Pearson Edexcel International Advanced Level Economics: Oligopoly and collusion (YEC11) – Revision Notes

These notes condense section 3.3.3 item 5, points a to g (oligopoly), of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. The specification labels Unit 3, Business behaviour, an IAL compulsory unit: it is the extra International A2 content, not part of the International AS. Full explanations and longer examples are in the study guide. Test yourself with the practice questions. See also the course hub, the checklist and the diagnostics. All figures are invented.

Key terms

Term	Meaning
Oligopoly	A market dominated by a few large, interdependent firms with barriers to entry
Interdependence	One firm’s best choice depends on what rivals do
Collusion	Firms co-operate to restrict competition, formally or tacitly
Cartel	A formal agreement on price or output
Price leadership	One firm sets price and others follow
Price war	Repeated price cuts to win share
Predatory pricing	Price below cost to force a rival out
Limit pricing	Price kept low, above own cost, so an entrant would lose money
Non-price competition	Competing on advertising, quality, service and similar
Dominant strategy	The best choice whatever the rival does

Assumptions (5a)

• Few firms with a large combined share
• Significant barriers to entry and exit
• Identical or differentiated products
• Price makers
• Interdependence and uncertainty about rivals
• Usually profit maximising

Barriers to entry and exit (5b)

Barrier	How it deters
Economies of scale	Entrant’s unit cost is higher
Limit pricing	Entrant would lose at the incumbent’s price
Patents	Exclusive legal right to use an invention
Branding	Loyalty; entrant must spend heavily
Sunk costs	Cannot be recovered on exit, so entry is risky
Legal	Licences, regulation, exclusive rights

Test for limit pricing. The price must be above the incumbent’s average cost and below the entrant’s average cost at its entry scale. If the incumbent’s cost is 5 and the entrant’s is 8, a price between 5 and 8 deters entry.

Game theory (5c)

Method in steps

1. For each rival choice, find your best reply.
2. If the same choice is best every time, it is a dominant strategy.
3. If both have a dominant strategy, that pair is the likely outcome.
4. Compare it with the joint-best outcome. If they differ, explain why co-operation is hard to keep.

Worked reminder: an advertising game. Firms Mist and Reed each choose to advertise (A) or not (N). Profits in millions are (Mist, Reed).

	Reed advertises	Reed does not
Mist advertises	(30, 30)	(55, 20)
Mist does not	(20, 55)	(45, 45)

• If Reed advertises, Mist gets 30 by advertising, 20 by not. Advertise is better.
• If Reed does not, Mist gets 55 by advertising, 45 by not. Advertise is better.
• Advertising is dominant for both, so the outcome is (30, 30), total 60. Neither advertising gives (45, 45), total 90.

Both spend on advertising and neither gains share. An agreement not to advertise would help both, but each has a reason to break it. The game is one-off: a repeated game can make co-operation easier because cheating can be punished.

Collusion (5c and 5d)

Cartel method. Find market output where MR = MC for the whole market. Read price from demand. Profit = (P − average cost) × Q. Share output between members.

Worked reminder. Demand is P = 70 − Q and marginal cost is 10. MR = 70 − 2Q = 10, so Q = 30 and P = 70 − 30 = 40. Profit = (40 − 10) × 30 = 900. Without collusion the competitive output would be Q = 60 (P = MC = 10).

Why cartels break down: each member gains by secretly selling more; detection is hard; demand or cost changes; new entrants appear; authorities may act.

Types: formal (cartel) or tacit (price leadership, following rivals’ prices).

Collusion is more likely when

• there are few firms and they know each other
• products are similar, so a price is easy to compare
• demand and costs are stable
• entry is difficult
• competition law is weak or rarely enforced

Collusion is less likely when there are many firms, products differ widely, cost levels differ, demand is volatile, or detection brings heavy penalties.

Price leadership. A dominant leader is the largest firm. A barometric leader is followed because it judges the market well. Followers gain price stability and avoid a price war. The risk is that the leader misjudges demand, or a follower undercuts.

Price war chain. One firm cuts price, so rivals match, so margins fall, so weaker firms may exit, so concentration can rise and prices may later rise again.

Stakeholders

	Gains	Losses
Producers	Higher, steadier profit	Fines, cheating, weaker cost control
Consumers	More stable supply	Higher prices, less choice
Workers	Job security in profitable firms	Fewer jobs if output falls
Governments	Possibly more tax revenue	Enforcement cost, welfare loss

Price competition (5e)

Price war and elasticity. Market demand has PED of −0.5. One firm cuts price from 10 to 9 (−10%) and rivals match.

• Quantity rises by 0.5 × 10% = 5%, from 1,000 to 1,050.
• Revenue before = 10 × 1,000 = 10,000. Revenue after = 9 × 1,050 = 9,450.
• Revenue falls by 550, or 5.5%.

When all firms match, nobody gains share and total revenue falls because demand is inelastic. If PED were −2, a 5% cut would raise quantity by 10% and revenue by 4.5%, so a matched price cut would be less harmful.

Predatory pricing. Price below cost. It pays only if the rival leaves, entry stays hard, and the later gain exceeds the earlier loss. Competition authorities may treat it as abuse of dominance.

Worked reminder: predatory pricing. A dominant firm has average cost 9 and sells 150 units. It cuts price to 6, so it loses (6 − 9) × 150 = 450 a period. After 2 periods the total loss is 900. When the rival leaves, price rises to 13, giving (13 − 9) × 150 = 600 a period. Recovery takes 900 ÷ 600 = 1.5 periods.

Limit pricing. Lower profit now to keep future profit. The threat must be believable: the incumbent needs low enough cost, and spare capacity helps.

Non-price competition (5f and 5g)

Method	Effect
Advertising and branding	Awareness and loyalty; may make demand less elastic
Quality	Justifies a higher price
Endorsement	Borrowed trust
Product placement	Product seen in other media
After-sales service	Repeat purchase

Break-even. A campaign costs 0.9 million. Extra profit per unit before the campaign cost is 2.5. Break-even extra sales = 900,000 ÷ 2.5 = 360,000 units.

Exam link. Pair each point with context: name the market, say whether products are identical or differentiated, and give one clear consequence for price, output or profit.

Evaluation points. Price competition: lower prices help consumers, but squeeze margins, investment, wages and supplier prices. Non-price competition: more choice and quality, but costly, may only shift customers between brands, and can raise barriers to entry. Judge by elasticity, the time frame, and how easily rivals copy.

Quick self-test

1. State two assumptions of oligopoly.
2. What is a dominant strategy?
3. Why is the advertising game above a dilemma?
4. Demand is P = 70 − Q and marginal cost is 10. What are the cartel price and output?
5. Why might a cartel member cheat?
6. Give one reason why price leadership is tacit collusion.
7. With PED of −2, a firm cuts price by 5%. By how much does revenue change?
8. Distinguish predatory pricing from limit pricing.
9. Name two barriers to exit.
10. State one benefit and one cost of advertising for consumers.

Answers

1. Any two: few large firms, high barriers to entry, interdependence, price makers.
2. The best choice for a firm whatever its rival does.
3. Each firm’s dominant strategy leads to (30, 30), but not advertising gives (45, 45).
4. Q = 30 and P = 40.
5. Selling more at the cartel price raises its own profit if rivals keep to the agreement.
6. Firms avoid competing on price without any formal agreement, by following the leader.
7. Quantity rises 10%, so revenue rises by 1.10 × 0.95 − 1 = 4.5%.
8. Predatory pricing is below cost to remove a rival; limit pricing is above own cost but below the entrant’s cost.
9. Sunk costs and redundancy costs (also long contracts).
10. Benefit: information or choice. Cost: spending paid for in the price, or persuasion.

Where marks are usually lost

• Writing “few firms” without linking it to interdependence
• Giving the payoff matrix outcome without checking best replies
• Confusing the cartel outcome with the Nash outcome
• Stating that collusion raises price without an effect on output and welfare
• Mixing up price war, predatory pricing and limit pricing
• Not using the PED when judging a price cut
• Listing non-price methods without a consequence for demand or entry
• Evaluation that is one-sided or missing
• Using a one-off game to explain a market where firms meet again and again, without noting the difference

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, Pearson Education Limited: section 3.3.3, Market structures and contestability, item 5, Oligopoly (points a to g), in Unit 3, Business behaviour.