An oligopoly is a market structure dominated by a small number of large firms whose decisions are interdependent. These firms often engage in strategic behaviour involving both competition and cooperation.
Characteristics of an oligopoly
Oligopolistic markets sit between perfect competition and monopoly, displaying a blend of competitive and monopolistic features. The key characteristics include:
Few dominant firms
An oligopoly typically consists of a small number of large firms that hold a substantial share of the market. These firms are large enough that the actions of one can significantly influence the others. The strategic interdependence that arises from this concentration means each firm must consider its rivals’ responses before changing prices or output.
High concentration ratio
Oligopolies are measured using the n-firm concentration ratio, which calculates the combined market share of the top ‘n’ firms in a market. A higher concentration ratio reflects a more oligopolistic market. A ratio of over 60% for the top 4 firms suggests strong oligopoly characteristics.
Interdependence
Firms do not act independently. Instead, they carefully observe each other’s behaviour. If one firm cuts prices or launches an advertising campaign, competitors are likely to respond, making independent decision-making risky. This leads to strategic behaviour, such as waiting, copying, or pre-empting rival moves.
Product differentiation
Products in oligopolistic markets may be homogeneous (e.g. petrol or steel) or differentiated (e.g. smartphones, branded foods). Differentiation allows firms to have some price-setting power, even when competing closely. Marketing, branding, and design are common tools used to make products stand out.
Barriers to entry
Significant barriers prevent new firms from entering the market, helping incumbent firms maintain market power and earn long-run abnormal profits. Barriers include:
High start-up or fixed costs
Economies of scale
Legal protections (e.g. patents)
Brand loyalty
Exclusive access to key resources
These obstacles reduce the threat of new entrants, contributing to market stability.
Concentration ratios
The n-firm concentration ratio is a quantitative measure used to determine the degree of market concentration in an industry.
Calculating the n-firm concentration ratio
To calculate it:
Identify the market shares of the top ‘n’ firms.
Add these market shares together.
For example, if the top 4 firms in a market have shares of 25%, 20%, 15%, and 10%, the 4-firm concentration ratio is:
25 + 20 + 15 + 10 = 70%.
A ratio above 50% suggests that the industry has strong oligopoly features. This can vary by sector and country.
Interpreting the results
A high ratio indicates that a few firms dominate the market, supporting the idea of oligopoly.
A low ratio suggests more competitive behaviour and less market control by a few firms.
Real-world example: In the UK grocery sector, Tesco, Sainsbury’s, Asda, and Morrisons hold approximately 70% of market share collectively. This confirms the oligopolistic nature of the industry.
Collusive vs non-collusive behaviour
Firms in an oligopoly can either choose to cooperate or compete, and this choice affects their pricing, output, and strategic decisions.
Collusive behaviour
Firms may attempt to reduce competition by forming agreements—either formally or informally—to fix prices, limit production, or share markets.
Key features:
Higher prices and lower output than in competitive markets.
Can result in supernormal profits for all participating firms.
Illegal in many countries due to anti-competition laws.
Non-collusive behaviour
When firms choose to act independently, they must anticipate how rivals will respond to changes in price, advertising, or product offerings. This creates an environment of strategic interdependence.
Key consequences:
Firms tend to avoid price cuts to prevent triggering a price war.
Leads to stable prices and increased use of non-price competition strategies.
Outcomes are less predictable and depend heavily on market conditions and firm behaviour.
Types of collusion
Collusion can take several forms, ranging from formal agreements to implicit understandings among firms.
Overt collusion
This is a formal, open agreement between firms to limit competition. Examples include setting prices, restricting output, or dividing markets. It is illegal in most jurisdictions and subject to heavy penalties.
Example: Historical collusion cases involving airline fuel surcharges or construction bidding rings.
Tacit collusion
Tacit collusion is unspoken and informal. Firms may follow the price changes of a dominant firm without any explicit agreement.
Difficult to detect and regulate.
Often seen in industries with a clear market leader whose pricing decisions are mirrored by rivals.
Cartels
A cartel is a formal organisation of producers who agree to coordinate prices and output.
Most famous example: OPEC, where oil-producing countries agree on output quotas to influence oil prices.
Highly unstable, as members have incentives to cheat.
Illegal under UK and EU competition law.
Price leadership
In this form of tacit collusion, a dominant firm sets a price, and other firms follow to maintain stability. It avoids overt collusion and can create price rigidity in the market.
Example: In UK banking, some interest rate changes are first made by one bank, followed closely by others.
Game theory and the prisoner’s dilemma
Game theory is essential to understanding oligopoly behaviour, especially when firms act non-collusively.
The prisoner’s dilemma
This scenario illustrates how rational behaviour by individuals (or firms) can lead to sub-optimal outcomes.
The basic model:
Two firms, A and B, can choose to collude or compete.
If both collude, they both earn high profits.
If one cheats while the other colludes, the cheating firm earns more, and the other loses.
If both cheat, they both earn low profits.
Key insights:
Trust is essential for sustained cooperation.
Firms face incentives to cheat, making collusion hard to maintain.
In repeated games, firms may be more likely to cooperate to preserve long-term gains.
Game theory explains why oligopolies often settle on stable pricing even without formal collusion.
Types of price competition
Although risky, some oligopolists engage in price-based competition to gain or defend market share.
Price wars
When firms continuously undercut each other, leading to a cycle of falling prices.
Consumers may benefit in the short term.
Firms suffer reduced margins and potential losses.
Example: Airlines cutting ticket prices aggressively on competitive routes.
Predatory pricing
Firms set prices below average cost to force rivals out of the market.
Once competition is eliminated, prices are raised again.
This strategy can be abusive and illegal.
Often difficult to prove, as low prices alone are not sufficient evidence.
Limit pricing
A firm sets prices low enough to discourage new entrants but still above average cost.
Sacrifices some profit in the short term to protect long-term market power.
Maintains high market share without directly engaging in a price war.
Non-price competition
To avoid destructive price competition, oligopolistic firms invest heavily in non-price competitive strategies.
Branding
Creating a strong brand identity builds customer loyalty and reduces price sensitivity. A well-known brand can act as a barrier to entry.
Example: Apple’s branding allows it to charge premium prices.
Advertising
Heavy expenditure on persuasive or informative advertising can increase market share and establish product differences.
Acts as a form of product differentiation.
Can create artificial barriers for smaller or new firms.
Loyalty schemes
Rewarding repeat purchases increases customer retention.
Examples: Tesco Clubcard, Boots Advantage Card.
Discourages customers from switching to competitors.
After-sales services
Providing extended warranties, technical support, free maintenance, or return policies adds value beyond price and encourages consumer preference.
Evaluation: outcomes for consumers and firms
Oligopolistic markets can yield both positive and negative outcomes, depending on the behaviour of firms.
Benefits to consumers
Lower prices may result from competition or the threat of entry.
Greater choice through product differentiation.
Innovation due to dynamic efficiency encouraged by non-price competition.
High quality of products and services due to strong brand competition.
Costs to consumers
Higher prices and restricted output if collusion occurs.
Reduced transparency, making price comparison difficult.
Lack of genuine choice in homogeneous product markets.
Benefits to firms
Potential for supernormal profits due to limited competition.
Market stability, especially with tacit collusion or price leadership.
Ability to invest in innovation, branding, and product development.
Economies of scale, reducing average costs as firms grow larger.
Costs to firms
Vulnerability to price wars, especially when interdependence breaks down.
High costs of advertising and promotion to maintain brand presence.
Regulatory scrutiny for anti-competitive behaviour.
Uncertainty and complexity in strategic decision-making.
Real-world examples
UK supermarkets
Tesco, Sainsbury’s, Asda, and Morrisons control about 70% of the market.
Engage in both price and non-price competition (loyalty cards, price matching).
Evidence of interdependence in pricing and promotional strategies.
UK telecommunications
Dominated by BT, Virgin Media, Sky, and others.
High barriers to entry due to infrastructure costs.
Non-price competition includes bundling broadband, TV, and mobile services.
Regulated by Ofcom to prevent abuse of market power.
Petrol retailers
Prices often move in unison, suggesting tacit coordination.
Homogeneous product leads to limited differentiation.
Regular investigations into pricing practices by competition authorities.
FAQ
Price stability in oligopoly is a well-documented phenomenon, often attributed to strategic interdependence and the kinked demand curve model. In this model, firms believe that if they raise prices, rivals will not follow, causing them to lose market share, but if they cut prices, competitors will match, leading to a price war and reduced revenue for all. As a result, firms avoid changing prices even when there are shifts in costs or demand. The kink in the demand curve, where marginal revenue is discontinuous, leads to a wide range over which marginal cost can fluctuate without altering the profit-maximising price. This discourages frequent price changes. Additionally, the use of non-price competition (e.g. product features, branding) allows firms to maintain competitiveness without altering price. Furthermore, price rigidity also benefits firms by allowing them to plan production and marketing more effectively, preserving market stability and minimising consumer uncertainty.
Advertising plays a critical role in sustaining profits in oligopolistic markets by enhancing product differentiation, building brand loyalty, and acting as a barrier to entry. In markets where price competition is limited, firms use advertising to attract and retain customers, increasing their pricing power. Successful advertising campaigns can convince consumers that a firm’s product is unique or superior, even if the actual differences are minimal. This perceived differentiation allows firms to charge higher prices and earn abnormal profits without losing significant market share. Moreover, sustained advertising can reinforce consumer habits and loyalty, reducing price elasticity of demand. High advertising spending also serves as a barrier to entry; new firms face difficulty competing with established brands without incurring significant marketing costs themselves. For example, in the soft drinks market, Coca-Cola and PepsiCo use massive advertising budgets to dominate consumer preferences, deterring smaller competitors. Overall, advertising reinforces market power and profit retention in oligopolistic industries.
In oligopolistic markets, uncertainty about rivals’ costs significantly influences firm behaviour, particularly regarding pricing and output decisions. Because firms are interdependent, each one must predict how rivals will react to changes. If a firm is unsure about a competitor’s cost structure, it cannot accurately gauge whether price cuts will be matched or undercut. This uncertainty often leads firms to adopt cautious strategies such as price rigidity, non-price competition, or price leadership, allowing the market leader to set prices while others follow. Alternatively, firms may use signalling or market research to infer cost changes, such as monitoring investment levels, wage agreements, or supply chain activity. Game theory also becomes relevant under uncertainty, as firms must consider various possible reactions and associated payoffs, leading to conservative or defensive pricing strategies. The risk of triggering aggressive retaliation discourages firms from testing rival cost structures directly. Overall, cost uncertainty reinforces strategic caution and contributes to stable but competitive oligopoly dynamics.
Loyalty schemes significantly affect competition in oligopolistic markets by increasing switching costs for consumers and reinforcing brand loyalty. In a market where firms sell similar or only slightly differentiated products, loyalty cards, rewards points, and exclusive member discounts create perceived and actual benefits for repeat purchases. This limits the incentive for consumers to try rival firms, even if prices are slightly lower elsewhere. As a result, firms can maintain customer bases without relying on aggressive price cuts, supporting price stability and enabling abnormal profits. Additionally, loyalty schemes provide valuable data on consumer behaviour, enabling targeted promotions and personalised marketing, which can further differentiate a firm’s offering. For example, in UK supermarkets, Tesco’s Clubcard or Sainsbury’s Nectar card allows firms to tailor discounts based on past purchases, enhancing customer satisfaction and retention. By making it harder for rivals to lure customers away, loyalty schemes act as a form of soft barrier to competition and entrench firm market power.
In oligopolistic markets, a first-mover advantage can provide a powerful strategic edge by allowing a firm to shape consumer preferences, capture significant market share early, and establish brand loyalty before rivals enter or respond. The initial entrant can define the market’s structure, set customer expectations, and build strong distribution networks. This advantage is particularly important when combined with product differentiation and non-price competition. The first mover often achieves economies of scale faster, reducing average costs and raising barriers to entry. Early brand recognition can make subsequent firms appear as imitators, weakening their appeal. Moreover, first movers can set industry standards, secure the best supplier contracts, and establish switching costs through loyalty schemes or long-term customer relationships. For example, in the streaming industry, Netflix capitalised on being first to scale globally, giving it a lead in brand presence, subscriber base, and original content. In oligopolies, this early lead often translates into lasting competitive advantage and sustained profitability.
Practice Questions
Evaluate whether collusion between firms in an oligopoly is more likely to benefit producers or consumers.
Collusion in oligopolies often benefits producers more than consumers. By agreeing to fix prices or limit output, firms reduce competitive pressure and can earn supernormal profits. Consumers typically face higher prices and less choice, especially under tacit or overt collusion. However, some argue collusion may lead to greater producer certainty and long-term investment, potentially improving quality or innovation. In rare cases, stable prices might also benefit consumers by avoiding price wars. Overall, the welfare loss from restricted competition suggests producers gain more than consumers, particularly when collusion reduces allocative efficiency and consumer surplus.
Analyse how interdependence between firms affects pricing behaviour in an oligopolistic market.
Interdependence in oligopoly means firms must anticipate rivals’ responses to their actions, especially regarding price changes. If one firm lowers its price, others may follow to protect market share, potentially sparking a price war and reducing profits for all. As a result, firms often avoid price competition, leading to price rigidity. Instead, they may engage in non-price competition such as advertising or product differentiation. Game theory, including the prisoner’s dilemma, illustrates how firms may choose to cooperate informally rather than compete aggressively, demonstrating the strategic nature of pricing in interdependent oligopolistic markets.
