Introduction to Oligopoly

An oligopoly is a market structure in which a small number of firms dominate the supply of a particular good or service. The defining feature is that there are only a few sellers in the market, each of which has a substantial share, so their behaviour cannot be analysed in isolation. Every action that one firm takes has a direct influence on its rivals, and each rival must take account of this when making its own decisions. This mutual awareness of actions and reactions is referred to as interdependence. It is this interdependence that makes oligopoly very different from both perfect competition and monopoly.

In a perfectly competitive market, each firm is so small in relation to the whole market that its individual decisions about price or output have no effect on the market outcome. The firm is a price taker. In a monopoly, on the other hand, a single firm dominates supply and therefore sets the conditions of the market. Oligopoly is between these extremes as there are only a few firms, so each has significant power, but because there is more than one firm, strategic behaviour and rivalry are unavoidable.

The chapter explains that examples of oligopoly in the United Kingdom include commercial banking, the cinema industry, and national newspapers. In each of these cases, a small number of firms account for the vast majority of sales. For example, in the cinema industry, just three main firms dominate the national market. This dominance gives them market power, but the presence of rivals means that their power is limited by the actions of one another. The same logic applies to other oligopolistic sectors.

Unlike monopolistic competition, where there are many small firms and free entry ensures that long-run profits are competed away, oligopoly is often protected by barriers to entry. Barriers to entry can take many forms. They may be structural, such as large economies of scale that make it difficult for new entrants to match the efficiency of established firms. They may be legal, such as patents or licences. They may be strategic, where existing firms deliberately act in ways that deter entry, such as aggressive pricing or advertising. Because of these barriers, established firms in an oligopoly are able to retain market power and earn profits above the normal level for extended periods.

Characteristics of Oligopoly

The first characteristic of oligopoly is that a few firms dominate the market. These firms hold a large combined market share, often measured by concentration ratios. A three-firm concentration ratio or a five-firm concentration ratio is commonly used to assess the extent of oligopoly. When this ratio is high, the market can be classified as oligopolistic.

The second characteristic is strategic interdependence. Each firm recognises that its demand curve and its profits depend not only on its own decisions but also on how rivals respond. This means that decision-making is not straightforward. A firm cannot simply calculate its own marginal cost and marginal revenue in isolation; it must form expectations about whether competitors will copy or ignore its actions. For example, if one bank lowers its interest rates on loans, it must anticipate whether other banks will match that reduction or maintain their existing rates.

The third characteristic is the presence of barriers to entry. Because only a few firms dominate, they may be able to sustain abnormal profits over time. Entry by new competitors would normally erode such profits, but barriers restrict this process. The strength of barriers varies by industry. In some markets they are very strong, meaning that oligopoly is stable over decades. In others they are weaker, and the market structure may be more contestable.

Strategic Behaviour and Rivalry

The fact that firms are interdependent means that there is no single predictable pattern of behaviour in oligopoly. Instead, there are many possible outcomes depending on how firms choose to act and how rivals respond. Sometimes firms may compete aggressively, seeking to win market share from one another. At other times they may cooperate, implicitly or explicitly, to reduce competition and maintain high profits. The outcome is therefore somewhere on a spectrum between intense rivalry and near monopoly.

Cooperation can occur in different ways. It can be formal, as in the case of cartels where firms explicitly agree to restrict output or fix prices. It can also be informal or tacit, where firms simply recognise their mutual interest in avoiding destructive competition and therefore refrain from undercutting one another. Competition authorities in the United States and other countries pay close attention to such behaviours, since they can harm consumers by keeping prices above competitive levels.

Rivalry, on the other hand, can take many forms. It may be price rivalry, such as price wars, or non-price rivalry, such as advertising and product differentiation. The choice between price competition and non-price competition is important in oligopoly. Because aggressive price competition can quickly erode profits, firms often prefer to compete in other ways that maintain price stability while still allowing them to attract customers.

Contrast with Monopolistic Competition

It is useful to contrast oligopoly with monopolistic competition to clarify the differences. In monopolistic competition, there are many firms, each producing a differentiated but similar product. Because of the large number of competitors and the absence of significant barriers to entry, any abnormal profits earned in the short run are competed away in the long run as new firms enter the market.

In oligopoly, by contrast, the number of firms is small and entry is restricted. This allows firms to maintain some degree of market power over time. Whereas in monopolistic competition each firm’s actions have negligible impact on the overall market, in oligopoly each firm’s actions are significant and provoke reactions. This creates the conditions for strategic decision-making, which is the essence of oligopoly analysis.

Non-Price Competition

In oligopolistic markets, one of the most important features is the tendency of firms to avoid competing primarily on price. Price competition, while simple, can be highly destructive. If two or three dominant firms in a market begin to undercut one another, the result can be a rapid fall in prices and a loss of profitability for all. Unlike in perfectly competitive markets, where individual firms are price takers and cannot influence the outcome, the large firms in an oligopoly have the ability to shape prices. Yet if they exercise this power through aggressive undercutting, it may trigger a price war that erodes their joint profits.

Because of this risk, firms often turn to non-price competition. Non-price competition refers to strategies aimed at increasing sales and strengthening market share without changing the price of the product. Instead of competing through lower prices, firms seek to differentiate themselves in other ways, such as advertising, branding, product design, packaging, quality of service, or loyalty programmes.

Definition of Non-Price Competition

Non-price competition is a strategy whereby firms in an oligopoly compete by emphasising aspects of their product or service other than price. This can mean building a strong brand identity, offering distinctive product features, creating attractive packaging, or running advertising campaigns that highlight quality, lifestyle, or emotional appeal. It can also involve after-sales service, warranty offers, or investment in customer loyalty schemes.

The key aim is to convince consumers that one firm’s product is different enough from its rivals that they are willing to choose it even if the price is the same, or in some cases slightly higher. In other words, the firm seeks to increase the perceived value of its product rather than to lower its cost to consumers.

Why Firms Prefer Non-Price Competition

There are several reasons why non-price competition is often favoured in oligopolies. The first is that it avoids triggering destructive price wars. Since firms in oligopoly are interdependent, they know that a cut in price will often be matched by rivals. If one firm lowers its price, its competitors may quickly follow to avoid losing market share. The end result is lower profits for all. By contrast, if firms compete through non-price measures such as advertising or branding, rivals cannot so easily replicate those changes, and prices can remain relatively stable.

The second reason is that non-price competition can increase consumer loyalty. Through advertising, firms can create strong emotional connections between consumers and the brand. For example, a cinema chain in the UK may highlight its superior seating comfort, loyalty reward points, or exclusive screenings, encouraging customers to choose it repeatedly over rivals, even when ticket prices are similar. Such loyalty makes demand for the firm’s product less sensitive to price changes, which strengthens its market power.

The third reason is that non-price competition allows for targeted differentiation. In oligopoly there are relatively few firms, so each can focus on carving out a distinctive niche. By emphasising particular qualities, such as higher service quality, innovative design, or better convenience, a firm may draw customers away from rivals and secure a larger market share without destabilising the overall price structure.

Examples of Non-Price Competition

Advertising is one of the most obvious forms of non-price competition. Firms in oligopoly often spend heavily on advertising campaigns to make their products appear superior, unique, or indispensable. This is seen in industries such as newspapers, where different firms emphasise their editorial tone, readership community, or additional supplements rather than competing simply on the cover price.

Brand loyalty schemes are another example. Firms may offer points systems, exclusive discounts, or rewards for repeat purchases. The US cinema industry provides examples where chains run membership schemes allowing unlimited access for a fixed monthly fee, or points that can be exchanged for free tickets. These schemes increase customer retention and reduce the incentive to switch to a competitor.

Product design and quality enhancements are also common. A firm may invest in more appealing packaging, improved service delivery, or new features that distinguish its product. In sectors such as commercial banking, differentiation may come through online platforms, mobile applications, or customer support rather than through changes in interest rates alone.

Consumer and Market Implications

The widespread use of non-price competition in oligopoly has important implications. For consumers, it can increase choice and improve quality. Firms that compete on non-price factors often innovate, improve design, and invest in customer service. This can raise consumer welfare compared to a situation where firms competed only through higher or lower prices.

However, it also has drawbacks. Heavy expenditure on advertising and branding may increase firms’ costs, which are often passed on to consumers through higher prices. Non-price competition may therefore allow firms to sustain higher prices than would otherwise be possible. Consumers may pay more, but they receive additional services, loyalty rewards, or branding benefits in return.

Another implication is that non-price competition can reinforce barriers to entry. Strong brands, established loyalty schemes, and heavy advertising expenditure create an environment in which new entrants find it very difficult to gain market share. Even if a new firm enters with lower prices, consumers may remain loyal to established brands, and the scale of advertising by incumbents may drown out the newcomer’s message.

Non-Price Competition and Market Stability

Non-price competition contributes to the relative stability of prices in oligopoly. Since firms are reluctant to cut prices for fear of retaliation, they instead channel resources into advertising or product differentiation. This keeps prices more stable than in more competitive markets. As a result, oligopolistic markets often display a combination of stable prices, heavy advertising, and strong brand identities.

It is worth noting that this pattern of behaviour helps explain why price in oligopoly can remain unchanged for long periods despite fluctuations in costs. When costs rise, firms may not pass these increases on immediately if they fear losing customers to rivals. Instead, they may intensify non-price strategies, such as emphasising quality or service. This makes non-price competition central to understanding the dynamics of oligopoly.

The Kinked Demand Curve Model

One of the main theoretical models used to explain behaviour in oligopolistic markets is the kinked demand curve model. This model was developed by the economist Paul Sweezy in the 1930s to explain why prices in oligopolies often remain stable for long periods, even when costs change. It is based on the assumption that firms in an oligopoly are highly interdependent and must always consider the possible reactions of their rivals when making decisions about price.

In oligopoly, a firm does not face a single, predictable demand curve. Instead, the demand it faces depends on how other firms in the market respond to its decisions. If one firm changes its price, it is likely that others will react in some way, either by copying the change or by refusing to do so. This creates uncertainty. The firm must form expectations about how rivals will behave and then make decisions accordingly.

Suppose a firm is currently charging a given price P* and producing output Q*. At this point, it is unsure whether changing price would be beneficial. If it raises its price, will rivals do the same? If it lowers its price, will rivals copy or will they hold prices steady? The answers to these questions determine the shape of the demand curve that the firm perceives.

The kinked demand curve is drawn to show two distinct segments. Above the current price P*, the demand curve is relatively elastic. This is because if the firm raises its price above P*, it expects that rivals will not follow. Consumers will then switch to the rival firms that continue to charge P*, so the firm that raised its price will lose a large share of its customers. This makes demand highly responsive to price increases.

Below the current price P*, the demand curve is relatively inelastic. This is because if the firm lowers its price, it expects rivals will match the cut to avoid losing market share. As a result, although the firm reduces its price, it does not gain many additional customers, since rivals also reduce theirs. The lower price, therefore, results in lower revenue without a proportionate increase in sales, making demand less responsive.

The point at which these two sections meet creates a kink in the demand curve. This kink corresponds to the current price and output, P* and Q*.

The shape of the kinked demand curve produces an unusual marginal revenue curve. Normally, the marginal revenue curve is a smooth line derived from the demand curve. In the kinked demand model, because the demand curve has a sharp change in slope at P*, the marginal revenue curve has a discontinuity. There is a vertical gap in the marginal revenue curve corresponding to the kink.

This has important implications. If the firm’s marginal cost curve passes through this discontinuity, then small changes in costs will not affect the profit-maximising price or output. In other words, as long as marginal cost lies within the discontinuous range, the firm will continue to produce Q* and charge P*. This explains why prices may remain rigid or sticky in an oligopoly, even when costs fluctuate.

Implications of the Model

The kinked demand curve model explains the tendency towards price stability in oligopolistic markets. Firms recognise that raising prices is dangerous because rivals may not follow, leading to a large loss of market share. Lowering prices is also unattractive because rivals are likely to copy, leaving all firms worse off. The safest course of action is to keep prices unchanged.

This is why prices in oligopoly often remain constant for long periods, with firms competing instead through non-price methods such as advertising or branding. The model also explains why price wars, while possible, are relatively rare. Firms understand that they are unlikely to benefit from cutting prices, since competitors will retaliate.

Another implication is that cost changes do not always lead to price changes. In competitive markets, a rise in costs usually shifts the supply curve, leading to a higher equilibrium price. In an oligopoly explained by the kinked demand model, a rise in costs may be absorbed by firms if the marginal cost curve remains within the discontinuity in the marginal revenue curve. This can result in periods of unusual price stability.

Limitations of the Kinked Demand Curve Model

Although the model provides a neat explanation for sticky prices, it also has limitations. One difficulty is that it does not explain how the initial price P* is determined. It can describe why a price once established remains stable, but it does not tell us how the firm reached that price in the first place.

Another limitation is that not all oligopolies display the same degree of price rigidity. In some industries, price wars do occur, and firms frequently change their prices. The kinked demand curve does not account for such outcomes.

The model also assumes that firms perceive demand in this particular way, but perceptions may differ. If firms believe that rivals will not copy price cuts, they may be more willing to reduce prices. If they believe rivals will match price increases, then the elastic and inelastic segments of the demand curve may be shaped differently.

Finally, the model does not capture other strategic behaviours in oligopoly, such as collusion, price leadership, or predatory pricing, which may also explain observed market outcomes. It is therefore best seen as one possible framework rather than a universal law.

Collusion

In an oligopolistic market, firms may be tempted to cooperate with one another in order to increase their joint profits. Since there are only a small number of firms, each with significant market power, it is possible for them to reach agreements, either formal or informal, that restrict competition. This behaviour is known as collusion.

Collusion occurs when firms coordinate their decisions on prices, output, or other strategic variables to avoid competing aggressively against each other. Instead of acting independently, they act together in ways that make the market resemble a monopoly, thereby maximising collective profits.

The logic of collusion is straightforward. If firms compete strongly with one another, they drive down prices, reduce their profit margins, and risk starting destructive price wars. If, instead, they agree to restrict output or set higher prices jointly, they can collectively behave like a monopolist. In this way, they can achieve abnormal profits that would not be possible under intense competition.

However, collusion is fraught with difficulties. Although joint profits may be maximised, each individual firm has a strong incentive to cheat on the agreement. By secretly undercutting the agreed price or producing slightly more than its quota, a firm can increase its own profits at the expense of its partners. This temptation to defect makes collusion unstable unless mechanisms exist to monitor and enforce the agreement.

Cartels

A cartel is the most explicit and formal type of collusion. A cartel is defined as an agreement between firms to fix prices or restrict output in order to maximise joint profits. Famous examples exist in global industries, the most prominent being the Organisation of Petroleum Exporting Countries (OPEC), which has attempted over decades to control the supply of oil and thereby influence its price on world markets.

Within a cartel, firms may agree to set a common price, divide the market among themselves, or restrict total output to maintain scarcity. By cooperating in this way, the firms effectively replicate the outcome of a monopoly.

How a Cartel Operates

To understand cartel behaviour, it is useful to look at a diagram showing two firms operating under a cartel arrangement.

The idea is that the cartel as a whole behaves like a single monopolist. It calculates the joint profit-maximising output by equating the market marginal revenue curve with the cartel’s marginal cost curve, which is the horizontal sum of the individual firms’ marginal cost curves. The resulting output is then allocated among the firms, often in proportion to their capacities or past market shares.

The agreed price is set at P*, which is higher than the competitive level, and the total output is restricted to Q₁ + Q₂. Each firm then produces its share, with Firm 1 producing Q₁ and Firm 2 producing Q₂, so that together they produce the agreed cartel output.

This arrangement should, in principle, yield higher joint profits for the firms than if they competed independently. However, problems quickly arise. If one firm is smaller, as in the example where Firm 2 produces less than Firm 1, it may feel disadvantaged and be tempted to expand output beyond its quota. By doing so, it can increase its own profits, but at the cost of destabilising the cartel. If the cheating is detected, other members may retaliate, and the agreement may collapse.

The Instability of Cartels

The main weakness of cartels is the temptation to cheat. Because each firm can increase profits by slightly breaking the agreement, the incentives are misaligned. As soon as one firm cheats, others may follow, leading to a breakdown of cooperation and a return to competitive outcomes.

In addition, cartels face legal restrictions. In many countries, including the United Kingdom, the European Union, and the United States, cartels are illegal. The UK Competition and Markets Authority, for example, has the power to investigate and fine firms up to 10 percent of their worldwide turnover if they are found guilty of operating a cartel. The legal prohibition reflects the view that cartels harm consumers by raising prices, reducing output, and restricting choice.

For these reasons, explicit cartels are relatively rare in modern economies, and those that do exist are often unstable. Nevertheless, they are a useful illustration of how collusion can operate in principle.

Tacit Collusion

Not all collusion is explicit or formal. Sometimes, firms may arrive at a cooperative outcome without any explicit agreement. This is known as tacit collusion.

Tacit collusion occurs when firms in an oligopoly recognise their mutual interdependence and act in ways that avoid competition, even though they have not communicated directly. For example, firms may simply observe one another’s prices and follow them closely, refraining from undercutting. Over time, this can create a stable pattern of parallel pricing, in which no firm takes the initiative to lower prices, and the market outcome resembles collusion.

Tacit collusion can emerge gradually as firms become accustomed to each other’s behaviour. Each firm realises that aggressive competition is harmful to all, so they settle into a pattern of restraint. Importantly, because there is no explicit communication or agreement, tacit collusion can be harder for regulators to detect and prosecute, yet the effect on consumers can be similar to that of a cartel.

Strategic Alliances

Another form of cooperation in oligopoly is the strategic alliance. Strategic alliances occur when firms agree to cooperate in specific areas of business, such as joint purchasing, research, or technology development.

For example, Tesco once joined with Carrefour in a strategic alliance to buy products collectively. The aim was to secure better purchasing terms from suppliers by exploiting larger combined buying power. Similarly, airlines often form alliances such as Star Alliance or SkyTeam, which allow them to coordinate schedules, share airport lounges, and offer joint ticketing. These alliances bring cost savings and efficiencies but may also reduce competition between airlines.

Strategic alliances can be beneficial to consumers in some ways, by creating more integrated services or lowering costs. However, they may also reduce rivalry between firms, raising concerns for regulators. In 2012, for example, the European Commission launched an investigation into whether the cooperation between members of the SkyTeam alliance was acting against consumer interests.

Price Leadership

One of the most common forms of tacit collusion is price leadership. Price leadership occurs when one firm, usually the dominant or most efficient in the market, takes the lead in setting prices, and the other firms follow.

For instance, if the leading firm raises its price, others match the increase. If it lowers its price, others follow suit. In this way, prices in the industry move together without any formal agreement. The dominant firm thus effectively coordinates pricing, and the smaller firms act as followers.

There are different forms of price leadership. In some cases, the largest firm leads. In others, a firm that is seen as having the best market knowledge or lowest costs may assume the role. Another variation is barometric price leadership, in which one firm is particularly good at detecting changes in market conditions, and others follow its lead because they trust its judgment.

Price leadership stabilises markets by reducing uncertainty. Each firm knows that if it follows the leader, it will avoid destabilising competition. But it also reduces consumer choice, since it prevents independent pricing.

Advantages and Disadvantages of Oligopoly

Oligopoly is a market structure that can produce both positive and negative outcomes for consumers, firms, and the wider economy. Because only a few firms dominate supply, the consequences of their behaviour are magnified. The advantages and disadvantages depend largely on whether firms choose to compete vigorously or to collude and restrict competition.

Advantages of Oligopoly

One advantage of oligopoly is the potential for stability of prices. In markets with many small firms, such as perfect competition, prices fluctuate frequently in response to changes in costs or demand. This can create uncertainty for both consumers and producers. In oligopoly, by contrast, prices tend to remain relatively stable over time. As explained through the kinked demand curve model, firms often avoid frequent price changes for fear of rival reactions. This stability benefits consumers because it allows them to plan their budgets with greater certainty. It also helps firms by reducing the risks associated with investment and long-term planning.

A second advantage is the potential for innovation and product development. Because firms in oligopoly earn abnormal profits over the long run, they often have resources to invest in research and development. Non-price competition encourages firms to differentiate their products through design, features, or branding. For example, in the cinema industry, large firms have invested in more comfortable seating, digital projection, and loyalty schemes as ways to attract customers. These innovations improve consumer welfare beyond what would be provided in a purely competitive market.

A third advantage is economies of scale. Since oligopolistic firms are large, they can often produce at lower average costs than smaller firms. Economies of scale arise when unit costs fall as output increases, due to factors such as bulk buying of inputs, specialisation of labour, or spreading fixed costs over more units. Consumers can benefit if these cost savings are passed on through lower prices or improved services. Even if prices remain higher than in perfect competition, the existence of large-scale production may ensure that the industry operates more efficiently than if many smaller firms were competing.

Finally, oligopoly can provide variety for consumers. Through branding and non-price competition, firms create different products tailored to different tastes. Consumers may value the choice between alternative newspapers, different cinema experiences, or varied banking services, even if prices are similar across providers.

Disadvantages of Oligopoly

Despite these potential benefits, oligopoly also has significant disadvantages. The most serious is the risk of collusion. When firms cooperate, either explicitly through cartels or tacitly through price leadership, they restrict competition and behave like a monopoly. This leads to higher prices, reduced output, and less consumer choice. The welfare loss to society is similar to that in a monopoly: consumers pay more and consume less than they would under more competitive conditions, while producers capture abnormal profits.

Another disadvantage is the creation of barriers to entry. Large oligopolistic firms often reinforce their dominance through heavy spending on advertising, strong brand identities, and loyalty schemes. These strategies make it very difficult for new entrants to break into the market. As a result, consumers may be denied the benefits of increased competition, and the market structure remains concentrated for long periods.

A further disadvantage is that prices, while stable, may remain consistently high. The kinked demand curve model suggests that firms avoid cutting prices for fear of retaliation. This can result in prices that are above the competitive level for long stretches of time. Consumers face predictability, but at a cost: they pay more than they would in a more competitive market.

There is also the risk of inefficiency. While oligopolies can achieve productive efficiency through economies of scale, they may not always pass these gains to consumers. Protected by barriers to entry and by the reluctance of rivals to compete on price, oligopolistic firms may become complacent, investing less in efficiency improvements than they might if competition were more intense.

Finally, oligopoly may produce outcomes that favour producers over consumers in terms of welfare distribution. The abnormal profits sustained by firms represent a transfer from consumers, who pay higher prices, to producers, who enjoy returns above the normal level. This raises concerns about equity and fairness in the distribution of resources.

Evaluation

The balance between advantages and disadvantages depends on the actual behaviour of firms in a given oligopoly. Where rivalry is strong, consumers may benefit from innovation, variety, and sometimes lower prices, though rarely as low as in perfect competition. Where collusion prevails, consumers face higher prices, restricted choice, and reduced welfare. For this reason, regulators closely monitor oligopolistic markets to ensure that firms do not engage in anti-competitive practices that harm consumers.

Market Concentration

Market concentration is one of the most widely used measures to identify whether a market is oligopolistic. Since oligopoly is defined by the dominance of a few firms, economists and regulators need a way to quantify the degree of concentration. This is where concentration ratios are applied.

A concentration ratio measures the combined market share of the largest firms in an industry. The most common are the three-firm concentration ratio and the five-firm concentration ratio. For example, a three-firm concentration ratio shows the proportion of the market controlled by the top three firms. If these firms account for more than fifty percent of sales, the market can usually be classified as an oligopoly.

Concentration ratios are expressed as percentages. A high concentration ratio indicates that a small number of firms dominate supply, whereas a low concentration ratio indicates that supply is spread more evenly across many firms.

Interpreting Concentration Ratios

Suppose that the three largest firms in an industry hold market shares of 30 percent, 25 percent, and 15 percent. Together, they control 70 percent of the market. This high ratio is a clear sign of oligopoly. If, however, the top three firms held only 15 percent, 10 percent, and 8 percent, the combined share would be 33 percent. This would suggest a more competitive structure, closer to monopolistic competition.

The key threshold is not rigid, but as a rule of thumb, when a few firms together control more than half of the market, oligopoly is said to exist.

Worked Example: Concentration Ratios in Practice

Consider the US cinema industry, which the chapter uses as an example. Suppose that the top three cinema chains account for 70 percent of cinema admissions nationally. This implies a three-firm concentration ratio of 70 percent. With such a high ratio, it is clear that the market is oligopolistic. Smaller firms may still exist, but their market shares are too small to alter the overall classification.

Another example is national newspapers. If the top five newspapers account for 85 percent of daily circulation, the five-firm concentration ratio is 85 percent. This too demonstrates oligopolistic control.

These ratios provide a numerical foundation for identifying oligopoly. Instead of relying only on qualitative judgments, they show clearly that a few firms dominate.

Strengths and Weaknesses of Concentration Ratios

Concentration ratios have the strength of being simple and easy to interpret. A single percentage figure immediately conveys the dominance of a few firms. They are widely used by competition authorities, regulators, and economists for this reason.

However, there are also weaknesses. Concentration ratios do not reveal how market shares are distributed among the largest firms. For example, if the top three firms control 70 percent, this could mean that each has about 23 percent. Alternatively, it could mean one firm has 60 percent and the other two only 5 percent each. Both give the same ratio, but the degree of dominance by a single firm is very different.

Another limitation is that concentration ratios ignore smaller firms. If the three-firm ratio is 70 percent, the remaining 30 percent may still be spread across many competitors, or it may be held by just one or two significant rivals. The ratio does not capture this detail.

In addition, concentration ratios are static. They show the structure of the market at a given moment, but do not explain how competitive behaviour actually unfolds. Even in a highly concentrated market, if firms compete aggressively, consumers may still benefit from lower prices and innovation. Conversely, even in a less concentrated market, tacit collusion could lead to outcomes similar toa monopoly.

Use by Regulators

Despite these weaknesses, concentration ratios remain important tools for regulators. When authorities such as the United States Federal Trade Commission's (FTC) Bureau of Competition considers whether to investigate a market, one of the first indicators they examine is concentration. A high ratio may trigger concern that firms are colluding or exercising market power in ways harmful to consumers.

If a merger between two large firms is proposed, regulators often calculate how the merger would affect concentration. For example, if two firms with 20 percent market share each plan to merge, the three-firm ratio may jump significantly. This could be grounds for intervention to protect competition.

Concentration and Oligopoly Outcomes

High concentration is closely linked with the outcomes described in earlier sections. In markets with high concentration, the temptation and feasibility of collusion are greater. Firms can more easily monitor one another’s behaviour, making tacit collusion more sustainable. Barriers to entry are also reinforced, since large firms with dominant shares can use advertising and brand loyalty to maintain control.

At the same time, high concentration also brings potential benefits. Large firms may exploit economies of scale, produce more efficiently, and invest in research and development. The balance of advantages and disadvantages therefore depends on how the firms in a concentrated market choose to behave.

Pricing Strategies in Oligopoly

Because firms in an oligopoly are interdependent, their pricing decisions are strategic. A firm must anticipate how its rivals will respond to any change in price. This makes pricing strategies in oligopoly more complex and varied than in any other market structure. Firms may adopt aggressive tactics, such as price wars and predatory pricing, or defensive strategies, such as limit pricing, to deter new entrants. Each of these has different implications for consumers, firms, and overall welfare.

Price Wars

A price war occurs when firms engage in a series of successive price cuts in order to gain or protect market share. One firm initiates the process by lowering its price, perhaps to attract customers from rivals. Competitors then retaliate by cutting their own prices. The first firm may respond again, and the cycle continues, often driving prices down to very low levels.

Price wars are damaging for firms because profit margins are rapidly eroded. The main beneficiaries are consumers, who enjoy temporarily lower prices. However, if prices fall below cost, some firms may be forced out of the market. The survivors may then raise prices once more, reducing the long-term benefit to consumers.

Price wars are more likely in markets where products are homogeneous and differentiation is limited. If consumers see little difference between competing goods, they will switch readily to the cheapest option, encouraging firms to undercut one another. They are less likely when strong branding or non-price competition is present, since loyalty reduces consumer responsiveness to price cuts.

Predatory Pricing

Predatory pricing is a strategy where a dominant firm deliberately sets its prices very low, sometimes below cost, in order to drive competitors out of the market. Once rivals have been eliminated, the firm raises its prices again to recoup losses and exploit its strengthened position.

The diagram shows how predatory pricing works. Initially, the market price is P₁ under normal competition. The dominant firm cuts price aggressively to P₂, which is below its average cost curve. Rivals cannot sustain losses and exit the market. Once they have left, the firm increases the price to P₁ (or higher), exploiting its monopoly power.

Predatory pricing is illegal in many countries because it restricts competition and harms consumers in the long run. Regulators monitor markets for signs of predation, though proving it can be difficult, since low prices may also result from genuine efficiency.

Limit Pricing

Limit pricing is another strategy used to deter competition, but it is different from predatory pricing. Instead of cutting prices to drive rivals out, a firm sets a price just low enough to discourage new entrants from entering the market.

The firm deliberately chooses a price below the profit-maximising monopoly level but above average cost. The aim is to signal to potential entrants that they would not be able to cover their costs at this price, so entry is not worthwhile.

If the firm behaved as a monopolist, it would set price at Pm and output Qm where marginal revenue equals marginal cost. But if it does this, abnormal profits attract new entrants. To deter them, the firm sets a lower price P₁ and produces more, Q₁. At this lower price, potential entrants cannot cover their average costs, so they stay out. The incumbent firm earns less profit than under a monopoly but protects its market position.

Limit pricing is common in oligopolies because barriers to entry are already high. By setting prices strategically, incumbents can reinforce these barriers and maintain dominance.

Entry Deterrence and Strategic Behaviour

Both predatory pricing and limit pricing are forms of entry deterrence. In an oligopoly, protecting market share is often more important than maximising short-run profits. Firms know that once new competitors enter, profits will be reduced permanently. By sacrificing some profit today through lower prices, they can prevent entry and safeguard future earnings.

Strategic behaviour in oligopoly therefore involves a constant trade-off between current and future profits. Firms may adopt tough strategies to signal to potential entrants that they are willing to fight aggressively, thereby discouraging entry even before it occurs.

Long-Run and Short-Run Considerations

Pricing strategies also differ between the short run and the long run. In the short run, price wars or predatory tactics may lead to very low prices and losses for some firms. In the long run, however, firms usually seek stability. Once rivals have been deterred or eliminated, prices may return to higher levels.

Consumers, therefore, experience mixed effects. In the short run, they may benefit from lower prices, but in the long run, they may face higher prices once competition has been reduced. Regulators intervene to prevent such outcomes, ensuring that markets remain contestable and that dominant firms do not abuse their position.