Oligopoly (Edexcel IGCSE Economics)

Revision Note

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

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.

Last updated: 6 June 2024

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