4.6 - Oligopoly
Measuring market concentration with concentration ratios
Certain markets are controlled by a small number of large companies, even if smaller firms exist. These are known as concentrated markets, and concentration ratios help measure how much influence the biggest firms have.
Calculating an n-firm concentration ratio
An n-firm concentration ratio shows the percentage of the total market controlled by the largest n firms.
Where:
- Combined revenues of the n largest firms = Sum of sales income from the selected top firms (£)
- Total market revenue = Overall sales value of the entire market (£)
High concentration ratios indicate that a few firms dominate, which can affect competition and pricing.
Worked example - Calculating a concentration ratio
A market has a total revenue of £150 million. The three largest firms have revenues of £48 million, £32 million, and £20 million. Calculate the 3-firm concentration ratio.
Step 1: Identify the values
- Revenues of the three largest firms: £48 million, £32 million, £20 million
- Total market revenue: £150 million
Step 2: Calculate combined revenues
Combined revenues = £48 million + £32 million + £20 million = £100 million
Step 3: Apply the concentration ratio formula
Defining oligopolies by structure and conduct
Oligopolies are markets where a handful of firms hold significant power. They can be described based on their setup or how companies interact.
Market structure characteristics
- Dominated by a small number of firms that control most of the market.
- High barriers to entry, making it difficult for new companies to join and challenge existing profits.
- Products are differentiated, meaning they are alike but have unique features to stand out.
Firm conduct characteristics
- Firms are interdependent, so one company's decisions impact others in the market.
- Companies may choose strategies that involve either competing aggressively or cooperating to maximise benefits.
Competitive and collusive behaviour in oligopolies
In oligopolies, firms decide between rivalries or partnerships, influenced by market conditions. This choice affects pricing, output, and overall strategy.
Competitive behaviour
Competitive behaviour occurs when firms challenge each other, often through price reductions, to gain market share.
Conditions that encourage competitive behaviour:
- One firm enjoys lower production costs than rivals.
- A larger number of significant firms operate in the market.
- Products from different firms are highly similar.
- Barriers to entry are not too high, allowing potential new competitors.
Collusive behaviour
Collusive behaviour involves firms working together, typically to keep prices high and stable.
Types of collusive behaviour:
- Formal collusion - Firms create an agreement, such as a cartel, to set prices or output levels (often illegal).
- Informal collusion - Firms implicitly follow similar practices without agreements, recognising mutual benefits in avoiding competition.
- Price leadership - One firm sets prices, and others match them to maintain consistency.
Conditions that encourage collusive behaviour:
- Firms face similar production costs.
- Only a few firms dominate the market.
- Strong brand loyalty keeps customers from switching, even if prices differ.
- High barriers to entry protect existing firms from new threats.
Outcomes of collusion and its similarities to monopolies
When firms in an oligopoly collude, the market can function like a monopoly, leading to specific economic effects.
Similarities between collusive oligopolies and monopolies
- Higher prices and lower output levels, resulting in underconsumption by buyers.
- Allocative inefficiency, where resources are not distributed to meet consumer needs effectively.
- Productive inefficiency, as firms may not minimise costs.
- Potential for dynamic efficiency through investment in innovation, though the drive to do so can be weak.
Collusion often leads to supernormal profits for firms, but at the cost of consumer welfare, potentially causing market failure.
Strategies in collusive oligopolies
Firms agree on output quotas to limit supply and keep prices elevated, aiming for industry-wide profit maximisation (where marginal cost equals marginal revenue for the whole sector).
Non-price competition in collusive markets:
- Differentiating products through improvements or branding.
- Offering sales promotions, such as loyalty schemes.
- Expanding into new export markets.
- Using predatory pricing to deter new entrants.
Arguments on the stability and impact of collusive oligopolies
Some views suggest collusive oligopolies may not be entirely negative or long-lasting.
- Formal collusion is rare due to legal restrictions, and informal versions can break down if one firm undercuts prices for first-mover advantage, sparking price wars.
- Non-price competition can drive innovation and improvements, benefiting consumers.
- Extremely high prices might invite new entrants, despite barriers.
- Competitive oligopolies often achieve strong efficiency levels in practice.
The kinked demand curve model for price stability
Interdependence in oligopolies creates uncertainty, as one firm's actions prompt reactions from others. The kinked demand curve model explains why prices often remain steady.
Assumptions of the kinked demand curve model
- If a firm increases prices, competitors will not follow, leading to a loss of customers.
- If a firm decreases prices, competitors will match it to protect their market share.
How the model explains price stability
Raising prices leads to elastic demand, causing a sharp drop in sales that outweighs revenue gains. Lowering prices results in inelastic demand, with no market share increase but lower overall earnings.
This creates a kinked demand curve, where firms avoid price changes to prevent losses, leading to long-term price stability even in competitive settings.
The model applies to specific oligopolies but may not fit all, as assumptions can vary by market. Other models might better describe different scenarios.