Pearson Edexcel International Advanced Level Economics: Oligopoly, collusion and competition (YEC11)

This guide covers oligopoly, interdependence, collusion and price and non-price competition: section 3.3.3 item 5, points a to g, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. The specification places Units 1 and 2 in the International AS and Units 3 and 4 in the extra International A2 content. This topic sits in Unit 3, Business behaviour, which the specification labels an IAL compulsory unit, so it is for the full International Advanced Level only. All firms, markets and figures below are invented for illustration.

Use it with the revision notes and the practice questions. Related pages: the course hub, the checklist, elasticity of demand and the 10-minute diagnostics.

What you must cover

Point	What you must be able to do
5a	State the assumptions of oligopoly
5b	Explain barriers to entry and exit: economies of scale, limit pricing, patents, branding, sunk costs, legal
5c	Use a two-firm, two-outcome game; explain collusive and non-collusive behaviour, cartels, price leadership, price wars
5d	Weigh the costs and benefits of collusion for producers, consumers, workers and governments
5e	Explain price competition: price wars, predatory pricing, limit pricing
5f	Explain non-price competition: advertising and branding, quality, endorsement, product placement, after-sales service
5g	Weigh price and non-price competition for firms, consumers, employees and suppliers

5a Assumptions of oligopoly

An oligopoly is a market in which a handful of big sellers hold most of the sales. The usual assumptions are:

• a small number of firms hold most of the market, so each one’s decisions matter to the others
• barriers to entry and exit are significant
• products may be identical (cement) or differentiated (mobile handsets)
• firms are price makers, with some control over price
• firms are interdependent: each must guess how rivals will respond before it changes price, output or advertising
• firms normally aim to maximise profit, though a firm may choose a different objective such as protecting its market share

Interdependence is the key idea. In perfect competition a firm ignores rivals. In oligopoly it cannot.

5b Barriers to entry and exit

A barrier is anything that makes it harder for a new firm to enter, or an existing firm to leave.

• Economies of scale. Large incumbents spread fixed costs over high output, so their average cost is lower. A small entrant starts with higher unit costs and cannot match the price.
• Limit pricing. The incumbent sets price below the profit-maximising level but above its own average cost, so an entrant would make a loss.
• Patents. Legal protection for an invention gives exclusive use for a period. Rivals cannot copy the product.
• Branding. Loyal customers and a strong identity mean an entrant must spend heavily on marketing to win sales.
• Sunk costs. Spending that cannot be recovered on exit, such as specialised equipment or advertising already done, makes entry risky and exit expensive.
• Legal barriers. Licences, regulation or government grants of exclusive rights restrict who may operate.

Worked example: limit pricing. In a market with two big producers, Alpha’s long-run average cost at 100 units is 9. A new entrant would start at 20 units with average cost 14.

• If Alpha charges 18, the entrant earns (18 − 14) × 20 = 80 and is attracted in.
• If Alpha charges 12, the entrant earns (12 − 14) × 20 = −40 and stays out.
• Alpha still earns 12 − 9 = 3 per unit, but it gives up 18 − 12 = 6 per unit in the short run.

The incumbent sacrifices some current profit to protect future profit. Limit pricing only works if the entrant believes the low price will continue.

5c Interdependence, game theory and collusion

A two-firm, two-outcome game

Alpha and Beta each choose a high price (H) or a low price (L). Profits are in millions a year, written (Alpha, Beta).

	Beta high	Beta low
Alpha high	(40, 40)	(10, 60)
Alpha low	(60, 10)	(25, 25)

If Beta charges high, Alpha earns 60 by charging low rather than 40. If Beta charges low, Alpha earns 25 by charging low rather than 10. Low is Alpha’s dominant strategy, and the game is symmetrical for Beta. Both choose low and end at (25, 25), although (40, 40) was available. This is the prisoners’ dilemma: self-interest leads to a worse joint result (50 in total, against 80).

Why firms collude, or do not

Collusive behaviour means firms co-operate to limit competition. Reasons: higher joint profit, less uncertainty, and protection from price wars. It can be formal (a cartel with agreed output or price) or tacit, with no written agreement.

Non-collusive behaviour is more likely when there are many firms, products are very different, demand is volatile, costs differ widely, or competition law is enforced. Each firm then acts alone.

Worked example: a cartel and the incentive to cheat

Market demand is P = 150 − Q. Two firms each have constant marginal cost of 30.

• Joint profit maximisation: MR = 150 − 2Q = 30, so Q = 60 and P = 150 − 60 = 90.
• Cartel profit = (90 − 30) × 60 = 3,600, or 1,800 each if output is shared equally (30 units each).
• If the market were competitive, P = MC = 30 and Q = 120, with zero profit.

Now Firm 1 secretly raises output to 40 while Firm 2 stays at 30. Q = 70, so P = 80. Firm 1 earns (80 − 30) × 40 = 2,000 and Firm 2 earns (80 − 30) × 30 = 1,500. Cheating pays Firm 1 (2,000 > 1,800), but if both cheat the price falls towards 30 and the cartel collapses. This is why cartels are unstable.

Price leadership and price wars

Price leadership. One firm sets the price and others follow. A dominant leader is usually the largest firm. A barometric leader is trusted because it reads market conditions well. Followers avoid a price war without any formal agreement, so it is a form of tacit collusion.

Price war. Firms repeatedly cut price to take market share. Price falls towards cost, profits fall, and weaker firms may exit.

5d Costs and benefits of collusion

	Benefits	Costs
Producers	Higher, more stable profit; less uncertainty	Cheating, fines if detected, less pressure to cut cost
Consumers	Possibly more stability of supply	Higher prices, less choice, less incentive for quality
Workers	Secure jobs and possibly higher pay in profitable firms	Lower output means fewer jobs; weaker bargaining if firms act together
Governments	Possibly higher tax revenue from profit	Cost of enforcing competition law; welfare loss; fines are a source of revenue

In the cartel example, consumer surplus falls from 0.5 × 120 × 120 = 7,200 at the competitive outcome to 0.5 × 60 × 60 = 1,800. The deadweight loss is 0.5 × (90 − 30) × (120 − 60) = 1,800.

Evaluation chain. Collusion raises price, so quantity falls, so consumer surplus falls and resources are misallocated. Whether it is serious depends on how much price rises, how easy detection is, whether any extra profit funds research, and how elastic demand is.

5e Price competition

• Price war. Competing cuts can raise sales, but if market demand is inelastic, total revenue falls. A war helps consumers in the short run and may drive out smaller firms.
• Predatory pricing. A firm sets price below its own cost to force a rival out, planning to raise price later. Competition authorities may treat it as an abuse of dominance.
• Limit pricing. See 5b: price is held low to deter entry.

Worked example: predatory pricing. A dominant firm has average cost 10 and sells 200 units. It cuts price to 7, losing (7 − 10) × 200 = 600 a period. The war lasts 3 periods, a total loss of 1,800. After the rival exits, price rises to 14, giving (14 − 10) × 200 = 800 a period. The loss is recovered in 1,800 ÷ 800 = 2.25 periods, so by the third period after exit. The strategy pays only if the rival really leaves and new entrants do not appear.

5f Non-price competition

Firms compete on features other than price, which avoids a price war.

• Advertising and branding. Builds awareness and loyalty and can make demand less elastic.
• Quality. Better materials, design or reliability justify a higher price.
• Endorsement. A well-known person or body recommends the product.
• Product placement. The product appears inside a film, programme or game.
• After-sales service. Warranties, repairs and support build repeat purchases.

Worked example: is an advertising campaign worth it? A campaign costs 2.4 million. Each extra unit sold adds 3 to profit before the campaign cost. Break-even extra sales = 2,400,000 ÷ 3 = 800,000 units. If the campaign is likely to lift sales by less than that, it does not pay for itself on its own. A firm may still run it for defensive reasons, to stop rivals taking its customers.

5g Costs and benefits of price and non-price competition

	Price competition	Non-price competition
Firms	Win share but squeeze margins; risk of a war	Build loyalty and a barrier to entry; costs of advertising and R&D
Consumers	Lower prices	More choice, quality and service, but possibly higher prices
Employees	Pressure on wages and jobs to cut cost	More jobs in marketing and service; secure jobs if the firm grows
Suppliers	Pressure to cut input prices	Demand for higher-quality inputs; steadier orders from a loyal firm

Evaluation chain. Price competition lowers price, so consumers gain, but low margins can cut investment in quality. Non-price competition widens choice, but spending that only moves customers between brands is wasteful. The best judgement uses evidence on elasticity, firm size and how easy it is for rivals to copy.

Common errors

• Calling an oligopoly “a market with two firms”. Two is a duopoly, a special case.
• Describing the dominant strategy without showing the comparison for each rival choice.
• Treating a price war and predatory pricing as the same. Predatory pricing is below cost with a plan to recover later.
• Saying collusion always raises prices without discussing whether it is stable.
• Listing non-price methods without linking them to demand or entry.

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.