OxfordAQA International AS and A-level Economics: Oligopoly (9640)

This guide covers specification section 3.3.3.4 (Oligopoly) of the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. Unit 3 assesses section 3.3, which is extra International A2 content, so this topic belongs to the second stage of the full International A-level. Section 3.5 quantitative skills may be tested anywhere.

Related: course hub, printable checklist, revision notes, practice questions, The Operation of Markets (AS content) and the free diagnostics. All figures below are invented and illustrative.

What the specification asks for

3.3.3.4 statement	Section
Characteristics; differences in number of firms, differentiation, entry; factors affecting conduct and performance	1
Interdependence and uncertainty; kinked demand curve	2
Collusive and competitive oligopoly; tacit and overt collusion; cartels	3
Price leadership, price agreements, predatory pricing, limit pricing, price wars	4
Non-price competition, including branding and advertising	5
Research and development	6
Strategic and innocent barriers	7
Objectives; advantages and disadvantages	8 and 9

This section of the specification does not name game theory. The payoff table in section 3 only illustrates interdependence.

1. Characteristics and why oligopolies differ

In an oligopoly a handful of big sellers supply most of the market. The main characteristics are:

• a small number of firms with a large share of sales (high concentration)
• barriers to entry that protect the leading firms
• products that may be identical or differentiated
• interdependence: each firm’s best choice depends on how rivals respond.

Oligopolistic markets can be very different. Three dimensions explain most of the variation: how many firms there are, how far products are differentiated, and how easily new firms can enter. A market for bulk building materials tends towards near-identical products, while branded sports shoes rely on differentiation.

Concentration is measured by a concentration ratio: the combined market share of the largest firms.

Worked example (invented). Country K’s paving slab market has total sales of 900 million units. Terrad sells 210, Brickon 180, Lumen 150 and Pavex 90. Twelve small firms sell 270 between them.

• Three-firm concentration ratio: (210 + 180 + 150) / 900 = 540 / 900 = 60%.
• Four-firm concentration ratio: (540 + 90) / 900 = 630 / 900 = 70%.

A high ratio suggests oligopoly but does not prove it. Entry conditions and whether firms compete or coordinate decide conduct (how firms behave) and performance (profit, efficiency, innovation, prices).

Conduct and performance are shaped by barriers to entry, concentration, product differentiation, the firms’ objectives and the pace of technological change.

2. Interdependence, uncertainty and the kinked demand curve

A price change by one firm changes rivals’ sales, so each firm must guess the response. That guess is the source of uncertainty and explains why oligopolists often avoid price changes.

The kinked demand curve model uses one assumption about reactions:

• If the firm raises price, rivals hold theirs, so many customers leave: demand above the kink is elastic.
• If the firm cuts price, rivals copy it, so few customers arrive: demand below the kink is inelastic.

The demand curve bends at the current price. The marginal revenue curve then has a vertical gap beneath the kink, because each segment of demand has its own marginal revenue.

Worked example (invented). A firm sells 200 units a week at £30. Above the kink, P = 40 − 0.05Q. Below it, P = 90 − 0.3Q. Both give £30 at Q = 200.

1. Marginal revenue above: MR = 40 − 0.1Q = 40 − 20 = £20.
2. Marginal revenue below: MR = 90 − 0.6Q = 90 − 120 = −£30.
3. The gap runs from −£30 to £20. Any marginal cost in that range leaves output at 200 units and price at £30. Check: if MC rises from £8 to £15, profit before fixed costs falls from (30 − 8) × 200 = £4,400 to (30 − 15) × 200 = £3,000, but price does not move.
4. Elasticity at the kink: above, PED = (1 / 0.05) × (30 / 200) = 3.0 (elastic). Below, PED = (1 / 0.3) × (30 / 200) = 0.5 (inelastic). Signs are dropped here when comparing sizes.
5. Test the reactions. A price rise to £33 gives Q = (40 − 33) / 0.05 = 140, so revenue falls from £6,000 to £4,620, down 23%. A cut to £27 gives Q = (90 − 27) / 0.3 = 210, so revenue falls to £5,670, down 5.5%. Neither change pays.

Evaluation. The specification says the model illustrates interdependence and offers insight into only a limited number of features of some oligopolistic markets. Weaknesses to use:

• It is silent on why the kink price was chosen in the first place.
• If MC rises beyond the gap (to £24 here) the model predicts Q = 160 and P = £32, but a cost rise common to all firms is usually matched by rivals, which breaks the assumed reactions.
• Real prices do change, often through price leadership.

3. Collusion, cartels and joint profit

Oligopoly can be competitive (firms rival each other) or collusive (firms coordinate to limit competition).

• Overt collusion is an open or formal agreement on price, output or market shares. A cartel is a group of firms with such an agreement.
• Tacit collusion is coordination without any formal agreement, for example following a leader’s price or keeping to long-standing price points.

Collusion may let the firms behave like one monopolist and maximise joint profit, producing where industry MR = MC.

Worked example (invented). Three identical firms face market demand P = 96 − 2Q (Q in thousand units, P in £). Marginal cost is £24 for all.

1. Competitive benchmark, P = MC: 96 − 2Q = 24, so Q = 36 and P = £24. Profit is zero.
2. Cartel: MR = 96 − 4Q = 24, so Q = 18 and P = £60. Joint profit = (60 − 24) × 18 = £648 thousand. With equal quotas each firm sells 6 and earns £216 thousand.
3. Cheating: firm A raises output to 9, the others keep 6. Q = 21, P = 96 − 42 = £54. Firm A earns (54 − 24) × 9 = £270 thousand (up £54 thousand). Each rival earns 30 × 6 = £180 thousand (down £36 thousand). Total profit is £630 thousand, below £648 thousand.

Each firm gains by cheating, but if all cheat the cartel collapses. A payoff table (profits in £m, firm 1 first) shows the same tension:

	Firm 2 keeps price	Firm 2 undercuts
Firm 1 keeps price	24, 24	9, 33
Firm 1 undercuts	33, 9	14, 14

Undercutting is the better reply to either choice, so the uncoordinated outcome is 14, 14 although 24, 24 is better for both.

Collusion is more likely with few firms, similar products, stable demand, hard entry and easy detection of cheating. It is less likely with many firms, differing costs or slow detection. Open price fixing is generally unlawful, which raises the cost of keeping agreements secret.

4. Pricing behaviour

• Price leadership. One firm (often the largest, or the one best placed to read the market) changes price and rivals follow. This is a form of tacit collusion.
• Price agreements. Firms agree prices openly or through understandings. They are overt collusion.
• Price war. Repeated rounds of price cutting. Consumers gain in the short run, but profits fall and weaker firms may leave.
• Predatory pricing. Setting price below cost to drive out a rival or deter entry, then raising it again.
• Limit pricing. Setting price low enough that entry would be unprofitable, though still above cost.

Worked example: limit pricing (invented). An incumbent has average cost £7. An entrant could make 60 thousand units at £10.40 each. At £13 the incumbent sells 400 thousand units, earning 400 × 6 = £2.4 million, but entry would be profitable. At £10 (below the entrant’s cost) it sells 480 thousand units and earns 480 × 3 = £1.44 million. It gives up £0.96 million a year to keep rivals out.

Worked example: predatory pricing (invented). A firm with average cost £9 normally sells 300 thousand units at £12, earning £0.9 million. During a one-year war it sells 360 thousand at £7, losing 360 × 2 = £0.72 million. After a rival leaves it sells 420 thousand at £13, earning 420 × 4 = £1.68 million. The war costs £0.9m + £0.72m = £1.62 million relative to normal; the gain is £1.68m − £0.9m = £0.78 million a year, so payback takes 1.62 / 0.78 = about 2.1 years.

Predation pays only if the firm outlasts its rival and entry stays blocked.

5. Non-price competition

Rivals can match a price cut quickly, and a price war damages everyone. Non-price competition lets a firm compete without cutting price. Reasons include making demand less price elastic, building loyalty and raising entry barriers.

Types include branding, advertising, design and quality, after-sales service, loyalty schemes and delivery speed.

Worked example (invented). A firm sells 6.5 million units with a margin of £4.50 a unit. A campaign costs £2.7 million.

• Break-even: 2.7 / 4.5 = 0.6 million extra units, 0.6 / 6.5 = 9.2% of current sales.
• If sales rise by 8%, extra units are 0.52 million, contribution is 0.52 × 4.5 = £2.34 million and the campaign loses £0.36 million.
• If sales rise by 10%, contribution is 0.65 × 4.5 = £2.925 million and net gain is £0.225 million.

Evaluation. Branding and advertising can inform and add variety, but they raise costs, may build market power and may act as a barrier to entry.

6. Research and development

R&D matters because new products and cheaper processes let firms compete without a price war. Supernormal profit gives oligopolists the funds and the prospect of a lead gives the motive. R&D outcomes are uncertain.

Worked example (invented). A firm with revenue £480 million spends £36 million on R&D, which is 36 / 480 = 7.5% of revenue. The chance of success is 0.4 and success is worth £150 million, so the expected value is 0.4 × 150 = £60 million, an expected net gain of £24 million. The project breaks even at a probability of 36 / 150 = 0.24.

Rivals may copy a result, weakening the incentive. Large spending can also act as a strategic barrier.

7. Strategic and innocent barriers to entry

Innocent barriers arise from the nature of the market, not from the incumbents’ actions: economies of scale, high capital cost, and the established reputation of the industry’s products. Strategic barriers are deliberately created or used by incumbents: limit pricing, predatory pricing, heavy advertising, excess capacity and exclusive contracts with suppliers or retailers.

Worked example (invented). The market is 1,200 thousand units and minimum efficient scale is 360 thousand units, which is 30% of the market. At most 1,200 / 360 = 3.3, so three firms of efficient size can fit.

8. Objectives and behaviour

Oligopolists may maximise profit, revenue or market share, or aim for survival and a satisfactory profit. The objective changes price and output.

Worked example (invented). Demand is P = 80 − 2Q (Q in thousand units) and MC = £20.

Objective	Rule	Q	P (£)	Revenue (£ thousand)	Profit (£ thousand)
Profit maximising	MR = MC	15	50	750	450
Revenue maximising	MR = 0	20	40	800	400
Zero economic profit	P = MC	30	20	600	0

A revenue maximiser sells more at a lower price than a profit maximiser.

9. Advantages and disadvantages: evaluating oligopoly

Possible advantages: economies of scale, funding for R&D, product variety and stable prices.

Possible disadvantages: higher prices and lower output under collusion, allocative inefficiency, wasteful advertising, barriers that protect profit, and less incentive to cut costs.

Chain of reasoning. Few firms, so interdependence; so a price war would hurt all; so firms avoid price competition; so they compete on branding and R&D; so consumers may gain variety and innovation but may also pay more. The net effect depends on entry conditions, whether collusion occurs and how much spending is real innovation. Reach a judgement for the market in the question.

Common errors

• Describing the kinked curve without the reactions behind it.
• Saying collusion always works; state why cheating is tempting.
• Treating a high concentration ratio as proof of collusion.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, first teaching September 2020, first AS exams May/June 2021, first A-level exams May/June 2022; published by OxfordAQA.