high, setting an industry-wide price (PC) and output (QC) where marginal cost equals marginal revenue for the whole market. Each firm then receives an output quota, allowing supernormal profits.
Collusion typically results in:
- Higher prices and limited output, causing underconsumption.
- Allocative and productive inefficiency, as resources are not used optimally.
- Potential for dynamic efficiency through investment in better methods, but little incentive to innovate.
- Supernormal profits for firms at consumers' expense.
Non-price competition in collusive oligopolies
Even with price agreements, firms may rival each other through:
- Product differentiation, such as enhancements or strong branding.
- Sales promotions, like loyalty schemes for repeat buyers.
- Expansion into new export markets.
New entrants may face predatory pricing but could persist if profits are attractive, potentially leading to renewed collusion.
Potential benefits and instability of oligopolies
Despite criticisms, some argue that oligopolies, especially collusive ones, are not always harmful and tend to be unstable over time.
Arguments for benefits of oligopolies
- Non-price competition - Without price rivalry, firms may focus on innovations, leading to dynamic efficiency and better products for consumers.
- Price restraint - Firms avoid excessively high prices to prevent attracting new entrants, even with high barriers.
- Efficiency in competitive oligopolies - These markets often operate efficiently in practice, balancing competition and stability.
Reasons for instability
- Formal collusion is rare due to illegality.
- Informal collusion is temporary, as firms may cheat by cutting prices for first-mover advantage, sparking price wars and falling prices.