Oligopoly

An oligopoly is a market structure dominated by a small number of large firms that hold a significant share of total market output. Oligopoly is arguably the most important market structure to study at A-Level because it describes many real-world industries — from supermarkets and mobile networks to banking and petrol retailing. The defining feature of oligopoly is interdependence: each firm's decisions are influenced by, and influence, the behaviour of its rivals.

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Characteristics of Oligopoly

Characteristic	Explanation
Few dominant firms	A small number of firms supply the majority of the market's output
High concentration ratio	The combined market share of the largest firms (e.g., CR4 or CR5) is high
Interdependence	Each firm must consider how its rivals will react to its pricing and output decisions
High barriers to entry	Economies of scale, brand loyalty, legal barriers, and sunk costs prevent easy entry
Product differentiation	Products may be differentiated (cars, smartphones) or homogeneous (oil, cement)
Non-price competition	Firms compete on advertising, branding, quality, and customer service
Price rigidity	Prices tend to be stable — firms are reluctant to change prices for fear of rivals' reactions

Measuring Concentration

Measure	Definition	Example
N-firm concentration ratio (CRn)	The combined market share of the n largest firms	CR4 in UK supermarkets ≈ 65% (Tesco, Sainsbury's, Asda, Morrisons)
Herfindahl-Hirschman Index (HHI)	Sum of squared market shares of all firms in the market	HHI > 2,500 indicates a highly concentrated market; used by the CMA in merger assessments

Exam Tip: Always use concentration ratio data to support your claim that a market is an oligopoly. The CMA considers a market to be concentrated if the CR5 exceeds 60% or the HHI exceeds 1,000. Stating specific figures — even approximate ones — shows the examiner you understand how to apply the concept.

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The Kinked Demand Curve Model

The kinked demand curve model was developed by Paul Sweezy (1939) and independently by Hall and Hitch (1939) to explain price rigidity in oligopolistic markets.

Assumptions

The model assumes that an oligopolist believes:

• If it raises its price, rivals will not follow — the firm will lose customers to cheaper competitors. Demand above the current price is therefore relatively elastic.
• If it cuts its price, rivals will follow — to protect their market share. The firm will not gain customers because all firms lower prices together. Demand below the current price is therefore relatively inelastic.

The Resulting Kink

The demand curve has a kink at the current price/output combination:

• Above the kink: elastic demand (rivals do not match price increases)
• Below the kink: inelastic demand (rivals match price cuts)

This creates a discontinuity in the MR curve — a vertical gap at the output level corresponding to the kink. The MC curve can shift up or down within this gap without changing the profit-maximising output or price, explaining why prices remain sticky even when costs change.

Evaluation of the Kinked Demand Curve

Strength	Weakness
Explains observed price rigidity in oligopolistic markets	Does not explain how the initial price was determined — it takes the current price as given
Consistent with the reluctance of firms to engage in price wars	Assumes a particular pattern of rival behaviour that may not hold in all cases
Simple and intuitive model	Empirical evidence is mixed — some oligopolies do engage in price competition

Exam Tip: The kinked demand curve model is a useful starting point but is widely regarded as an incomplete theory of oligopoly. The examiner will reward you for acknowledging its limitations and comparing it with game theory as a more sophisticated approach. Never present the kinked demand curve as the "answer" to oligopoly behaviour.

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Game Theory and Strategic Behaviour

Game theory, developed by John von Neumann and Oskar Morgenstern (1944) and refined by John Nash (1950), provides a more rigorous framework for analysing strategic interdependence in oligopoly.

The Prisoner's Dilemma

The prisoner's dilemma is the most famous game theory example and illustrates why oligopolists may fail to cooperate even when cooperation would benefit them all.

Example: Two firms deciding whether to set high or low prices

	Firm B: High Price	Firm B: Low Price
Firm A: High Price	A earns £5m, B earns £5m	A earns £1m, B earns £8m
Firm A: Low Price	A earns £8m, B earns £1m	A earns £3m, B earns £3m

Analysis:

• If both firms set high prices, both earn £5m — the best collective outcome
• But each firm has a dominant strategy to set a low price, because:
  • If Firm B sets a high price, Firm A earns £8m by setting a low price (vs £5m for a high price)
  • If Firm B sets a low price, Firm A earns £3m by setting a low price (vs £1m for a high price)
• The Nash equilibrium is (Low, Low) — both firms earn £3m
• This is a sub-optimal outcome — both firms would be better off cooperating, but the incentive to cheat makes cooperation unstable

Applications of Game Theory