Oligopoly (AQA A Level Economics)

• An oligopoly is a market structure in which a few large firms dominate the industry with each firm having significant market power and the concentration ratio of the top 5 firms is usually high
  • E.g. Banks, insurance companies, department stores, supermarkets, petrol retailers, sport stores etc.

Diagram: The Level of Market Power in an Oligopoly

Firms in an oligopoly market experience a higher degree of market power and the market share is more concentrated
 

Characteristics of an Oligopoly Market

• Concentration ratios reveal what percentage of the total market share a specific number of firms have, e.g the five-firm concentration ratio reveals the market share of the top five firms in the industry
  • The most commonly used ones in the UK are the five-firm, ten-firm, and twenty-firm concentration ratios
     
• A five-firm concentration ratio of around 60% is considered to be an oligopoly
   
• A one-firm concentration ratio of 100% would be a pure monopoly
  • Many government regulators define a monopoly as a firm with more than 25% market share
    
    • They act to prevent mergers or acquisitions from taking place, which would give one firm more than 25% of the market share

• Collusive behaviour in oligopolies occurs when firms cooperate to fix prices and restrict output
  • They cease to compete as vigorously as they can
  • The incentive to collude in these markets is high
     
• Non collusive behaviour in oligopolies occurs when firms actively compete to maintain/increase market share
  • Price wars may break out occasionally between competitors
  • Little is to be gained as competitors can quickly follow each others actions, resulting with very little change in market share but a significant loss in profits, due to the lower prices generated by the price war

Diagram: A Collusive Oligopoly

When firms join together in collusion, they agree on a price and act like a monopoly in the industry by removing competition  

Diagram analysis

•  Five firms with a concentration ratio of 80% meet secretly and agree to fix prices at a particular level
• The five firms present in the market as a single firm
• The firm produces at the profit maximisation level of output, where MC = MR (Q₁)
  • At this level, AR (P₁) > AC (C₁)
  • The collusive oligopoly is making higher levels of abnormal profit

Types of collusion

• Collusion can be overt or tacit
  • The net effect of collusion is that a group of firms end up acting more like a monopoly in the market
     
• Overt collusion occurs when firms explicitly agree to limit competition or raise prices (price fixing)
  • A cartel is the most restrictive form of collusion and is illegal in most countries
  • The consequences of overt collusion include:
    • Higher prices for consumers
    • Less output in the market
    • Poor quality products and/or customer service
    • Less investment in innovation
       
  • Overt collusion often happens in the following ways
    • Price fixing
    • Setting output quotas, which limit supply and naturally result in price increases
    • Agreements to block new firms from entering the industry

• Tacit collusion occurs when firms avoid formal agreements but closely monitor each other's behaviour, usually following the lead of the largest firm in the industry
  • The most common form of tacit collusion is price leadership
    • Price leadership occurs when a dominant firm sets the price for its products or services, and other smaller firms in the industry typically follow suit
    • This dominant firm, known as the price leader, often has a significant market share or holds a strategic position in the industry
  • Tacit collusion requires firms to monitor the price of the largest firm in the industry and then adjust their prices to match
  • It is difficult for regulators to prove that collusion has occurred

• Cooperation is a legal agreement between rival firms to share resources and expertise to achieve a specific goal
• • It allows firms to increase sales and market share without violating antitrust (anti monopoly) laws
     
• Through the sharing of resources, firms reduce the cost of production and benefit economies of scale 
  • This leads to increased innovation, greater choice, and potentially lower prices for consumers 

• Cooperation can take the form of joint ventures and strategic alliances
  • E.g In 2023, Sony and Honda established a collaborative venture to produce an electric vehicle. They benefited from shared brand recognition and technologies
     

• Collusion is an illegal agreement between rival firms to control price or output
• Firms effectively act like a monopoly to maximise profits
• Limiting choice or raising prices is an anti-competitive practice that  reduces consumer surplus 
  • Regulatory authorities have to monitor and regulate this behaviour to ensure fair outcomes for consumers