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Oligopoly (Edexcel IGCSE Economics)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Characteristics of Oligopoly

  • Oligopoly market structure is where a small number of large firms dominate the industry

    • E.g. the UK supermarket industry is dominated by a few firms: Tesco, Sainsbury's, Asda and Morrisons

  • Oligopolies have significant market power, a large market share and the concentration ratio of the top 5 firms is usually high
     

  • In many economies, Governments regulate and may intervene in mergers and acquisitions in order to ensure that no single firm gains more than 25% market share

Characteristics of an Oligopoly Market


High Barriers to Entry and Exit


High Concentration Ratio

  • Entering the industry is difficult due to the existing dominance of relatively few firms

  • Start-up costs tend to be high, e.g. setting up a car manufacturing company costs billions

  • Exit barriers are high Leaving the industry is difficult due to the high level of sunk costs e.g. mobile phone companies are bidding billions on 5G auctions run by the government, but they cannot recoup this money if they leave the industry

  • A concentration ratio calculates the percentage of the total market share a specific number of firms serve

  • A 3-firm concentration ratio reveals the total market share (concentration) of the largest 3 firms in the industry

  • A 5-firm concentration reveals the total market share (concentration) of the largest 5 firms in the industry

  • The higher the concentration ratio - and the lower the number of firms - the more concentrated the market power , e.g. the UK supermarket's 5-firm concentration ratio is around 67%


Interdependence of Firms


Product Differentiation

  • With relatively few competitors, oligopolists study each other's behaviour and are highly interdependent in their actions

  • There is a strong incentive to collude, as this will lead to greater profits

  • There is little incentive to compete on price, as this can lead to damaging price wars

  • Products tend to be highly differentiated despite being similar in nature (e.g. petrol, chocolate bars)

  • Branding around the product is highly differentiated to the point where consumers perceive it as different and are extremely brand loyal

Price & Non-price Competition

  • Firms in an oligopolistic market are highly competitive and can use price or non-price strategies to increase market share

There is a high degree of interdependence between competitors in an oligopoly market

  • Competitors closely watch each others actions

  • They are very responsive to new innovations

  • They may use game theory to determine the best course of action

Non-price competition

  • Non-price competition tends to be the most common way in which oligopolists compete

    • The focus of competition is on product differentiation to develop brand loyalty and to convince consumers their product differs from the competition

      • E.g. Firms achieve this high levels of spending on advertising, branding, packaging, loyalty cards, etc 

      • Often products may be similar, e.g. running shoes, however consumers perceive there to be big differences between the brands

Price competition

  • Price competition is less common, as firms want to avoid a price war

    • Price wars occurs when competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share, resulting in all firms achieving lower profits

    • Limit pricing is the practice of temporarily lowering prices to prevent a new competitor from entering the industry. Prices are often lowered to a point below the cost of production.

    • Predatory pricing is when a firm temporarily reduces its price (often below its cost of production) in order to drive out an existing competitor. This action is illegal and firms will be heavily fined by the Government if caught

Evaluating Monopolies

  • Some oligopoly markets, such as pharmaceutical firms, can be controversial

    • E.g. patents on life saving drugs prevent rivals from entering the industry. The patent is necessary to allow the firm to recoup extensive research spending and extensive drug trials

    • The patent leads to temporary monopoly power, which can lead to high prices and anti-competitive behaviour. This raises ethical considerations for consumer welfare

Advantages and Disadvantages of an Oligopoly Market Structure


Advantages 


Disadvantages
 

  • Consumers may benefit with lower prices. With a few firms dominating the market, large-scale operations result in economies of scale, reducing average costs 

  • Lower costs enable firms to generate supernormal profits, which can be reinvested in research and development to create more innovative goods/services for consumers 

  • A high degree of competition gives firms an incentive to continuously strive to improve the quality of goods and services 

    • E.g. competition among streaming platforms firms - Netflix, Amazon Prime and Disney has led to significant improvements in content quality and user experience

  • High barriers to entry restrict the number of firms entering the market, resulting in low innovation levels

  • High levels of spending on branding and advertising can increase production costs. This cost may be passed on to consumers as higher prices 

  • The market dominance by a few firms enables control over prices or output. Limited competition results in fewer choices for consumers

  • There is a potential for firms to engage in illegal collusion or operate as cartels by fixing price or output 

  • Price wars may break out occasionally between competitors. Little is to be gained as from lower prices resulting with very little change in market share, but a significant loss in profits

Examiner Tips and Tricks

You may be asked to assess whether the oligopoly would benefit consumers. Make sure to acknowledge the positives and negatives for consumers. For example, Apple, Samsung, and Huawei dominate the smartphone industry and benefit from economies of scale and lower costs, possibly resulting in cheaper products for consumers. Large profits could be used for innovation and R&D, leading to improved smartphones. However, if firms engage in non-price competition (marketing campaigns), it may lead to higher prices and fewer choices for consumers.

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    Author
    Reviewer
    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

    Jenna Quinn

    Author: Jenna Quinn

    Expertise: Head of New Subjects

    Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.