In simple terms
A friendly intro before the formal notes — no formulas yet.
High Street Battles: Coffee Shops vs. Supermarkets
Most markets are neither pure monopolies nor perfectly competitive. This lesson explores the realistic middle ground where firms — like your local coffee shop or the big supermarket chains — compete for you.
Picture a busy food court. Dozens of independent stalls sell similar-but-slightly-different food; each tries to stand out to win customers. That is monopolistic competition — many firms, differentiated products, easy to open a new stall. Now picture the handful of supermarket chains in a town. There are only a few, so if one cuts the price of milk the others notice at once and react. That is oligopoly — a few big players locked in a staring contest, each move triggering a counter-move.
- 1
First, read the market's structure: count the firms, check whether products are identical or differentiated, and judge how easy entry is.
- 2
In monopolistic competition, a single firm behaves like a mini-monopoly in the short run, setting output where MR = MC and possibly earning abnormal profit.
- 3
In the long run, low barriers let new firms enter, competing that profit away until only normal profit remains — but at less than the lowest-cost output, so there is excess capacity.
- 4
In oligopoly, firms are interdependent: each decision depends on the expected reaction of rivals, which pushes them towards either collusion or strategic (often non-price) competition.
Explore the concept
Use the live diagram and synced steps — play it or tap a step card to walk through.
Key formulas
Tap any symbol to reveal exactly what it means and its units.
Full topic notes
Formal explanation with the rigour you need for the exam.
HL flag: where this sits in the course
HL only. The full treatment of market structures — including monopolistic competition, oligopoly, the kinked demand curve and game theory — is assessed at Higher Level. SL students are not examined on this material. HL Paper 1 and Paper 3 can both draw on it, and Paper 3 may require calculation and diagram work built on these models.
Monopolistic Competition: Many Firms, Many Choices
Monopolistic competition blends the two benchmark models. Like perfect competition it has many firms and low barriers to entry; like monopoly, each firm sells a product that is slightly different from its rivals', which gives it a downward-sloping demand curve and a small amount of price-setting power.
In the short run, a monopolistically competitive firm behaves like a mini-monopolist. It maximises profit where marginal revenue equals marginal cost (MR = MC) and can earn abnormal (supernormal) profit if price exceeds average total cost at that output (P > ATC).
In the long run, that abnormal profit cannot last. Low barriers mean new firms enter, drawing customers away and shifting each incumbent's demand (AR) curve to the left and making it flatter (more elastic), because more substitutes now exist. Entry continues until the demand curve is just tangent to the ATC curve, where P = ATC and only normal profit remains. Symmetrically, short-run losses would trigger exit until the survivors return to normal profit.
Large number of firms: each has a small market share and none can dominate; firms act independently and ignore rivals' individual reactions.
Product differentiation: the defining feature — products differ by branding, quality, design, service or location, creating brand loyalty and a downward-sloping demand curve.
Low barriers to entry and exit: if incumbents earn abnormal profit, new firms can enter freely and compete it away.
Non-price competition: firms compete heavily through advertising, branding and packaging rather than price alone.
Excess capacity and inefficiency (HL)
The long-run tangency point is the key HL insight. Because the demand curve slopes downward, it can only be tangent to ATC on the falling part of the ATC curve — never at its minimum. So the firm produces LESS than the output that would minimise average cost. The gap between the firm's actual output and the minimum-ATC (productively efficient) output is called excess capacity.
Productive inefficiency: the firm does not produce at minimum ATC, so average costs are higher than they could be — society could have the same goods at lower cost.
Allocative inefficiency: price exceeds marginal cost (P > MC), so output is below the socially optimal level where P = MC; consumers value extra units by more than they cost to make.
But: consumers gain variety and choice from differentiation, which some economists argue partly offsets the efficiency loss.
Oligopoly: The Few and the Interdependent
An oligopoly is a market dominated by a few large firms — think supermarket chains, mobile networks, or global soft-drink and aircraft makers. Its defining feature is interdependence: because each firm is large relative to the market, one firm's decision on price, output or advertising materially affects its rivals, who then respond. Every firm must therefore anticipate rivals' reactions before it acts. This strategic dimension is why game theory is the natural tool for oligopoly.
Few large firms: a small number account for most industry output; measured by a high concentration ratio.
High barriers to entry: economies of scale, brand loyalty, patents or heavy sunk advertising costs deter new entrants.
Interdependence: firms are mutually dependent — the key behavioural feature, absent from monopolistic competition.
Products differentiated OR homogeneous: cars and phones are differentiated; oil, steel and cement are near-homogeneous.
Collusion versus non-collusion
Interdependence pulls oligopolists in two directions. They may collude — cooperate to behave like a single monopolist, restricting output and raising price to increase joint profit — or they may act non-collusively, competing on price or, more often, on non-price factors. Collusion itself comes in two forms.
Overt (formal) collusion / cartel: an explicit agreement to fix prices or share out output, e.g. OPEC. In most countries this is illegal and attracts heavy fines.
Tacit collusion: coordination without a formal agreement — most commonly price leadership, where a dominant firm sets a price and others follow. Harder to prove, so harder to prosecute.
Why collusion is unstable: each member can raise its own profit by secretly cheating — undercutting the agreed price to grab extra sales — so agreements tend to break down (see the game-theory section).
Non-price competition: where firms do not collude, they usually avoid price wars (easily matched, mutually damaging) and compete instead through advertising, branding, product design, quality and loyalty schemes.
The kinked demand curve and price rigidity (HL)
The kinked demand curve model explains why prices in a non-collusive oligopoly are often rigid — they stay put even when costs change. It rests on an asymmetric assumption about how rivals react, taken from each firm's own point of view at the current market price.
A caution examiners like to test: the kinked demand curve DESCRIBES price rigidity, but it does not explain how the price P* was set in the first place, and it is only one model of non-collusive behaviour. Real oligopolies also show price wars and price leadership, so treat the kink as one useful tool, not the whole story.
If the firm cuts its price, rivals will MATCH the cut to avoid losing customers. The firm gains few extra sales, so demand BELOW the current price is relatively inelastic.
If the firm raises its price, rivals will IGNORE the rise and keep theirs low. The firm loses many customers, so demand ABOVE the current price is relatively elastic.
The kink: these two segments meet at a kink at the current price P*. The result is a demand curve that is flat (elastic) above P* and steep (inelastic) below it.
The MR gap: the kink produces a vertical discontinuity in the marginal revenue curve. Marginal cost can rise or fall anywhere WITHIN that gap and the profit-maximising price stays at P*.
Conclusion: price is sticky. This helps explain why oligopolists so often leave price alone and compete on non-price factors instead.
Game theory and the prisoner's dilemma (HL)
Game theory models the strategic interdependence at the heart of oligopoly. The classic set-up is the prisoner's dilemma, shown as a 2×2 payoff matrix for two firms each choosing between two strategies — for example, 'keep to the agreed high price (collude)' or 'undercut (defect)'. Each cell shows the payoff (profit) to each firm for that combination of choices. The dilemma: each firm has a dominant strategy to defect — undercutting is its best response whatever the rival does — so both defect and both end up worse off than if they had trusted each other and colluded. That is precisely why cartels are so hard to sustain.
Measuring market concentration
Economists gauge how concentrated a market is with a concentration ratio — the combined market share of the largest firms. A high ratio points to oligopoly or monopoly; a low ratio to monopolistic or perfect competition.
n-firm Concentration Ratio (CRn) =
Common mistakes examiners penalise
Confusing monopolistic competition with monopoly — both have downward-sloping demand and set MR = MC, but monopolistic competition has MANY firms and LOW barriers, so abnormal profit is competed away to normal profit in the long run. A monopoly can keep abnormal profit behind high barriers.
Forgetting excess capacity — in long-run monopolistic competition the firm is at P = ATC but NOT at minimum ATC. Saying it is 'productively efficient like perfect competition' loses marks; stress the tangency on the falling part of ATC.
Assuming oligopolists always collude — interdependence creates a TEMPTATION to collude, but firms may just as well compete (price wars, non-price competition), and collusion is unstable and often illegal. State the incentive to cheat.
Misreading the kinked demand curve — the inelastic segment is BELOW the current price (rivals match cuts); the elastic segment is ABOVE it (rivals ignore rises). Reversing these, or claiming the model explains how the price was originally set, are classic errors.
Muddling the prisoner's dilemma — the dominant strategy is to DEFECT (undercut), and both defecting leaves both WORSE off than colluding. Do not claim the equilibrium is the joint-best (collusive) outcome.
Treating an oligopoly diagram as one-size-fits-all — there is no single oligopoly diagram; choose the model (kinked demand, game theory, or collusion drawn like monopoly) that fits the question.
For HL Paper 1, learn to draw the long-run monopolistic-competition diagram (AR tangent to ATC, MR = MC, output below minimum ATC) AND to set out a 2×2 prisoner's-dilemma matrix — examiners reward a correct, fully-explained diagram or payoff matrix, not just a mention. For oligopoly, always anchor your answer in interdependence.
Key concepts in this lesson
This HL lesson develops two of the course's key concepts. Interdependence is the behavioural core of oligopoly — no firm can decide in isolation, which is why collusion, the kinked demand curve and game theory all matter. Efficiency runs through the comparison of structures: monopolistic competition carries excess capacity (productive and allocative inefficiency), while oligopoly outcomes range from near-monopoly (collusion) to more competitive results depending on firms' strategic choices. Reminder: this material is examined at Higher Level only.
Worked examples
See the formulas applied — reveal one step at a time, like the exam.
'The Daily Grind' is a coffee shop in a monopolistically competitive market. In the short run it maximises profit where MR = MC at an output of 100 cups per day; at that output the price read off the demand (AR) curve is £3.50 and average total cost (ATC) is £2.50. The currency is pounds (£).<br><br>a) Identify the profit-maximising output and explain the rule used. [2]<br>b) Calculate the short-run abnormal profit. [3]<br>c) Explain what happens to this profit in the long run and why the outcome involves excess capacity. [4]
- 1
a) Profit-maximising output (2)<br>The firm maximises profit where marginal cost equals marginal revenue (MC = MR) — the last unit adds exactly as much to revenue as to cost. That occurs at 100 cups per day. (Producing more would add more to cost than revenue; producing less would forgo profitable units.)<br><br>b) Short-run abnormal profit (3)<br>Abnormal profit = (Price − ATC) × Quantity.<br>= (£3.50 − £2.50) × 100<br>= £1.00 × 100 = £100 per day. Because P (£3.50) > ATC (£2.50), the firm earns abnormal profit in the short run.<br><br>c) Long run and excess capacity (4)<br>The £100 abnormal profit signals a profitable opportunity. Because barriers to entry are low, new coffee shops enter, drawing customers away from The Daily Grind. Its demand (AR) curve shifts left and becomes more elastic as more substitutes appear. Entry stops only when abnormal profit is gone — when the AR curve is just tangent to ATC, so P = ATC and the firm earns just normal profit. Since AR slopes down, that tangency must be on the falling part of ATC, so the firm produces below the minimum-ATC output. The difference between that output and the least-cost output is excess capacity — the firm is not productively efficient.
Two petrol stations, A and B, are the only sellers on a motorway junction. Each can set a HIGH price (the collusive outcome) or a LOW price (undercut). The payoff matrix shows daily profit (£), written as (Profit to A, Profit to B):<br><br>| | B: HIGH | B: LOW |<br>|---|---|---|<br>| A: HIGH | (100, 100) | (20, 130) |<br>| A: LOW | (130, 20) | (50, 50) |<br><br>Using the matrix, explain the likely outcome and why the firms fail to sustain the collusive (High, High) result.
- 1
Step 1 — Read the joint-best outcome. If both keep the HIGH price, each earns £100 — the collusive outcome, and the highest COMBINED profit (£200). This is what a cartel between A and B would try to achieve.<br><br>Step 2 — Find A's best response to each of B's choices.<br>• If B plays HIGH: A earns £100 by playing High, but £130 by playing Low (undercutting to steal B's customers). A prefers Low.<br>• If B plays LOW: A earns only £20 by staying High (it is undercut), but £50 by also playing Low. A prefers Low.<br>So whatever B does, A is better off playing Low — Low is A's dominant strategy.<br><br>Step 3 — By symmetry, do the same for B. The payoffs mirror A's, so Low is also B's dominant strategy.<br><br>Step 4 — Predicted outcome. Both play their dominant strategy, giving (Low, Low) = (£50, £50) — the Nash equilibrium. Note this is worse for both than the (£100, £100) they could have earned by colluding.<br><br>Step 5 — Why collusion breaks down. Even if A and B formally agree to hold the High price, each sees a private £30 gain (130 vs 100) from secretly cheating. Because both face that identical incentive, the agreement is unstable — the very interdependence that makes collusion tempting also makes it fragile. In practice firms may sustain cooperation only through repeated interaction, trust or the threat of retaliation (a future price war), which the one-shot prisoner's dilemma leaves out.
A supermarket industry has these market shares: Firm 1 (27%), Firm 2 (15%), Firm 3 (14%), Firm 4 (9%), Firm 5 (10%), Firm 6 (8%), Others (17%). Calculate the 4-firm concentration ratio (CR4) and comment on the market structure. [4]
- 1
1. Identify the four largest firms. (1)<br>Ranked by share: Firm 1 (27%), Firm 2 (15%), Firm 3 (14%), then Firm 5 (10%) — Firm 5 at 10% is larger than Firm 4 at 9%, so Firm 5 is the fourth largest.<br><br>2. Calculate CR4. (1)<br>CR4 = 27% + 15% + 14% + 10% = 66%.<br><br>3. Comment on structure. (2)<br>A CR4 of 66% is high: two-thirds of the market is held by just four firms. This is characteristic of an oligopoly — a few large, interdependent firms with significant market power and likely high barriers to entry. Given the interdependence, we would expect strategic behaviour such as non-price competition or possible (tacit) collusion.
Paper 1, part (a): Explain, using a game-theory (prisoner's dilemma) example, why firms in an oligopoly may fail to sustain a collusive agreement. [10]
- 1
Model answer: An oligopoly is a market dominated by a few large firms that are interdependent — each firm's best decision depends on how its rivals are expected to react. This interdependence gives firms an incentive to collude: by jointly restricting output and holding a high price (acting like a monopolist) they can raise their combined profit. But the same interdependence makes such an agreement fragile, and game theory shows why.
How it all connects
The big idea sits in the middle — tap a linked idea to explore the link.
Tap a linked idea to see how it connects back to the main topic — that connection is what examiners reward.
Glossary
Try to recall each definition before you reveal it.
Quick check
Answer in your head first — then tap to check. No pressure.
Revision flashcards
Flip the card. Test yourself before the exam.
Monopolistic Competition
A market structure with a large number of firms selling differentiated products, with low barriers to entry and exit. Each firm has a little price-setting power but no ability to earn long-run abnormal profit.
Key takeaways
Review these before you close the topic — retrieval beats re-reading.
- ✓
Large number of firms: each has a small market share and none can dominate; firms act independently and ignore rivals' individual reactions.
- ✓
Product differentiation: the defining feature — products differ by branding, quality, design, service or location, creating brand loyalty and a downward-sloping demand curve.
- ✓
Low barriers to entry and exit: if incumbents earn abnormal profit, new firms can enter freely and compete it away.
- ✓
Non-price competition: firms compete heavily through advertising, branding and packaging rather than price alone.
Practice — then mark it
The whole point: a real Cambridge question, marked mark-by-mark.
Get a Paper 1 (a) answer marked: use a prisoner's dilemma to explain why oligopoly collusion breaks down
Get a Paper 1 (a) answer marked: use a prisoner's dilemma to explain why oligopoly collusion breaks down
Extra simulations & links
PhET, GeoGebra and other curated tools — open in a new tab.
Frequently asked
Checkpoint
One marked question is worth ten re-reads — close the loop before you move on.
Reading it isn’t knowing it — prove it.
Before you move on: do Get a Paper 1 (a) answer marked: use a prisoner's dilemma to explain why oligopoly collusion breaks down on paper, snap a photo, and get examiner-style feedback on exactly where you win and lose marks.