AQA A-level Economics: Oligopoly: interdependence, collusion and kinked demand (7136) – Revision Notes

These notes condense the Oligopoly sub-section of the AQA A-level Economics specification (7136, version 1.3), numbered 3.1.5.5 on the AQA website and 4.1.5.5 in the combined PDF. For full explanations and longer worked examples, read the study guide, then test yourself with the practice set. Related pages: the course hub, the checklist and the free diagnostics. All figures here are invented for revision.

Key definitions

Term	Meaning
Oligopoly (structure)	A market with a few dominant firms, high concentration and barriers to entry
Oligopoly (conduct)	A market where firms behave interdependently: watching, matching, leading or colluding
Concentration ratio	Combined market share of the n largest firms
Interdependence	A firm’s best choice depends on rivals’ reactions
Uncertainty	The firm cannot be sure how rivals will react
Collusive oligopoly	Firms coordinate to limit competition, openly or tacitly
Non-collusive oligopoly	Firms compete and decide independently
Cooperation	Joint action that does not restrict competition (shared standard, joint project)
Collusion	Agreement or understanding that restricts competition (prices, output, markets)
Cartel	Formal agreement to fix price or restrict output
Price leadership	One firm moves price, the others follow
Price war	Repeated price cuts as rivals retaliate
Non-price competition	Rivalry through branding, quality, service, advertising, innovation

Must-know distinctions

• Structure versus conduct. Structure is how the market looks (few firms, high barriers). Conduct is how firms behave (interdependent, collusive). A market can fit one and not the other.
• Collusion versus cooperation. Judge the effect on competition. Collusion restricts it; cooperation need not.
• Overt versus tacit collusion. Overt means an explicit agreement. Tacit means an understanding, often through price leadership.
• Dominant-firm versus barometric leadership. Dominant: the largest firm sets price and others follow. Barometric: a respected firm reads the market first.
• Illustration versus theory. The kinked demand curve illustrates interdependence. It is not the only model of oligopoly.

Concentration ratio: method

1. Find the total market sales (or use shares that sum to 100%).
2. Rank firms from largest to smallest.
3. Add the top n sales or shares.
4. Divide by the total and multiply by 100 if you used sales.

Reminder (invented). Five firms hold 40%, 25%, 15%, 12% and 8%. CR2 = 40 + 25 = 65%. CR3 = 65 + 15 = 80%. If the top two merge, one firm holds 65%, so CR1 = 65%.

Limits: hides the split within the group; depends on market definition (local, national, global); ignores imports; says nothing about conduct.

Kinked demand: method in steps

1. Draw demand with a kink at the current price.
2. Above the kink: elastic (rivals do not follow a rise).
3. Below the kink: inelastic (rivals match a cut).
4. Marginal revenue has a vertical gap at the kink output.
5. If marginal cost cuts the gap, price and output stay the same.
6. Add the limits: no explanation of how the price was set, and it ignores collusion.

Reminder (invented). Price £12, output 50. Above: P = 17 − 0.1Q. Below: P = 27 − 0.3Q.

• PED above = −10 × (12 / 50) = −2.4. PED below = −(1 / 0.3) × (12 / 50) = −0.8.
• MR above = 17 − 0.2 × 50 = 7. MR below = 27 − 0.6 × 50 = −3. The gap runs from −3 to 7.
• Marginal cost of £4 gives profit (12 − 4) × 50 = £400. At £6 it is £300. Price stays at £12 in both.
• Raise to £14: Q = (17 − 14) / 0.1 = 30, revenue £420, below £600. Cut to £9: Q = (27 − 9) / 0.3 = 60, revenue £540, below £600.
• If marginal cost reaches £9, it cuts the upper MR: 17 − 0.2Q = 9 gives Q = 40 and price 17 − 4 = £13.

Cartel and collusion: method

1. Treat the firms as one monopolist: set MR = MC.
2. Read price from the market demand curve.
3. Share output or profit by quota.
4. Test the incentive to cheat.

Reminder (invented). Demand P = 80 − Q (£, thousand units), marginal cost £20 for both firms. MR = 80 − 2Q = 20, so Q = 30 and P = 80 − 30 = £50. Joint profit = (50 − 20) × 30 = £900 thousand, which is £450 thousand each. If one firm secretly cuts to £45, market demand is 35. If it takes 30 units and the rival 5, profits are 25 × 30 = £750 thousand and 25 × 5 = £125 thousand. Cheating pays until the rival retaliates, and the total falls from £900 thousand to £875 thousand.

Why cartels break down: incentive to cheat, many members, different costs, falling demand, new entrants, detection and fines, low trust.

Conditions that favour collusion: few firms, high concentration, similar costs, homogeneous product, stable demand, high barriers, easy monitoring of prices.

Price wars and non-price competition

• Price war: each cut raises sales but narrows the margin. Profit falls as price approaches marginal cost. Good for consumers now, risky if rivals exit and prices rise later.
• Why non-price competition: price cuts are copied fast; brand loyalty makes demand less elastic; quality and service are harder to match; supernormal profit pays for it.
• Advertising ratio (invented): £12 million advertising on £240 million revenue is 12 / 240 = 5% of revenue.
• Cost view: advertising is a fixed cost that raises average total cost unless it raises sales enough.

Interdependence and uncertainty: chain of reasoning

1. A firm’s profit depends on its own price and on rivals’ prices.
2. It cannot know how rivals will respond, so it faces uncertainty.
3. It therefore avoids unpredictable price changes, so prices become stable.
4. Competition moves to branding, quality and service.
5. Agreement removes the uncertainty, which tempts firms to collude.
6. Collusion lets firms act as a monopolist and raise their joint profit, but each member can gain by cheating, so the agreement is fragile.

Use this chain whenever a question asks about the significance of interdependence. Add a context point at each step.

Factors affecting behaviour

Outcome	Factors that push it up	Factors that push it down
Price	High concentration, collusion, high barriers, strong brands	Price war, threat of entry, regulation, buyer power
Output	Rivalry, low barriers, falling costs	Quotas, collusion
Investment	High profit, secure position, expected return	Uncertainty, short-term targets, fear of copying
Research	Supernormal profit, patents, race for a new product	Complacency, easy copying
Advertising	Differentiated products, rival ad spend, brand value	Homogeneous goods, high price competition

Advantages and disadvantages

Advantages: economies of scale, funds for research and investment, variety and quality through non-price competition, price stability.

Disadvantages: higher prices, restricted output, collusion risk, complacency, costly advertising, barriers that limit entry.

Evaluation points: depends on how much profit is reinvested, how strong rivalry is, how long barriers last and how active regulators are. Always end with a supported judgement.

Quick self-test

1. Shares of 40%, 25%, 15%, 12% and 8%: what is the three-firm concentration ratio?
2. Give one reason why a high concentration ratio does not prove collusion.
3. Define oligopoly in terms of conduct.
4. Above the kink, is demand elastic or inelastic, and why?
5. In the kinked model, MR above the kink is 2 and below it is −2 at the kink output. What happens if marginal cost rises from 0 to 1?
6. Give one difference between cooperation and collusion.
7. Demand P = 80 − Q, marginal cost £20. What are the cartel price and output?
8. State two reasons a cartel might collapse.
9. A firm spends £12 million on advertising and earns £240 million revenue. What is the advertising to revenue ratio?
10. Name two features that distinguish barometric from dominant-firm leadership.

Answers

1. 40 + 25 + 15 = 80%.
2. It reflects market shares only; firms may still compete hard, and the market may be defined narrowly or broadly.
3. A market where firms act interdependently, matching, leading or colluding on price and output.
4. Elastic, because rivals do not follow a price rise so the firm loses customers.
5. Nothing: price and output stay the same, as MC remains inside the gap between −2 and 2.
6. Cooperation does not restrict competition; collusion does (for example by fixing prices).
7. Q = 30 and P = £50.
8. Any two: incentive to cheat, falling demand, entry, different costs, detection and fines.
9. 12 / 240 = 5%.
10. Barometric: a respected, not necessarily largest, firm moves first because it reads conditions. Dominant: the largest, often lowest-cost, firm sets price.

Where marks are usually lost

• Defining oligopoly only as “a few firms” and ignoring interdependence.
• Mixing up the n largest firms with a single firm’s share.
• Drawing the kink the wrong way round, with inelastic demand above it.
• Saying the kinked model explains all oligopoly behaviour.
• Treating cooperation and collusion as identical.
• Listing advantages and disadvantages with no context and no judgement.
• Forgetting that cheating makes cartels unstable.
• Giving numbers without units or workings.

Official syllabus

AQA, AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, first teaching from September 2015.