Oligopoly judged against a competitive benchmark: the deadweight loss and X-inefficiency, then economies of scale that can still give a lower price, dynamic efficiency and what it depends on.
In December 2024 the Competition and Markets Authority cleared the merger of Vodafone and Three, the UK’s third and fourth largest mobile networks, creating the largest operator with over 27 million subscriptions. Earlier that year the CMA had provisionally found that the deal would lead to price increases for tens of millions of customers. It let the merger go ahead only once the firms gave legally binding commitments: to invest £11 billion in a combined 5G network over eight years, and to cap selected tariffs and data plans for three years.
Why would a competition authority let four firms become three?
Sources: CMA final decision, reported by Herbert Smith Freehills and RCR Wireless (December 2024).
A market can be supplied by many small firms or by a few large ones.
Could the market with a few large firms ever give consumers a lower price?
Fewer firms usually means more market power, but large firms can reach economies of scale. If their costs are low enough, their profit-maximising price can be below the price many small, higher-cost firms would charge.
Start with demand for the whole market. To judge oligopoly fairly, we need a benchmark: the same market supplied by many small firms competing with each other.
MC1 is the industry’s marginal cost if the market is split between many small firms. Competing firms keep producing until price falls to marginal cost, so the competitive outcome is where MC1 meets demand: Pc and Qc. This is the benchmark.
Check: Under competition, where does industry output settle?
Competing firms keep expanding while price is above marginal cost, so output rises until price equals MC1.
Now suppose a few firms take over the market with the same costs, MC1, and act together, as a collusive oligopoly does. Like a monopoly, they produce where MC1 = MR, at Qm, and charge Pm, read up to demand.
Check: With the same costs, how does the collusive oligopoly compare with the benchmark?
Pm is above Pc and Qm is below Qc: the oligopoly restricts output to raise the price.
This is the first cost: allocative inefficiency. At Qm, price is well above MC1, so units that consumers value at more than they cost to make are not produced. The triangle from Qm to Qc is the deadweight welfare loss. Consumers also pay a higher price on the units they do buy, so some consumer surplus becomes abnormal profit.
The diagram does not show every cost. With little competitive pressure, costs can drift above the lowest possible: X-inefficiency. Barriers to entry protect abnormal profit in the long run. Choice can be narrow, and heavy spending on advertising and branding adds to costs without improving the product.
Check: Which of these is X-inefficiency?
X-inefficiency means producing at a higher cost than necessary, because without strong rivals there is little pressure to control costs.
Now the case for oligopoly. A few large firms can reach economies of scale that many small firms cannot: one national network instead of many small ones, bulk buying, high fixed costs spread over far more customers. So their marginal cost is lower: MC2, well below MC1. This is a new, lower curve, not a movement along MC1.
The oligopoly still maximises profit where MC2 = MR, at Qo, with the price Po read up to demand. Because its costs are so much lower, Po is below the competitive price Pc, and output Qo is above Qc. Consumers can pay less in a market with a few large firms than in one with many small firms.
Check: Why is Po below Pc on this diagram?
The oligopoly still uses MC = MR, but with much lower costs that point is at a higher output, so the price read off demand is lower.
Two more benefits. Abnormal profit can pay for research and development, so costs keep falling and products improve over time: dynamic efficiency. And oligopolists that do not collude can compete hard through price wars, quality and new products, so consumers gain choice. But look at Qo: price is still above MC2, so some allocative inefficiency remains.
Teacher tip: In a 20 marker this diagram is your evaluation. It shows that a more concentrated market does not prove higher prices: the answer turns on how far costs fall and whether the savings reach consumers.
So is oligopoly good or bad for consumers? It depends. Cost savings only reach consumers if rivals or the threat of entry force firms to pass them on. Profit can fund research or simply go to shareholders. A collusive oligopoly looks like the cartel diagram, while a competitive one can behave much like a competitive market. And regulation matters: the CMA let Vodafone and Three merge only with an investment commitment and capped prices.
Check: Which makes it more likely that consumers gain from an oligopoly?
Rivalry and the threat of entry force firms to pass lower costs on as lower prices and better products.
They read the price across from MC2 = MR, so their “price” was really the marginal cost of the last unit. The price comes from demand: consumers will pay Po for Qo.
Using a diagram, explain how an oligopoly could charge consumers a lower price than a market of many small competing firms.
If the market were supplied by many small firms, competition would push output up to where the industry’s marginal cost, MC1, meets demand, giving price Pc and output Qc.
A few large firms can reach economies of scale that small firms cannot, such as spreading the high fixed cost of a national network over millions of customers. Their marginal cost is therefore lower, at MC2.
The oligopoly still maximises profit where MC2 = MR, at output Qo, and charges Po, the price consumers will pay for that output. Because MC2 is so far below MC1, Qo is greater than Qc and Po is below Pc, so consumers pay less than they would in the competitive market.
However, price is still above MC2, so some allocative inefficiency remains, and the result depends on the cost saving being large. Firms only pass savings on if rivals or the threat of entry force them to, which is why the CMA cleared the Vodafone and Three merger only with price caps and an investment commitment.
Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.