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

This guide teaches the oligopoly content of the AQA A-level Economics specification (7136, specification version 1.3). It covers the sub-section called Oligopoly, numbered 3.1.5.5 on the AQA website and printed as 4.1.5.5 in the combined AS and A-level PDF. Every figure below is invented for practice, with made-up firms and markets, and is not real data.

Work through it with the revision notes and the practice set. For the wider unit, see the individuals, firms, markets and market failure guide, the course hub and the checklist. To find weak spots first, try the free diagnostics.

What the specification asks for

Specification point	Taught in
Characteristics; markets differ in number of firms, differentiation and entry	Section 1
Structure versus conduct definitions	Section 1
Concentration ratios and how to calculate one	Section 2
Interdependence and uncertainty	Section 3
Collusive versus non-collusive; cooperation versus collusion	Section 4
Cartels, price agreements, price leadership	Section 5
Kinked demand curve model	Section 6
Price wars; reasons for non-price competition	Section 7
Barriers to entry; factors affecting prices, output, investment, research and advertising	Section 8
Advantages and disadvantages of oligopoly	Section 9

1. Characteristics, structure and conduct

An oligopoly is a market dominated by a few large firms. The specification stresses how widely oligopolistic markets differ: in how many firms there are, how differentiated the products are and how easily new firms can enter. A market with three producers of an identical product and a market with six producers of heavily branded goods are both oligopolies.

Typical features:

• a few firms hold most of the market, so each has real market power
• barriers to entry stop new firms from eroding supernormal profit
• products may be identical (cement, say) or differentiated (branded snacks)
• firms are interdependent: one firm’s decision affects the others
• prices tend to be stable, with competition shifting to non-price methods

Defined by structure: a market with a high level of concentration, few dominant sellers and barriers to entry. Defined by conduct (behaviour): a market in which firms act interdependently, watching rivals, matching or leading price changes, or colluding. The two can diverge. A market with many small firms may behave in a collusive way, and a concentrated market may be fiercely competitive. Say which definition you are using, and use the other as a contrast.

2. Concentration ratios

An n-firm concentration ratio adds together the market shares of the n biggest firms in the market.

Worked example (invented). The market for ready-made soups in Country A has eight firms. Sales in a year, in millions of units: W 34, X 22, Y 15, Z 10, V 8, U 5, T 4, S 2.

1. Market total: 34 + 22 + 15 + 10 + 8 + 5 + 4 + 2 = 100 million units, so each figure is also a percentage share.
2. CR3 = 34 + 22 + 15 = 71%.
3. CR4 = 71 + 10 = 81%.

When shares are not given, divide by total market sales. If the top four firms sell 96, 84, 60 and 36 (£ million) in a market worth £480 million: CR2 = (96 + 84) / 480 = 37.5%, and CR4 = 276 / 480 = 57.5%.

Merger effect. If Y and Z merge, the new firm holds 15 + 10 = 25%. The three biggest are then W 34, X 22 and the merged firm 25, so CR3 = 34 + 25 + 22 = 81%, up from 71%.

Limits. A ratio hides how the shares are split inside the top group, depends on how the market is defined, may ignore imports, and says nothing about behaviour. A low ratio in a national market can sit alongside local monopolies. A high ratio does not prove collusion.

3. Interdependence and uncertainty

Interdependence means a firm cannot choose its best price or output without considering how rivals will respond. Uncertainty follows: the firm does not know the reaction. Several results flow from it.

• Price stability. Firms avoid price changes they cannot predict.
• Non-price competition. Rivals find it harder to copy a new brand image than a lower price.
• An incentive to collude. Agreement replaces guesswork with a known outcome.
• Strategic behaviour. Firms may signal intentions or threaten retaliation.

4. Collusive and non-collusive oligopoly; cooperation and collusion

Non-collusive oligopoly: firms compete and decide independently, though still watching rivals. Collusive oligopoly: firms coordinate to limit competition, openly (an agreement) or tacitly (an unspoken understanding that all follow).

Cooperation is working together for a purpose that does not harm competition, for example sharing a safety standard or a joint research project that rivals could not afford alone. Collusion is an agreement or understanding that restricts competition, usually on prices, output or markets. In the UK, price-fixing cartels are unlawful under competition law. Cooperation can still be harmful if it spills over into agreed prices, so judge the effect on competition.

The specification wants you to recognise that collusion may allow oligopolists to act as a monopolist and maximise their joint profits.

5. Cartels, price agreements and price leadership

A cartel is a formal agreement among firms to fix price or restrict output (often with quotas). A price agreement can be a one-off arrangement, such as agreeing a minimum price. Price leadership is when one firm moves price and the others follow, without any written agreement. It takes two forms:

• Dominant-firm leadership: the largest firm, often with the lowest costs, sets the price and smaller firms follow.
• Barometric leadership: a firm that is respected for reading market conditions moves first, and others follow because it reflects costs and demand.

Worked example (invented duopoly). Market demand is P = 100 − Q (P in £, Q in thousand units). Each firm’s marginal cost is constant at £20.

• Joint profit maximisation: marginal revenue = 100 − 2Q. Set equal to 20, so Q = 40 and P = 100 − 40 = £60.
• Joint profit = (60 − 20) × 40 = £1,600 thousand. Sharing equally gives 20 thousand units and £800 thousand each.

The agreement is fragile. Suppose A secretly cuts to £55 and takes 40 of the 45 thousand units demanded at that price, leaving B with 5. A earns (55 − 20) × 40 = £1,400 thousand. B earns 35 × 5 = £175 thousand. Cheating pays until B retaliates; if B matches £55, demand is 45, each sells 22.5 thousand and each earns 35 × 22.5 = £787.5 thousand, which is less than £800 thousand. Cartels also break down when there are many members, when firms have different costs, when demand falls, or when entrants appear. Detection and fines weaken them as well.

6. The kinked demand curve model

The specification says to use this model only as an illustration of interdependence between firms, and not to teach it as the only model of oligopoly. The idea:

• If the firm raises its price, rivals do not follow, so it loses customers: demand above the kink is elastic.
• If it cuts price, rivals match to avoid losing share, so it gains few customers: demand below the kink is inelastic.

The demand curve therefore has a kink at the current price. The marginal revenue curve has a vertical gap at the output where the kink sits. If marginal cost passes through that gap, profit-maximising price and output do not change.

Worked example (invented). Current price is £10 and output 40 units. Above the kink, P = 14 − 0.1Q. Below it, P = 30 − 0.5Q. Check both give £10 at Q = 40: 14 − 4 = 10 and 30 − 20 = 10.

1. Elasticity above the kink: dQ/dP = −10, so PED = −10 × (10 / 40) = −2.5 (elastic).
2. Elasticity below the kink: dQ/dP = −2, so PED = −2 × (10 / 40) = −0.5 (inelastic).
3. MR above: 14 − 0.2Q = 14 − 8 = 6. MR below: 30 − Q = 30 − 40 = −10. So the MR gap runs from −10 to 6 at Q = 40.
4. If marginal cost moves anywhere between −10 and 6, output stays at 40 and price at £10. At MC = £2, profit is (10 − 2) × 40 = £320. At MC = £5 it is (10 − 5) × 40 = £200. Price has not moved.
5. Test the incentives. Raise price to £11 and rivals stay put: Q = (14 − 11) / 0.1 = 30, revenue £330, below £400. Cut to £9 and rivals match: Q = (30 − 9) / 0.5 = 42, revenue £378, below £400.
6. If MC rises above 6, to £7, it cuts the upper MR curve: 14 − 0.2Q = 7 gives Q = 35 and price 14 − 3.5 = £10.50. Price finally moves.

Sketch (price on the vertical axis, quantity on the horizontal):

Price
 14 *
    |  *  (flatter: elastic)
 10 |------K
    |        \  (steeper: inelastic)
    |          \
    +--------------------- Quantity
              40

Weaknesses: it does not explain how the original price was set; evidence of price rigidity is mixed; rivals may follow price rises when costs rise for everyone; and it ignores collusion, entry and non-price rivalry.

7. Price wars and non-price competition

A price war is a spiral of price cuts. Using the duopoly above (demand P = 100 − Q, MC £20, firms share equally):

Price (£)	Market output (thousand)	Profit per firm (£ thousand)
60	40	800
55	45	787.5
40	60	600
30	70	350
20	80	0

Each cut raises sales but cuts the margin by more, so profit falls to zero at price equal to marginal cost. Price wars hurt firms and help consumers in the short run, but they may drive out weaker firms, and the survivors may then raise prices again.

Reasons for non-price competition: price cuts are copied quickly and cut everyone’s profit; branding builds loyalty and makes demand less elastic; quality and service are harder to match; and supernormal profit funds the spending.

Worked example (invented). A firm has fixed costs of £40 million and sells 50 million units. Fixed cost per unit is 40 / 50 = £0.80. Adding £10 million of advertising raises it to 50 / 50 = £1.00, an extra 20p per unit. The advertising pays only if it raises demand or lets the firm charge more.

8. Barriers to entry and factors affecting behaviour

Barriers include economies of scale, brand loyalty, high sunk and start-up costs, control of distribution, patents, and the threat of a price war against an entrant. The higher the barriers, the more secure the supernormal profit.

What shapes prices, output, investment, research and advertising?

• Number of firms and concentration: fewer firms, easier collusion, higher price.
• Product differentiation: more differentiation means more advertising and a more inelastic demand.
• Barriers to entry: high barriers allow supernormal profit and long-term investment; low barriers push firms towards limit pricing.
• Costs and economies of scale: low-cost leaders can set prices that rivals follow.
• Rivals’ expected reactions and the threat of regulators.
• Size of profits: large retained profit can fund research and development, but secure profit can also reduce the urge to innovate.

9. Advantages and disadvantages

Advantages: economies of scale lower costs; supernormal profit can fund research and development and investment; non-price competition can raise quality and variety; price stability helps planning; the threat of rivals’ reactions can restrain prices.

Disadvantages: higher prices and lower output than in competitive markets; collusion harms consumers; productive inefficiency or complacency when competition is weak; large advertising spend raises costs; high barriers protect profit; fewer entrants means less choice and less dynamic pressure.

Evaluation chain. Barriers → supernormal profit → funds research → new product. Whether this beats the cost of higher prices depends on how much is actually reinvested, how strong rivalry is, the regulator’s attitude, and the time period. A well-evaluated answer reaches a judgement.

Common errors

• Calling the kinked demand curve the theory of oligopoly. It illustrates interdependence.
• Using the share of one firm instead of the combined share of the n largest.
• Treating collusion and cooperation as the same.
• Saying a cartel always lasts. Incentives to cheat are strong.
• Listing advantages and disadvantages with no judgement.

Official syllabus

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