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Business Competition » Oligopoly

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 1.2.4 (h)-(j)

What an oligopoly is
The seven main features of oligopoly, including collusion, price competition and non-price competition
The advantages and disadvantages of oligopoly, including cartels and price wars

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What is an oligopoly?

A few big firms dominate many markets, like the petrol stations along this road: an oligopoly

Between a monopoly (one firm) and a market with lots of small firms, there is another kind of market. A few big firms share most of the sales. This is called an oligopoly. It is examined on Paper 1 (Microeconomics and Business Economics).

Key terms:

Oligopoly: a market dominated by a small number of large firms.
Collusion: when firms agree to work together, for example to fix prices, instead of competing.
Cartel: a group of firms that agree to fix prices or limit output.
Price competition: firms compete by changing their prices, usually by lowering them.
Non-price competition: firms compete in ways other than price, such as advertising, branding, quality and customer service.
Price war: a fight between firms in which each keeps cutting its prices below its rivals.

Real examples include supermarkets, mobile phone makers and airlines on busy routes. In each, a handful of big names take most of the sales.

The main features of oligopoly

👥 Few firms

There are only a small number of businesses in the market. Each one is big enough that its decisions affect the others.

🏢 Large firms dominate

The big firms take most of the sales. Small firms may exist, but they have only a small share.

🎁 Different products

The firms sell products that are similar but not identical. Each tries to make its own version look special, with its own brand.

🔒 Barriers to entry

New firms find it hard to join, for example because of high start-up costs or big marketing budgets. This protects the big firms.

🤝 Collusion

With so few firms, they may agree to work together. If they agree to fix a high price, they can all earn more profit.

📢 Non-price competition

Firms often avoid cutting prices and compete with advertising, branding, quality, extra features and service.

🏷 Price competition

Firms sometimes cut prices to win customers from rivals. Because rivals can copy a price cut quickly, it can spark a price war.

Worked example

In the country of Tavira, three phone companies (Nexa, Orbi and Pelo) supply 90% of mobile phone contracts. A new company would need to spend a very large amount on masts and advertising. Nexa, Orbi and Pelo each offer slightly different contracts with their own brand names, and they spend heavily on adverts.

This is an oligopoly. There are few firms, large firms dominate, products are different, there are barriers to entry (high start-up costs and marketing budgets) and the firms use non-price competition.

Collusion and cartels

Suppose Nexa, Orbi and Pelo secretly agree to charge the same high price. Customers have nowhere cheaper to go, and all three firms earn more profit. This is collusion. When the firms agree formally to fix prices or limit output, they form a cartel. Cartels are bad for consumers, who pay more. Collusion is also against the law in many countries. How governments deal with it is covered in the lesson on regulating competition.

Advantages of oligopoly

Choice: there are several firms with different products and brands, so consumers can choose between them.
Quality: firms use non-price competition, so they work hard to make their product better than their rivals' products.
Innovation: the big firms make large profits, which can pay for research and new products. They also want a new feature that rivals do not have.
Price: price competition between firms can bring lower prices, and in a price war prices can fall a long way.

Disadvantages of oligopoly

If the few big firms secretly agree high prices, it's a cartel and customers pay more

Collusion and cartels fixing high prices: consumers pay more and have less choice than they would in a competitive market.
Price wars: each firm keeps cutting prices to beat the others. Customers enjoy low prices at first, but the firms make small profits or losses. Weaker firms may close, which leaves fewer firms and less choice.
Choice and quality: if firms collude, they have less reason to offer more choice or better quality.
Innovation: firms may spend more on advertising than on new ideas, and barriers to entry keep out new firms that might bring them.

Common mistakes

Calling any market with a few firms a cartel. A cartel needs an agreement to fix prices or limit output.
Saying firms in an oligopoly never compete on price. They often avoid it, but price competition and price wars do happen.
Mixing up oligopoly (a few firms) with monopoly (one firm dominates).
Saying only advantages or only disadvantages. Exam answers need both sides.

Exam-style question

In the country of Merenia, four airlines carry 85% of passengers on domestic flights. Each airline has its own brand and spends heavily on advertising. Last year the airlines agreed secretly to keep fares high.

(a) Define the term 'oligopoly'. [2 marks]

(b) Identify two features of an oligopoly shown in the information. [2 marks]

(d) Analyse one way in which an oligopoly can benefit consumers. [4 marks]

Model answer

(a) An oligopoly is a market dominated by a small number of large firms (2).

(b) Few firms: there are only four airlines (1). Non-price competition: each airline advertises heavily and has its own brand (1). (Large firms dominate, with 85% of passengers, would also be correct.)

(c) The airlines have colluded to keep fares high (1). Consumers must pay higher prices than they would if the airlines competed (1). With no cheaper option available, consumers have less choice and some may not be able to afford to fly (1).

(d) Oligopolists use non-price competition (1), so each airline tries to make its service better, for example with more comfortable seats (1). Consumers therefore get higher quality (1) and a greater choice of airlines and services (1).

Exam tip

In part (c), use the information given. Name the collusion in the question and then explain what it does to price and choice.

Recap

An oligopoly is a market dominated by a small number of large firms.
Features: few firms, large firms dominate, different products, barriers to entry, collusion, non-price competition and price competition.
Advantages: choice, quality, innovation and sometimes lower prices.
Disadvantages: collusion and cartels fixing high prices, and price wars.

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