Why are oligopoly prices often stable, and when do a few large firms compete or collude?
Oligopoly: the features of a few interdependent firms, the kinked demand curve and price stability, collusion and cartels, game theory and the prisoner's dilemma, and non-price competition.
An SQA Advanced Higher Economics answer on oligopoly: the features of a market dominated by a few interdependent firms, the kinked demand curve explanation of price stability, collusion and cartels, the use of game theory and the prisoner's dilemma, and why firms compete on non-price terms.
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What this key area is asking
Oligopoly is the structure that best describes much of the real economy: supermarkets, banks, energy and mobile networks. The defining idea is interdependence, each firm's best move depends on what rivals do, so simple output rules no longer give a single prediction. You must explain the features of oligopoly, the kinked demand curve account of price stability, the incentives to collude (and to cheat), the use of game theory and the prisoner's dilemma, and why firms turn to non-price competition.
The features of oligopoly
The concentration ratio (the share of the market held by the largest few firms) is the usual measure: a high ratio, for example the largest four firms holding most of the market, signals oligopoly.
The kinked demand curve and price stability
The classic model of why oligopoly prices are sticky rests on each firm's beliefs about rivals' reactions.
Because has a gap at the kink, the firm's marginal cost can rise or fall within that gap and the profit-maximising output (where ) does not change. So the price stays at the kink even when costs move, predicting the stable prices seen in many oligopolies. The model's weakness is that it explains why the price stays put but not how the original price was chosen.
Collusion and cartels
Rather than compete, oligopolists may collude: agree to fix prices or share the market, acting jointly like a monopoly to raise total profit.
- Overt collusion: an explicit agreement, a cartel (illegal in the UK and most economies under competition law).
- Tacit collusion: unspoken coordination, often price leadership, where one firm sets the price and others follow.
Collusion raises price towards the monopoly level and is bad for consumers, which is why competition authorities pursue cartels.
Game theory and the prisoner's dilemma
Game theory models the strategic choices oligopolists face. The prisoner's dilemma shows why collusion is fragile:
Whatever the rival does, charging low gives each firm a higher payoff (undercut a high-price rival; avoid being undercut by a low-price rival). So low is each firm's dominant strategy, and the equilibrium is both charging low even though both would prefer to collude at the high price. This is why there is always a temptation to cheat on a cartel, and why stable collusion needs enforcement or repeated dealing.
Non-price competition
Because cutting price risks a damaging price war (rivals match) and raising it loses customers, oligopolists compete mainly on non-price terms:
- Branding and advertising to build loyalty and differentiate products.
- Product quality, design and innovation.
- Loyalty schemes, after-sales service and special offers.
Non-price competition can benefit consumers (variety, quality) but also raises costs and can entrench the leading firms.
Worked example: the temptation to cheat
Why this matters
Oligopoly describes the markets students actually shop in, so it is a favourite for data-response and the project. The interdependence, the temptation to collude and the reliance on non-price competition all feed directly into the market failure and intervention topic, where competition authorities police cartels and mergers. Game theory in particular is the analytical tool the SQA expects you to apply to real pricing behaviour.
Try this
Q1. In the kinked demand curve model, is demand elastic or inelastic for a price rise above the current price, and why? [2 marks]
- Cue. Elastic: the firm expects rivals not to follow a price rise, so it loses a large share of customers to them, making demand sensitive to the rise.
Q2. Explain why a cartel agreement to fix a high price is difficult to sustain. [2 marks]
- Cue. Each member can earn more by secretly undercutting the agreed price to win market share (a dominant strategy to cheat), so without enforcement the agreement breaks down.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA AH (style)10 marksUsing the kinked demand curve model, explain why prices in an oligopoly tend to be stable.Show worked answer →
Worth 10 marks: the model (about 5 marks) and the stability conclusion (about 5 marks).
The model (about 5 marks). The kinked demand curve assumes a firm believes rivals will react asymmetrically to a price change. If it raises its price, rivals will not follow, so it loses many customers: demand above the current price is elastic. If it cuts its price, rivals will match to protect their share, so it gains few customers: demand below the current price is inelastic. The demand curve is therefore kinked at the current price, with a corresponding discontinuity (a vertical gap) in the marginal revenue curve at the current output.
Stability (about 5 marks). Because the curve has a vertical gap at the kink, a firm's marginal cost can rise or fall within that gap without changing the profit-maximising output, since is still satisfied across the gap. So price stays at the kink even when costs change. The model predicts sticky prices and explains why oligopolists prefer non-price competition. A balanced answer notes the model describes stability but does not explain how the original price was set, and that collusion can also produce stable prices.
SQA AH (style)10 marksUse game theory to explain why two firms in an oligopoly might fail to sustain a high price even though both would be better off doing so.Show worked answer →
Worth 10 marks: the game set-up (about 5 marks) and the dominant-strategy outcome (about 5 marks).
The set-up (about 5 marks). Model two firms each choosing to charge a high price (collude) or a low price (compete), in a prisoner's dilemma payoff matrix. If both charge high, both earn good profits. If both charge low, both earn low profits. If one charges low while the other charges high, the price-cutter wins most of the market and the highest payoff of all, while the high-price firm does worst.
The outcome (about 5 marks). For each firm, whatever the rival does, charging low gives the higher payoff: if the rival charges high, undercutting captures the market; if the rival charges low, matching avoids being undercut. Charging low is therefore the dominant strategy for both, so the equilibrium is both charging low, even though both would be better off colluding at the high price. This explains the temptation to cheat on a cartel and why explicit, enforceable collusion (or repeated dealing) is needed to sustain high prices.
Related dot points
- Monopoly: barriers to entry, the profit-maximising equilibrium with abnormal profit, the efficiency loss compared with perfect competition, and the conditions for and types of price discrimination.
An SQA Advanced Higher Economics answer on monopoly: barriers to entry, the profit-maximising equilibrium where MC equals MR, why a monopoly restricts output and raises price relative to perfect competition, the resulting efficiency loss, and the conditions for and three degrees of price discrimination.
- Monopolistic competition: many firms with differentiated products, short-run abnormal profit competed away to long-run normal profit and excess capacity; and contestable markets where the threat of entry constrains behaviour.
An SQA Advanced Higher Economics answer on monopolistic competition and contestable markets: many firms selling differentiated products, short-run abnormal profit competed away to long-run normal profit with excess capacity, and the theory of contestable markets where low entry and exit barriers discipline incumbent firms.
- Perfect competition: its assumptions, short-run and long-run equilibrium, the role of entry and exit, and why it achieves both allocative and productive efficiency.
An SQA Advanced Higher Economics answer on perfect competition: its assumptions, why the firm is a price taker with horizontal demand, short-run abnormal profit, how entry and exit drive the market to long-run normal profit, and why the outcome is both allocatively and productively efficient.
- Costs, revenue and profit: short-run and long-run cost curves, total, average and marginal revenue, the profit-maximising MC = MR rule, and the distinction between normal and abnormal profit.
An SQA Advanced Higher Economics answer on the theory of the firm's costs and revenues: short-run and long-run cost curves, the law of diminishing returns, marginal revenue, the profit-maximising rule that marginal cost equals marginal revenue, and the difference between normal and abnormal profit.
- Market failure and intervention: externalities, public goods, merit and demerit goods, information failure and monopoly power; the policy responses of taxes, subsidies, regulation, tradable permits and provision; competition policy; and the risk of government failure.
An SQA Advanced Higher Economics answer on market failure and intervention: externalities and the divergence of private and social cost, public goods, merit and demerit goods, information failure and monopoly power, the policy toolkit of taxes, subsidies, regulation, tradable permits and provision, competition policy, and why intervention can itself cause government failure.
Sources & how we know this
- Advanced Higher Economics Course Specification — SQA (Qualifications Scotland) (2024)