Oligopoly: Price & Non-Price Competition (AQA A Level Economics)

• Firms in an oligopolistic market are highly competitive and can use price or non-price strategies to increase market share
• There is a high degree of interdependence between competitors in an oligopoly market
  • Competitors closely watch each others actions
  • They are very responsive to new innovations
  • They use game theory to determine the best course of action

• Non-price competition tends to be the most common way in which they compete
  • The focus of competition is on product differentiation to develop brand loyalty
    • E.g. Firms achieve this high levels of spending on advertising, branding, packaging, loyalty cards, etc 

• Price competition is less common, as firms want to avoid a price war
  • As goods and services are very close substitutes in an oligopolistic market, a price change initiated by one firm will cause other firms to react to price change
  • Individual firms will take into account the likely reactions of their competitors
    • This mutual interdependence leads to price stability or rigidity within the market 
  • The kinked demand curve demonstrates the concept of price rigidity

• The kinked demand curve provides one explanation of why prices are stable in oligopolistic competition
• Rival firms react to price changes initiated by a competitor

Diagram: Kinked Demand Curve

Prices are rigid at P_1. Competitors will not raise their price above this price.  If the firm sets its price lower, all competitors will follow suit, and there will be little change to market share 

Diagram analysis

• A firm produces a quantity of Q₁ and sells at price P₁
• This is a very similar price point found in the industry

Elastic section (A-B)

• If a firm increases its price from P₁ to P₂, it is unlikely that rival firms will follow the price increase
  
  • The firm will lose consumers to rival firms if they charge a higher price 
• This means that a small increase in price leads to a greater than proportionate decrease in quantity demanded, resulting in an overall fall in market share and total revenue
  • • This section of the demand curve (A-B) is elastic

Inelastic section (B-C)

• If a firm decreases its price from P₁ to P₃, it is likely that rival firms will respond by also decreasing price
  • All firms in the market will offer the new lower price
  • Market share remains the same. However, total revenue and profit decline for all
• This means that a decrease in price leads to a less than proportionate increase in quantity demanded, resulting in an overall fall in total revenue
  • This section of the demand curve (B-C) is inelastic

• The change in elasticities, brings about a kink in the demand curve at a price level of P₁
  • This creates price rigidity, as firms tend not to change price due to the anticipated behaviour of competitors (mutual interdependence)

• To avoid a price war, firms focus on non-price competition strategies to increase sales
  • This is why there is a high level of expenditure on research and advertising in oligopolistic industries

• Firms in oligopolistic markets commonly engage in non-price competition
• In other market structures, price competition is usually competitive
• Several reasons push firms towards a focus of non-price competition
   

Reasons why Oligopolistic Firms Engage in Non-price Competition

Reason	Explanation
Operation of cartels	If a small number of firms form a cartel, they agree a fixed price for their product This is anti-competitive and illegal. If they are caught, these firms are subject to high fines Some of the most famous cartels include the Middle East Oil Cartel (OPEC) and the drug cartels in Mexico and Columbia
Price leadership	A dominant firm in the industry is usually the price leader. Other smaller firms typically set a price close to it E.g Coca-Cola acts as the dominant firm, and its rival PepsiCo adjusts prices close to it. They differentiate through advertising campaigns or highlighting unique flavours
Price agreements	Firms may engage in price fixing to keep prices high E.g In the airline industry, major airlines might agree to set high ticket prices. To compensate for lack of price competition, they may focus instead on improving customer service or loyalty programmes
Price wars	This occurs when competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share By focusing on non-price strategies such as product differentiation or branding, firms can reduce the risk of engaging in price wars
Barriers to entry	Firms develop their advertising and branding as it increases barriers to entry New firms then find it difficult to compete with goods that have established brand loyalty with consumers

Evaluating an Oligopoly Market Structure

Advantages

Disadvantages

Consumers may benefit with lower prices. With a few firms dominating the market, large-scale operations result in economies of scale, reducing average costs    Lower costs enable firms to generate supernormal profits, which can be reinvested in research and development to create more innovative goods/services for consumers  A high degree of competition gives firms an incentive to continuously strive to improve the quality of goods and services

High barriers to entry restrict the number of firms entering the market Fewer firms may result in less innovation of goods and services   The dominance of a few firms enables control over prices or output. Limited competition results in fewer choices for consumers High levels of spending on branding and advertising can increase production costs. This cost may be passed on to consumers through higher prices  There is a potential for firms to engage in illegal collusion or operate as cartels by fixing price or output