AQA A-Level Economics (7136)

## Learning Outcomes

- Understand why **interdependence** is central to competition in oligopoly
- Identify the difference between **collusive** and **non-collusive** behaviour
- Explain why **non-price competition** is often more common than price competition in oligopolistic markets
- Analyse the **kinked demand curve** as an explanation of price rigidity
- Use **game theory** and the **prisoner's dilemma** to explain why collusion may break down
- Interpret **concentration ratios** and understand their limits as evidence of market power
- Develop evaluative chains of reasoning about consumers, firms, efficiency and competition policy

## AQA A-Level Economics (7136) Syllabus

For the AQA A-Level Economics (7136), you are expected to understand competition and market dynamics mainly in the context of **oligopoly**, with a focus on the following syllabus points:

- Know that **oligopoly** involves a few dominant firms and **interdependence** between them
- Explain the difference between **collusive** and **non-collusive** behaviour
- Understand **cartels** and **price leadership**
- Explain why firms may compete through **price competition** and **non-price competition**
- Understand **kinked demand curve theory** as an explanation of price rigidity
- Use **game theory** to explain strategic behaviour and why collusion may be unstable
- Interpret **market concentration** using measures such as concentration ratios
- Assess the effects of oligopoly behaviour on efficiency, consumers and market outcomes

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. Why is oligopoly usually defined by **interdependence** and not only by “a few firms”?
2. What is the difference between **collusive**, **non-collusive**, and **tacitly collusive** behaviour?
3. How does the **kinked demand curve** explain sticky prices?
4. Why might firms in an oligopoly avoid price competition and use branding or innovation instead?
5. How can **game theory** show that collusion is profitable but unstable?

## Introduction

Competition is not just about firms cutting prices. In many real markets, especially oligopoly, firms compete while constantly watching rivals. A price cut, new advert, product launch or loyalty scheme can trigger a response from competitors. This makes market behaviour more strategic than in perfect competition or monopoly.

For AQA, this topic matters because it links theory to real business behaviour. You need to explain not just what firms do, but why they do it, how rivals may react, and what this means for consumers, profits and efficiency.

> **Key Term: oligopoly**
> A market structure dominated by a few firms, usually with high barriers to entry and strong interdependence.

### Interdependence and forms of competition

The defining feature of oligopoly is **interdependence**. Each firm knows that its decisions on price, output, advertising or investment can affect rivals, and rivals' reactions then affect its own profit.

> **Key Term: interdependence**
> A situation where each firm's decisions depend on the expected reactions of rival firms.

This is different from other market structures:

- In **perfect competition**, firms are price takers and have no reason to worry about individual rival reactions.
- In **monopoly**, there are no close rivals in the market, so strategic reaction is much less central.
- In **oligopoly**, reaction matters all the time.

This helps explain why competition in oligopoly often takes two forms:

- **Price competition**: trying to gain sales by cutting prices
- **Non-price competition**: trying to gain sales without cutting price
  > **Key Term: non-price competition**
  > Competition through quality, branding, advertising, design, customer service, loyalty schemes or innovation rather than lower prices.

Why is non-price competition so common in oligopoly? Because price cuts are risky. If one supermarket, airline or mobile phone provider cuts price, rivals may copy the cut. The result is a fall in price across the market, but only a small gain in market share for the original firm. Revenue may rise a little, but profit margins usually fall.

By contrast, non-price competition may increase brand loyalty and reduce the **price elasticity of demand** for the firm's product. If consumers see one firm's product as more distinct, they are less likely to switch when another firm changes price.

A strong chain of analysis looks like this:

- firm increases advertising
- brand loyalty increases
- demand becomes less price elastic
- customers become less sensitive to rival price cuts
- firm gains market power
- profit may rise

However, this is not always good for consumers. Better quality and innovation may improve choice, but heavy spending on branding can also raise costs and act as a barrier to entry for smaller firms.

> **Test Tip:** If the question asks why oligopolists use non-price competition, do not just list advertising and branding. Explain the reason: fear of retaliation in price competition and the aim of building customer loyalty.

### Collusion, cartels and price leadership

Oligopolists may compete, but they may also cooperate.

> **Key Term: collusion**
> When firms work together on price, output or market sharing in order to reduce competition and increase joint profit.

Collusion can be:

- **Overt collusion**: an open or formal agreement
- **Tacit collusion**: coordination without a formal agreement
  > **Key Term: tacit collusion**
  > Coordination between firms without an explicit agreement, often shown by parallel pricing or following a price leader.

A **cartel** is the clearest form of overt collusion. Firms may agree to restrict output and keep prices high, creating an outcome similar to monopoly. This means:

- higher prices
- lower output
- supernormal profit
- reduced consumer surplus
- allocative inefficiency

In effect, consumer welfare falls because consumers pay more and buy less than they would in a more competitive market.

Collusion can also protect inefficient firms. If firms agree prices rather than compete strongly, weaker firms may survive when they would otherwise be forced to cut costs or exit. That weakens pressure for productive efficiency.

Price leadership is a less direct form of coordination. One firm changes price, and others follow. This can stabilise the market and avoid price wars, but it may also reduce competition.

Still, evaluation matters. Not every form of cooperation is harmful. Firms may cooperate on health and safety, shared research or industry standards. That can lower costs or improve product quality without directly fixing price.

Why is collusion difficult to sustain?

- each firm has an incentive to cheat by secretly cutting price
- costs and objectives differ between firms
- new firms may enter if profits are high
- demand may change unexpectedly
- competition authorities may investigate

So the likely exam judgement is that collusion can raise profits in the short run, but is often unstable and usually harmful to consumers.

> **Test Tip:** When evaluating collusion, use the structure “on the one hand... on the other hand... it depends...”. Good “it depends” factors include barriers to entry, likelihood of cheating, legal enforcement and whether firms still compete through quality and innovation.

### Kinked demand curve and price rigidity

The **kinked demand curve** is a model of non-collusive oligopoly. It is used to explain why prices in oligopolistic markets may be stable.

> **Key Term: kinked demand curve**
> A theory suggesting that demand is more elastic above the current price and less elastic below it, helping explain price rigidity in oligopoly.

The assumptions are:

- if one firm raises price, rivals do not follow
- the firm loses many customers, so demand is relatively elastic above the current price
- if one firm cuts price, rivals do follow
- the firm gains few extra customers, so demand is relatively inelastic below the current price

This creates a kink at the current market price. The associated **marginal revenue** curve has a discontinuity. If marginal cost changes within this gap, the profit-maximising price may stay the same.

So the model explains **price rigidity** or **sticky prices**.

Example chain:

- firm considers a price rise
- rivals keep their prices unchanged
- consumers switch away
- demand falls sharply
- revenue falls

Now a price cut:

- firm cuts price
- rivals match the cut
- market share hardly changes
- price falls across the market
- profit falls

Since both actions are unattractive, firms may keep price unchanged and compete through advertising, service or product design instead.

This is useful in exam answers because it links directly to interdependence and non-price competition.

However, the model has limits:

- it explains why price may stay stable, not how the original price was chosen
- not all oligopolies behave this way
- some markets do have frequent price changes
- it is a descriptive model, not a full theory of all oligopoly behaviour

So use it carefully. It is an explanation of price rigidity, not a complete model of oligopoly.

### Game theory, concentration and how to evaluate answers

> **Key Term: game theory**
> The analysis of strategic behaviour where the outcome for each firm depends on the decisions made by rivals.

Game theory is useful because oligopoly is strategic. A firm's best action depends on what others do.

The classic example is the **prisoner's dilemma**. Two firms can either collude by keeping prices high or cheat by cutting price.

A simple payoff matrix might be:

- if both keep prices high: each earns 10
- if Firm A cuts price and Firm B does not: A earns 15, B earns 4
- if Firm B cuts price and Firm A does not: B earns 15, A earns 4
- if both cut price: each earns 6

Both firms would be better off jointly if they colluded and kept prices high. But each firm has an incentive to cheat. That is why collusion may break down.

This gives you a strong chain of reasoning:

- collusion raises joint profit
- but each firm can gain more by secretly undercutting
- rivals expect this risk
- trust is weak
- collusion becomes unstable

This can be stronger than simply stating “firms may cheat”.

Market structure can also be measured.

> **Key Term: concentration ratio**
> The combined market share of the largest firms in an industry, such as the four-firm concentration ratio.

Worked example:

Suppose the four largest firms in a market have shares of 30%, 25%, 15% and 10%.

Step 1: identify the four largest firms  
Step 2: add their market shares

CR4 = 30 + 25 + 15 + 10  
CR4 = **80%**

This suggests a highly concentrated market.

A higher concentration ratio often means greater potential for interdependence and collusion. But do not overstate this. A concentrated market may still be competitive if:

- barriers to entry are low
- there is strong foreign competition
- consumers can switch easily
- firms are under threat from new technology

So concentration measures are indicators, not proof of market power or anti-competitive behaviour.

> **Key Term: concentration ratio**
> The combined percentage market share of the largest firms in a market.

How to structure an evaluative answer:

Start with a clear judgement on the basic theory. For example, “Non-price competition is often more important than price competition in oligopoly because firms fear retaliation.”

Then develop both sides:

- financial or market evidence: profits, market share, price rigidity, barriers to entry, concentration
- non-price factors: branding, innovation, service, product differentiation
- limitations: different oligopolies behave differently; some are more contestable; digital markets may change quickly; collusion may be unstable

A strong ending should not be generic. It should say what the answer depends on, such as market transparency, ease of entry, how differentiated products are, and whether firms interact repeatedly.

Common student errors:

- defining oligopoly only as “a few firms” and missing interdependence
- using the kinked demand curve to explain how price is first set
- assuming all high concentration means illegal collusion
- describing advertising without analysing how it affects elasticity, market share or profit

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Oligopoly is best understood through **interdependence** between a few dominant firms
- Firms in oligopoly may use **price competition** or **non-price competition**
- Non-price competition is common because price cuts may trigger retaliation and reduce profit margins
- **Collusion** involves firms cooperating on price, output or market sharing
- **Tacit collusion** occurs without an explicit formal agreement
- A **cartel** can create monopoly-like outcomes with higher prices and lower output
- Collusion often reduces consumer surplus and can cause allocative inefficiency
- The **kinked demand curve** explains why prices may be rigid in oligopoly
- The kinked demand model does not explain how the original price was set
- **Game theory** shows why collusion may be jointly profitable but individually unstable
- A **concentration ratio** measures the market share held by the largest firms
- High concentration may suggest market power, but it does not by itself prove weak competition

## Key Terms and Concepts

- oligopoly
- interdependence
- non-price competition
- collusion
- tacit collusion
- kinked demand curve
- game theory
- concentration ratio


Market Structures and Competition - Competition and market dynamics