Oligopoly

Oligopoly: Game Theory & Interdependence

An oligopoly is a market dominated by a few large firms, each with significant market share. Oligopoly is the most common market structure in modern economies.

Characteristics of Oligopoly

1. High concentration ratio: a few firms hold a large share of the market (e.g., UK supermarkets: Tesco, Sainsbury's, Asda, Morrisons hold ~67%)

2. Interdependence: each firm's decisions (pricing, output, advertising) affect and are affected by rivals — the defining feature of oligopoly

3. High barriers to entry: economies of scale, brand loyalty, patents, high start-up costs

4. Product differentiation: may be significant (cars, smartphones) or limited (petrol, cement)

5. Non-price competition: heavy advertising, loyalty schemes, product development

6. Price rigidity: prices tend to be "sticky" — firms are reluctant to change prices

The Kinked Demand Curve Model

The kinked demand curve (Sweezy, 1939) explains price rigidity in oligopoly.

Assumptions

• If a firm raises its price, rivals will not follow → the firm loses customers to competitors → demand is elastic above the current price
• If a firm lowers its price, rivals will match the cut to protect market share → the firm gains few extra customers → demand is inelastic below the current price

Implications

• The demand curve has a kink at the current price
• The MR curve has a vertical discontinuity (gap) at the kink
• MC can shift within this gap without changing the profit-maximising price or output
• This explains why oligopolistic prices are often stable despite cost changes

Evaluation

• Strengths: explains observed price stickiness; reflects real-world interdependence
• Weaknesses: does not explain how the current price was determined in the first place; assumes rivals always match cuts but never follow rises (not always true); firms may compete on price (price wars do occur)

Game Theory

Game theory analyses strategic decision-making where the outcome depends on the actions of all players. It formalises the interdependence central to oligopoly.

The Prisoner's Dilemma

The classic game theory model applied to oligopoly:

Two firms choosing whether to set high or low prices:

	Firm B: High Price	Firm B: Low Price
Firm A: High Price	A: £10m, B: £10m	A: £2m, B: £12m
Firm A: Low Price	A: £12m, B: £2m	A: £5m, B: £5m

Analysis:

• Both firms have a dominant strategy to set a low price (regardless of the rival's choice, low price yields a better individual outcome)
• The Nash equilibrium (John Nash) is (Low, Low) → both earn £5m
• But the collectively rational outcome is (High, High) → both earn £10m
• This is the prisoner's dilemma: individual rationality leads to a suboptimal collective outcome

Nash Equilibrium

A Nash equilibrium is a set of strategies where no player can improve their payoff by unilaterally changing their strategy, given the strategies of other players.

In the prisoner's dilemma, (Low, Low) is the Nash equilibrium — neither firm benefits from changing price alone.

Repeated Games

In reality, firms interact repeatedly, which changes incentives:

• Firms can adopt tit-for-tat strategies: cooperate initially, then mirror the rival's previous action
• Reputation matters — firms that undercut may face retaliation
• This makes tacit collusion (cooperating without formal agreement) more likely
• The shadow of the future encourages cooperation: if firms expect to compete indefinitely, the long-run benefits of cooperation outweigh short-run gains from cheating

Collusion

Overt (Formal) Collusion — Cartels

A cartel is a formal agreement among firms to fix prices, restrict output, or divide markets. Cartels act as a collective monopoly.

• OPEC (Organisation of the Petroleum Exporting Countries) is the most prominent example
• Cartels are illegal in the UK and EU (Competition Act 1998, Article 101 TFEU)
• The CMA (Competition and Markets Authority) investigates and fines cartel behaviour

Why cartels are unstable:

• Each member has an incentive to cheat (increase output beyond quota to earn more at the cartel price)
• Difficult to monitor compliance
• Firms have different costs and want different prices
• New entrants may undercut the cartel
• Demand changes may make the agreed price unsustainable

Tacit Collusion

Firms may coordinate behaviour without formal agreement:

• Price leadership: a dominant firm sets the price, others follow ("barometric" or "dominant firm" leadership)
• Focal points: firms converge on obvious price points (e.g., petrol prices ending in .9)
• Parallel pricing: firms observe and match rivals' prices without communication

Tacit collusion is harder to prosecute because there is no explicit agreement, but competition authorities monitor suspicious pricing patterns.

Factors Favouring Collusion

• Few firms (easier to coordinate)
• Similar cost structures
• Homogeneous products
• Stable demand
• High barriers to entry
• Lack of regulatory scrutiny

Non-Price Competition

Because price competition is risky (may trigger a price war), oligopolists often compete through:

• Advertising and branding (building brand loyalty)
• Product differentiation (new features, design, quality)
• Loyalty schemes (Tesco Clubcard, Nectar)
• Customer service and after-sales support
• Innovation and R&D
• Location and distribution networks

Contestable Markets Theory

Baumol (1982) argued that what matters is not how many firms are in a market but the threat of entry.

A perfectly contestable market has:

• No barriers to entry or exit
• No sunk costs (costs that cannot be recovered on exit)
• Access to the same technology as incumbents

Even a monopolist or oligopolist will behave competitively if the market is contestable — they keep prices low and profits normal to deter "hit-and-run" entry.

Evaluation of Contestability

• Strengths: explains why some concentrated markets have competitive outcomes; shifts focus from structure to behaviour
• Weaknesses: perfect contestability is as theoretical as perfect competition; sunk costs exist in most industries; incumbents can respond strategically (limit pricing, predatory behaviour); brand loyalty is a significant barrier

Evaluation of Oligopoly

Consumer Welfare

• Negative: collusion raises prices and restricts output (deadweight loss)
• Negative: advertising costs passed on to consumers
• Positive: non-price competition improves product quality and variety
• Positive: economies of scale may mean lower prices than many small firms
• Positive: supernormal profits fund R&D and innovation (Schumpeter)

Efficiency

• Allocative: unlikely (P > MC, especially with collusion)
• Productive: possible due to economies of scale but may have X-inefficiency
• Dynamic: potentially high (large firms have resources for innovation — but interdependence may lead to slow adoption if first-mover disadvantage exists)

Exam Technique

• Use game theory matrices to illustrate the prisoner's dilemma
• Draw the kinked demand curve with the MR discontinuity
• Discuss both collusive and competitive oligopoly outcomes
• Apply to real-world examples (supermarkets, airlines, mobile networks, OPEC)
• Evaluate using the concept of contestability as a counter-argument to market concentration
• 25-mark essays should consider whether oligopoly benefits or harms consumers — evaluate with evidence