Evaluating the costs and benefits of oligopoly

Overview

Allocative efficiency, productive efficiency and dynamic efficiency.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   State the main potential costs of oligopoly to consumers and to the economy.

   Model answer

   Price is likely to be held above marginal cost, so output is restricted, consumer surplus is transferred to producers and a deadweight welfare loss arises. Barriers to entry keep supernormal profits from being competed away. Resources are absorbed by persuasive advertising and cosmetic product variation. Weak competitive pressure allows costs to drift upward, and collusion, whether open or tacit, can hold prices well above what a competitive market would deliver.

2. 2

   State the main potential benefits of oligopoly to consumers and to the economy.

   Model answer

   Large firms can exploit economies of scale, so unit costs may be lower than a fragmented industry could achieve, and part of that saving may reach consumers. Retained supernormal profit can finance research and development that smaller firms could not fund, generating dynamic efficiency. Non-price competition can deliver genuine improvements in quality, choice and service. Price stability is itself of some value to consumers and to firms planning investment.

3. 3

   What is allocative efficiency, and why does oligopoly typically fail to achieve it?

   Model answer

   Allocative efficiency occurs where price equals marginal cost, so the value consumers place on the last unit equals the cost of producing it and no reallocation of resources could make anyone better off without making someone worse off. Oligopolists face downward-sloping demand and set output where marginal revenue equals marginal cost; since marginal revenue is below price, price exceeds marginal cost and units that consumers value above their cost go unproduced.

4. 4

   What is productive efficiency, and is oligopoly productively efficient?

   Model answer

   Productive efficiency means producing at the minimum point of the average cost curve, so output is obtained at the lowest possible unit cost. Oligopolists are generally not productively efficient, because they restrict output below the level that would minimise average cost and because weak competitive pressure permits organisational slack, though their scale means their minimum average cost may still be far lower than that of a small firm.

5. 5

   What is dynamic efficiency, and why might oligopoly deliver it better than perfect competition?

   Model answer

   Dynamic efficiency is improvement over time through innovation in products and in production methods, which shifts cost curves down and creates goods that did not exist before. Oligopoly may deliver it better because research is expensive, risky and has to be funded from somewhere, and only firms with supernormal profit and the scale to spread development costs over large output can undertake it. In perfect competition profits are competed away to normal levels, leaving no surplus to invest and no protection from imitators.

6. 6

   What is X-inefficiency and why is it a risk in oligopoly?

   Model answer

   X-inefficiency is the gap between the cost a firm actually incurs and the minimum cost at which its output could be produced, caused by organisational slack, overstaffing and weak cost control rather than by the scale of output. It is a risk in oligopoly because barriers to entry and muted price competition mean that a firm with excessive costs is not driven out, so the discipline that forces cost minimisation is absent.

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