This document discusses the theory of oligopoly, which describes markets with a small number of large firms that dominate the market. Key characteristics include high concentration ratios, interdependence between firms, differentiated products, and high barriers to entry. Firms in an oligopoly engage in non-price competition through branding, marketing, and product differentiation. They also sometimes collude on prices or market share. The kinked demand curve model suggests firms will match price cuts but not price increases, leading to generally rigid prices in oligopoly markets. Collusion aims to maximize joint profits but is unstable as firms have incentives to cheat.

1. Theory of oligopoly
“Competition amongst the few”
Copyright Economics Department, King’s School, Chester

2. Characteristics of oligopoly
 The market is dominated by a few large firms
 concentration ratios are high
 There is a high degree of interdependence
between firms
 Firms supply products which are heavily branded
or differentiated
 Entry barriers exist so that profits are abnormal in
the long run
Copyright Economics Department, King’s School, Chester

3. Features of oligopoly markets
 There is a great deal of non-price competition
between firms
 Price rigidity is the norm
 Aggressive price wars break out periodically
 Firms may collude to fix prices, agree not to
compete in each others’ ‘patch’, carve up the
market, follow a leader’s price changes
 Firms may exercise control over the supply chain
through ‘vertical restraints’, controlling the
distribution and sale of the product
Copyright Economics Department, King’s School, Chester

4. Why non-price competition?
 Advertising and marketing are used to raise
demand, develop brand loyalty and command a
‘premium’ price
 Often the emphasis of corporate strategy is on
increasing market share (service quality, longer
opening hours) rather than maximising profit
 Incumbent firms may use advertising and
marketing to restrict entry
Copyright Economics Department, King’s School, Chester

5. Kinked demand curve model
 This model takes as its starting point the idea that
oligopolistic firms are highly interdependent
 So, if one firm lowers its price others will follow for
fear of losing market share
 But, if one firm raises its price others will not in
order to gain market share
 Firms in oligopoly, therefore, face two demand
curves - one relatively elastic curve for a price rise
and one relatively inelastic for price reductions
 The firm’s demand curve ‘kinks’ around the
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6. Kinked demand curve model
Price
What does the MR curve for
the kinked demand curve look
like?
P0
D = AR
D = AR
Q0
Output
Copyright Economics Department, King’s School, Chester

7. Kinked demand curve model
Price
Each AR curve has its own
MR curve but only up to the
output sold at P0 - ie output
Q0
P0
D = AR
MR
Q0
MR
D = AR
Output
Copyright Economics Department, King’s School, Chester

8. Kinked demand curve model
The MR curve has a vertical
discontinuity at output Q0.
Price
MC3
The consequence is that MC
can vary between MC1 and
MC2 yet the price will not
change - it is rigid.
MC2
What if the MC curve is MC3?
MC1
P0
Does the firm maximise
profit?
D = AR
Q0
MR
Output
Copyright Economics Department, King’s School, Chester

9. The nature of collusion
 Collusion is an attempt to maximise joint profits of
the group by acting together as a monopolist
 Price fixing requires a quota system to divide the
market output between the members of the cartel
 Collusion is easiest / most successful when:
there are a small number of firms in the industry
there is a way of ‘policing’ firms’ output and prices
there is no dominant buyer
entry barriers prevent new firms from undercutting the
incumbents’ agreed price
 demand is stable and price inelastic




Copyright Economics Department, King’s School, Chester

10. Problems with collusion
 Collusion is not stable and cartels break down
 Although joint profits are maximised through price
fixing, each firm is not maximising profit
 Each firm has an incentive to cheat on the
agreement by producing more than its quota or
discounting its prices
 Cartels run foul of competition policy
 BA / Virgin
http://news.bbc.co.uk/1/hi/business/6925397.stm
http://news.bbc.co.uk/1/hi/business/5105454.stm
 Bus service operators, Kingston upon Hull (1998)
Copyright Economics Department, King’s School, Chester

11. Deny
Confess
Will’s options
Deny
Freddie’s options
Confess
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12. Firm X’s pricing
strategy
Firm Y’s pricing strategy
High
Low
High
Low
Copyright Economics Department, King’s School, Chester