3.4.4 - Oligopoly

Features and Concentration

The defining characteristic is interdependence. In perfect competition, one firm's decisions do not matter much to the rest of the market. In oligopoly, they do. A price cut, an advertising campaign, or a product launch by one large firm can trigger a direct response from its rivals, so strategy matters from the start.

Oligopolies usually share four broad features. First, a few firms hold most of the market. Second, barriers to entry are often high, so new firms cannot easily challenge the established businesses. Third, firms are interdependent rather than acting independently. Fourth, products may be differentiated, as in cars or smartphones, or relatively homogeneous, as in petrol, cement, or steel.

Barriers matter because they protect market power and profit. Internal economies of scale can leave new entrants with much higher average costs than the incumbents. Brand loyalty, very high capital requirements, patents or licences, and control over key distribution channels or resources can all keep rivals out. Exit can also be costly if firms have sunk spending in networks, branding, or specialist assets, so firms may be trapped in the market as well as protected within it.

Concentration ratios help measure how dominated a market is. If the four largest firms in a market have sales of 30, 25, 15, and 10 out of a total market size of 100, the 4-firm concentration ratio is 80%. A high ratio suggests a market is oligopolistic, while a lower ratio suggests stronger competition. As a rough guide:

Concentration ratios are useful to regulators because they give a quick picture of market power and help when assessing mergers. But they are not enough on their own. The answer depends on how the market is defined, the ratio says nothing directly about how easy entry is, and it does not show whether the top firms are evenly sized or whether one firm dominates the rest.

Collusion and Price Leadership

Oligopolists face a basic choice: compete or coordinate. If firms choose not to coordinate, the market behaves as a non-collusive oligopoly and rivalry becomes more explicit. If they do coordinate, they may be able to act more like a collective monopoly by restricting output, raising price, and reducing uncertainty.

Firms may want to collude because destructive price competition hurts everybody. Coordination can make profit more stable, reduce the risk of repeated price wars, and raise joint profit. Collusion is most likely when there are only a few firms, costs and products are similar, barriers to entry are high, demand is fairly stable, and firms can monitor each other's behaviour closely.

There are two main forms. Overt collusion is a formal agreement, usually through a cartel, to fix price, divide the market, or agree quotas. A cartel tries to behave like one large monopoly. Tacit collusion is looser: firms reach a similar outcome without any explicit agreement. That might happen through repeated observation, mutual understanding, or simply knowing that aggressive rivalry will damage everyone.

The most common tacit form is price leadership. Under dominant-firm price leadership, the largest or lowest-cost firm moves first and smaller firms follow. Under barometric price leadership, a firm with a reputation for reading market conditions well changes price first and rivals treat that move as a signal. Tacit collusion can also appear through unwritten understandings, such as not pushing advertising too far, not poaching a rival's core customers, or not invading each other's strongest regional markets too aggressively.

Firms may still reject collusion. Formal cartels are illegal in most developed economies, so there is the risk of investigation and fines. Even without the law, every member is tempted to cheat by undercutting the agreed price or producing more than its quota. A low-cost firm or a strongly differentiated brand may prefer open competition because it expects to win market share anyway. The more profitable the collusive outcome is, the greater the incentive for one firm to break ranks first.

OPEC is the classic cartel example: its member countries agree production quotas to support the oil price. Its agreements also show how fragile collusion can be. In March 2020, OPEC and Russia failed to agree deeper output cuts, Saudi Arabia cut its prices and raised output, and the oil price fell by about a quarter in a single day; a month later the producers agreed a record cut of 9.7 million barrels a day.

In the UK, competition policy and the Competition and Markets Authority are designed to stop explicit price-fixing and market-sharing agreements, which is why tacit coordination is so important in oligopoly analysis. The fuel surcharge case shows both risks of overt collusion. Between 2004 and 2006, British Airways and Virgin Atlantic coordinated the fuel surcharges on their long-haul flights, which rose from about £5 to £60 on a return ticket. Virgin then reported the arrangement to the competition authority, so under its leniency policy it was not fined, while British Airways was fined £58.5 million.

Game Theory and Interdependence

Game theory makes interdependence easier to analyse. The firms are the players, the options open to them are the strategies, and the resulting profits are the payoffs. A payoff matrix shows what each firm gets under every possible combination of choices.

Firms do not always think about risk in the same way. A maximax strategy goes for the best possible payoff. A maximin strategy chooses the option with the least damaging worst-case outcome. In oligopoly, maximin is often attractive because firms worry about what rivals might do if they react aggressively.

The classic prisoner's dilemma is about two suspects deciding whether to confess, but the same logic works for pricing. Imagine two firms choosing whether to keep price high or cut it:

If both firms keep price high, they do best jointly. But each firm can do even better individually by cutting price while the other keeps price high. That means cutting price is the dominant strategy because it gives the better payoff whatever the rival does. Once both firms reason that way, they end up with the lower-profit outcome where both cut price. The matrix also shows the two attitudes to risk. A maximax firm compares each strategy's best payoff (10m for keeping price high, 12m for cutting) and cuts price. A maximin firm compares each strategy's worst payoff (2m for keeping price high, 5m for cutting) and also cuts price.

That final position is a Nash equilibrium: given what the other firm is doing, neither can improve its payoff by changing strategy alone. This is why collusion is hard to sustain. Even when cooperation would make both firms better off, each has an incentive to defect first.