When preparing for your AP Microeconomics Exam, you may become overwhelmed with the different market structures and what they stand for. In this AP Microeconomics oligopoly crash course review, we will talk about the oligopoly market structure and look at a few examples to understand better the industry. We will also touch the basics of the exam and what you should prepare for.
What is an Oligopoly?
Oligopoly is a market structure where a few large firms share a highly concentrated market share. It is in the middle of a monopoly and the perfect competition, where a few large firms control the market offering similar products. They are interdependent on each other, meaning that if one company makes a drastic decision, all companies will be affected by that decision, either good or bad.
Oligopoly firms normally are large in profit, size, and client term. Those firms are constantly competing against each other, and those competitions tend to be fierce, since the firms usually offer similar products at a similar price, and mostly their only way to differentiate themselves from the competition is through extensive marketing campaigns.
In order to avoid price wars, oligopoly firms may collude to agree on their price range and protect their sales volume. An official agreement on set prices is called a cartel and is illegal in most countries. You may recall watching movies such as “City of God” and “End of Watch”, both featuring drug cartels. The organization of petroleum exporting countries (OPEC) is another perfect example, an organization formed by twelve oil exporting countries that control the global oil market. The reason why international cartels exist is because it’s beyond the control of an individual country.
Oligopoly firms are highly interdependent. To solve the mystery of marginal revenue in an oligopoly, the interdependence of the firms is examined using the game theory, which consist in analyzing strategies that competing firm’s may use, or their dominant strategy before making a move. The game theory is often explained as the “prisoner’s dilemma” illustrating the choices oligopolies face.
The prisoner’s dilemma is a scenario where two suspects are arrested for a crime with not enough evidence of their guilt. They are then placed in different rooms without any kind of communication with each other, and interrogated and offered a play-off if they confess to the crime. If they choose not to confess they will get 3 years of jail time, and if the deny and are found guilty they could face from 1 to 10 years in prison.
Image Source: Economics Online
So how does this game work?
In this game theory, the outcome completely depends on the behavior of the other prisoner. To avoid the worst, the prisoners could confess and get 3 years, and if they could collide and both deny, they would get only 2 years. With the incentive that if one confesses and the other denies, the one confessing will get only one year if the other denies. So the safest outcome is to deny and both get 2 years, but without communication between them, they have to look for the dominant strategy of the other player.
To find out the dominant strategy, you have to look for the best of the worst playoff. The worst playoff for Robin here in confessing would be to get 3 years, or deny and get 10 years if Tom confesses. So his best of the worst is to confess because he does not trust Tom enough to know he will deny.
How is this Relevant to an Oligopolistic Market?
Firms are unlikely to trust each other, even if they come to an agreement for example to raise their prices together. So if you cannot trust the other firm to abide by their colluding agreement, it is safer to go with the dominant strategy.
Dominant strategy: is the firm’s best outcome without consideration of the other player.
Nash equilibrium point: is the best strategy for both firms and neither player can make a move to get a better result. In the Prisoners case, it would be to confess.
The demand curve for an oligopoly is known as the Kinked-Demand curve theory and is made of two segments of two separate demand curves, the upper highly elastic and the lower inelastic. It explains the likely reaction of other firms when one firm changes its price or other variables. If one firm raises their price, it is expected that the demand will be relatively elastic, and the firm will lose market share and a decrease in their total revenue. If a business reduces its price, the relative price change is smaller and the demand would be inelastic. This has little to no effect on the market share.
To better understand the kinked demand curve, let’s look at this graph.
Image Source: Tutor2u
- It predicts price stability, reinforcing their market position and increasing profit
- Short-term price wars between rival firms can happen while firms are looking for short term advantages and win extra market share.
Now to but this into practice, let’s look at a few examples. One example would be computer operating systems. Microsoft Windows, Apple Mac
OS X, and Linux are capturing close to 100% of the market share, and all other software providers have to make their programs compatible with these systems in order to survive, further enforcing the market power of the major players.
Another example is cellphone carriers, where approximately 90% of the national market is held by four companies, Sprint-Nextel, T-Mobile, Verizon, and AT&T. Although there are other smaller companies who fill up the other 10% of the market, they have little influence to no voice in the market and have to adjust to the leading companies to survive.
Are oligopolies good for Consumers? Consumers can easily compare prices among the few existing firms, which forces the companies to set competitive prices, and the stable prices help consumers to plan their spending and it also stabilizes the trade market.
The negative effect oligopolies have on consumers is that prices are high, qualities may not be as good as they could be due to lack of incentives for quality improvement, high barriers to enter the market, and the realization of many creative ideas can only be made possible when a major player adopts the ideas for use.
This may look like a lot to remember for the exam, but don’t worry, by the time you finish reading this crash course, you should have a good understanding of the concepts of oligopoly and what you need to know for your AP Microeconomics exam.
To get a better grasp on the terms involved, let’s look at the Important terms to remember
Important Economics Terms to Remember
- Collusion: oligopoly firms are likely to have tactical agreements between them, which involves increasing prices so all firms can have higher profits. This hurts consumers because their prices are higher than the normally would be in a perfect competition and are illegal.
- Non-price competition: they are usually involved in non-price competitions, where they compete by appearance or quality, or product differentiation.
- High concentration ratio: they have a high concentration ratio, which is the market share they control.
- X-inefficient: meaning that their products are not as efficient as they could be due to the lack of competitive incentives to cut cost and increase efficiency.
- High entry barriers: barriers to entry are high due to brand loyalty and high financial recourse needed to enter and compete with the leading firms.
- Low contestability: which refers to the difficult level of competition.
- Price Setter: meaning they are able to set their own prices rather than following the market price.
So Why is it Important for Me to Know What an Oligopoly is for AP Microeconomics?
If you are preparing for the AP Microeconomics exam, it is important that you understand the concept of oligopoly and know how to analyze a holistic situation of an oligopoly market. The question inevitable appears in the exam, either in the multiple choice section or in the FRQ section.
Is Oligopoly Part of My AP Microeconomic Exam?
Yes, as a student of AP Microeconomics, it is important to have a clear understanding of the oligopoly market structure, the key terms, and you should be able to analyze a holistic situation and formulate a graphic explanation in your answer.
To get a better understanding how to prepare yourself, Hopefully this crash course will help you to understand the concept and identifying an oligopoly market structure, and give you that little extra you were looking for to outperformed your classmates.
Let’s put everything into practice. Try this AP Microeconomics practice question:
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Data is plotted as bar charts. The x-axis of the charts is numbered from 1-9, which refers to the number on Map 4. For example, A1 is 1 on the map. The 3 bars in different colors represent the 3 different stores in each area. However, some areas might not have 3 bars as some stores might not sell that type of product. Below are the results (Results are in HKD [$] and a unit of dried seafood is measured by catty – a traditional Chinese unit.).
It is evident that most of the products are priced similarly in different stores. However, there are products which the price is considerably different in different stores, such as the Japanese abalone. This is due to the fact that abalone is a special and expensive dried seafood product. This can be supported by Mr. Shum who said that price of special products vary (see Appendix B). In addition, price might differ as some stores only sell high quality expensive dried seafood. On the other hand, some shops want to lower the price to clear excess stocks. Nevertheless, the trend shown in the price survey suggests that prices of dried seafood are similar within the area. Such findings also suggest that either firms do not compete on price, or they react to rival’s price changes quickly.
In the interview, shop owners were asked about some facts of this industry. Three shop owners were interviewed. The aim of this was to see if some shop owners responded in the same way to the same questions or differently. The responses are organized in Appendix A.
Data acquired is from interviews with Mr. Shum, Mr. Chan and Ms. Chan conducted on 23rd June 2010 (See Appendix B). All shop owners said that most of their customers are return customers. This demonstrates that the customers have loyalty towards a shop. Meanwhile, price does not seem to be an important factor influencing customers’ purchases, as Mr. Shum and Ms. Chan claimed that customers were not very sensitive to price. All of these elements suggest that customers’ loyalty exists in the dried seafood market, which is a feature of monopolistic competition and oligopoly.
While talking about prices, the shop owners admitted that prices were very similar on the street. In fact, Mr. Chan and Ms. Chan said that prices were agreed by the industry. This means that a large number of shops were involved in a price agreement. Such practice is a feature of a collusive oligopoly, and its goal is likely to be maximizing profit. This idea can be illustrated below:
If shops compete, they would aim to produce at allocative efficiency (Achieved when it the maximum combination of goods and services of what consumer actually want ), producing at price Pc and quantity Qc and earning supernormal profit of area C and F. Area A, B and E represents the consumer surplus (Excess of what consumers are willing to pay over what they actually pay). If shops collude, they will behave like a monopoly and maximize industry profit where MR (Marginal revenue) = MC (Marginal cost). So shops can restrict quantity to Qm and raise price to Pm. Supernormal profit increases to area B, C and D (Dobson and Palfreman 104-107).
There is a condition that has allowed this collusion to happen. Mr. Shum indicated that ‘many stores have been opened for decades and we [shop owners] know each other quite well’. The firms’ good relationships make price collusion easier to operate. It is also the case that Hong Kong is currently discussing competition laws. An article on this is found and discussed later in the section.
Due to collusion, there is little price competition, as suggested by similar pricing in the price survey. Even if firms try to compete on price by setting lower prices, customers may fear that the products might be of lower quality or even fake. This view could be supported by news reported by the Government which a few shop owners were arrested for selling fake abalone at an extremely low price in February 2010 (Hong Kong's information Services Department). Therefore, no shop owner says that lower prices are better although all agree that there is competition in the market.
Besides price competition, the interview also focused on non-price competition. While asking about their shops’ unique selling points, all three said they had none. In addition, they had no paid advertisement or promotions.
They mentioned that providing good service to gain reputation and customer loyalty was the main form of non-price competition. Mr. Chan and Ms. Chan said that they relied on loyal customers recommending new customers. It is true that it is difficult to distinguish the quality for most of dried seafood by view or smell, unless it is tasted for flavour and texture after cooked. Therefore, customers’ trust in shopkeepers is important. It can be seen how firms would depend on non-price competition for greater sales. This is a characteristic of monopolistic competition and oligopoly.
However, as Mr. Shum said, ‘many stores have been open for decades’, it is believed that old customers have been revisiting the shops for years. Old shops tend to have built reputation and a good relationship with customers, so reputation is associated with old shops. Therefore, this causes a large barrier to entry as most new entrants have no reputation at all and customers would hardly trust them. Hence, even though shop owners have indicated that there is barely any government regulation in opening shops, long-term customer loyalty and ineffectiveness of advertising have acted as disincentives for potential entrants. This perhaps explains why, according to the owners, the number of shops has not changed much. Also, this suggests that few shops have exited the market. This allows one to infer that abnormal profits are being made as firms would have fewer incentives to leave the market. Also, since most shops have survived for decades, it is supportive of long term abnormal profit, which is a characteristic of oligopoly.
In addition, the shop owners indicated that it would be easy to clear stocks if shops want to leave the market. Hence, there is no sunk cost and no barrier to exit at all, which is a characteristic of perfect competition and monopolistic competition.
Such finding contradicts the information provided in the report published by Conover and Dong as they state that the firms in the market compete on price vigorously (Conover and Dong).
Backup secondary research – Competition law
As shown by an article published in July 2010, the government of Hong Kong is still discussing the law (Clifford Chance). It is expected that the law is not imposed until sometime during 2012 (SJ Berwin's EU & Competition Team). Since there is no competition law, this provides an excellent condition and incentive for the dried seafood shops to collude.
Interview with a wholesaler
The aim of interviewing a wholesaler is to determine the size of the difference in the retail and wholesale prices. This would give a general idea if shops are making abnormal profits or not.
Summary and analysis of the interview with the wholesaler
Data discussed in this section all referred to an interview with Mr. Shum on 23rd June 2010 (See Appendix C). Mr. Shum, the wholesaler, gave the wholesale and retail prices of six products. Below is the result:
Table 1: Compares the retail price and the wholesale price
Wholesale Price per Catty
Retail Price per Catty
% difference (in respect of wholesale price)
Dried Oyster (Cheapest)
Japanese dried scallop (Cheapest)
22’ Japanese abalone
Jinshan shark fin 6-7”
8A dried shrimp from Thailand
Australian sea cucumber
Average price difference
Looking at Table 1, the retailers have at least raised the price by 12.5%. On average, the retail prices are 20.1% more expensive than the wholesale prices. Such large difference is perhaps caused by price collusion so that shops could earn more profit. This is why Mr. Chan suggested that this ‘industry is quite profitable’ (See Appendix B). In the long run, abnormal profit may be earned, is a characteristic of oligopoly. Such estimation would be more reliable if the shops’ expenditures are known. However, all shop owners refused to show their financial reports.
54 customers were surveyed in the targeted area. 7 questions were designed based on the interview results and asked to determine customers’ habits and the possible cross price elasticity (XED) (The responsiveness of quantity demanded of product A to the change in price of product B) of the more expensive, abalone, and cheaper products, shark fin and dried oyster.
During the survey, it could be observed that most of the customers surveyed were older and most of them were around 50-60 years old. It was rare to see young people shopping for dried seafood.
Below are the graphs for the results obtained from the survey:
Chart 6: It appears that many people do not shop around for this type of product. This suggests that they tend to be loyal to one or two shops.
Chart 7: 43% of the customers go to the same store for most of the time and 26% of the customers always go to the same store. This suggests that customer loyalty exists, and this, to some extent, gives shops the ability to be a price maker.
Chart 8: 76% of the customers are not very aware of the prices of the dried seafood on the street. It suggests that the customers do not shop for the cheapest price. Such figure suggests that customers do not have perfect knowledge.
Chart 9: Around 50% of the customers choose to switch their purchases to shop B when it decreases the price by 10-20%, which is large. So this suggests that the XED of abalone in different stores is low. This also implies that customers tend to purchase abalone in the shops they trust.
Chart 10: Around 50% of the surveyed customers chose to switch their purchases when shop B decreases the price by 10-20%, which suggests that the XED of shark fin is quite low in different stores.
Chart 11: Around 60% of the surveyed customers chose to switch their purchases from shop A to shop B when shop B decreases the price by 10-20%. This suggests that the XED of Japanese dried oyster is quite low.
Chart 12: 51% of the surveyed customers think that quality is the most important, followed by reputation. This might suggest that customers tend to go to stores with good reputation as they believe the quality in these shops would be higher. Meanwhile, only 8% thinks that price is important, which is low. This might be due to customers’ concept that cheaper dried seafood means lower quality.
Chart 13: The majority thinks that paid advertisement is the least important factor. Customers may not trust what is on the advertisement (“Word of mouth” is not included as it is not paid advertisment.). The shop owner says that the customers usually go to a shop by based on friends’ recommendations, so they do not care much about advertisement (See Appendix B).
Summary and analysis customers’ survey
It appears that 87% of the customers only shop in 1-3 shops. 69% of the customers constantly revisit the same shop while purchasing dried seafood. This suggests a high degree of customer loyalty. Since they are loyal to certain shops, most of them do not switch their purchases easily. For the three dried seafood products surveyed, over 50% of customers are willing to purchase other shops’ dried seafood if prices are reduced by 10-20%, which is a large percentage change in price. This suggests a
relatively inelastic XED. Cheaper products in one shop are not necessarily a close substitute of the same products in other shops. This is why the shop owners said that a price change would not change customers’ purchases. In addition, 76% of them are not sensitive to the price of dried seafood. This shows that customers do not have perfect knowledge. All of the above elements are features of monopolistic competition and oligopoly.
51% and 37% respectively think that quality and reputation are important, implying that customers would not shop in random shops, where quality is not guaranteed, unless they have a good reputation. Meanwhile, 81% of customers considered paid advertisement to be the least important factor. So new entrants, who have no reputation at all, would find it hard to compete with old shops, which have a number of loyal customers, as it is ineffective for them to advertise and promote products to attract customers. This can be considered as a high barrier to entry and is supportive of oligopoly.
Summing up, the customer survey has suggested that if a shop wants to attract customers, they would need to sell good quality dried seafood and have a good reputation. Eventually, this would win long-term customer loyalty. In addition, only 8% of the customers think price is influential. Such findings have suggested that non-price competition plays a large role in the industry. These elements are features of monopolistic competition and oligopoly.
Such findings contradict the published report published as it states that price is a sensitive issue (Conover and Dong).
The conclusion will first refer to the three hypotheses formulated.
Hypothesis 1 states that the market is in perfect competition. This can be supported by the large number of firms in the market and the fact that no firm dominates the industry. Meanwhile, barriers to exit are low. However, these are also features of monopolistic competition.
In fact, more evidence suggests that the market is in monopolistic competition. The price survey suggests that firms can alter prices, thus firms are price makers. The product survey indicates that products are slightly differentiated as the dried seafood in different shops can be of different qualities and from different countries. Customer loyalty also explains why the customer survey shows that customers do not acquire perfect knowledge of the market.
The market shows features of oligopoly. Price collusion, as suggested by similar pricing and interviews with shop owners, between firms would be a significant piece of evidence. Because customer loyalty is associated with old shops, new firms can hardly attract any customers. This acts as a large barrier to entry. It also suggests that firms mainly rely on non-price competition. Referring to the data provided by the wholesaler and the interview with shop owners, it can be estimated and suggested that abnormal profit can be made in the long run. Hence, hypothesis 1 is mostly rejected.
Hypothesis 2 states that customers are loyal to certain shops, but they shop according to price. Even though data shows that most customers are loyal to a shop, they would not change purchases according to price. Firstly, they are not very price sensitive due to their imperfect knowledge. Secondly, they also tend to visit shops with reasonable pricings as they fear lower prices mean the dried seafood is in low quality. Therefore, hypothesis 2 is partly accepted.
Hypothesis 3 states that the main form of competition in the dried seafood market is price competition. Data shows that shops mainly depend on reputation to win customers’ loyalty. Price collusion has caused the price of dried seafood to be similar. Therefore, hypothesis 3 is rejected.
The findings in the investigation have proven that most of the hypotheses are wrong. The market does not closely resemble a perfectly competitive market. On the spectrum, the market would be placed:
Relating to the research question: ‘What is the market structure of the dried fish market in Sheung Wan?’, the dried seafood market resembles a monopolistically competitive market with characteristics of an oligopoly.
Such a surprising result has demonstrated how theory would fail to explain a market in practice due to its complexity. It is also amazing to see little information is published on how shops operate in dried seafood market, given that this street is a very famous street in Hong Kong. Almost all published information about this street is related to tourism. Even if there is a published report on it, it mismatches with some of the primary research data. If only secondary research is done, perhaps the collusive agreement on price would never be discovered. This emphasizes the significance of this report.
Issues for consideration
During the research, three issues are raised, and this would probably have an effect on the market structure of dried seafood industry:
1. By 2012, the competition law will be imposed (SJ Berwin's EU & Competition Team), and shops will not be able to collude legally again. Will they compete more on price, or continue utilizing customer loyalty to attract customers?
2. From the data acquired from customer survey and interviews with shop owners, it is known that most of the customers are old. This suggests that young people do not buy dried seafood as much. In the future, if the older generation is gone, how will firms attract young customers and survive?
3. A new Mass Transit Railway station will be built and some exits will be built and opened on the street in the next few years (MTR Corporation Limited). This will possibly result in a large rise in rents. Developers will start buying old buildings for development of new buildings. This may force the street to move, or even disappear.
Limitation of the investigation
Only 3 shop owners were willing to give interviews. In some occasions, one shop owner may have biased opinions. For example, Mr. Chan claimed that the market is very competitive while the others thought that competition was not very vigorous. If more shop owners can be interviewed, the extra information acquired can make data more reliable.
The estimation of abnormal profit is based on Mr. Chan’s interview and the comparison of wholesale and retail price. To come to such conclusion, it is assumed that Mr. Chan has not exaggerated the level of profit and shops’ expenditures can always be covered by revenue. Therefore, the estimation of profit may be unreliable. If more time is provided, it may be possible to find a shop owner who is willing to show their financial reports, which would give a better idea as to what extent the dried seafood market is a profitable business.
Due to time constraints, the price survey is only limited to five sample products, which is not large enough to represent prices of all products. Therefore, if more prices of products can be surveyed, it would further confirm whether there is a similarity in price.
The estimation of low XED of products is based on a simulated price of the products, which is hypothetical. Therefore, it may not represent customers’ real reactions towards price changes. If time is allowed, it is better to wait and survey a change in quantity demanded in a shop after a price change to calculate the XED for the products.
Finally, the area targeted is only part of the market. It may not fully represent the characteristics of the whole market.
Blink, Jocelyn and Ian Dorton. “Perfect competition, Monopoly, Monopolistic competition, Oligopoly.” Economics. Great Britain: Oxford University Press, 2007. 95-119. Print.
Clifford Chance. “New competition law announced for Hong Kong.” Clifford Chance, 2010. PDF File
Conover, Shawneen A, and Dong Yuan-fang. "Hong Kong Dried Fish Market." National Marine Fisheries Service Mar. 1998. PDF File.
Dobson, Stephen, and Susan Palfreman. “The competitive market mode, Imperfect Competition.” Introduction to Economics. New York: Oxford University Press, 1999. 85-107. Print.
Dried Seafood Street Shops. 23 June 2010. Personal photograph by author. JPEG file.
“Google Maps” Google maps. Google. n.d. 18 July. 2010. http://maps.google.com.hk/?ie=UTF8&hl=en
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Hong Kong’s information Services Department. “Customs seizes fake abalone slices (with photos).” Press Release. The Government of Hong Kong, 11 Feb. 2010. Web. 15 July 2010. <http://www.info.gov.hk/gia/general/201002/11/P201002110187.htm>.
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MTR Corporation Limited. “Alignment.” MTR – West Island Line. N.p., 2010. Web.,
3 Oct. 2010. <http://www.mtr-westislandline.hk/en/project-details/
Mr. Chan. Personal interview. 23 June 2010.
Mr. Shum. Personal interview. 23 June 2010.
Ms. Chan. Personal interview. 23 June 2010.
SJ Berwin's EU & Competition Team. "Hong Kong: Hong Kong's Proposed New
Competition Law Unveiled ." Articles on All Regions, Law, Accountancy,
Management Consultancy Issues. Mondaq, 12 July 2010. Web. 1 Oct. 2010.