2021 H2 Economics Paper 2 Essay 3: Suggested Answers

Why the telco market is an oligopoly. The market is defined by three key features. First, a few large firms dominate: the leading firms together hold the overwhelming majority of the market, a high concentration ratio that is a hallmark of oligopoly and reflects substantial market power. Second, there are high barriers to entry, including the brand loyalty and contract lock in that tie existing customers to incumbents, the legal licences required to operate, and the large financial investment needed for telecommunications infrastructure, all of which shield incumbents from new competitors. Third, there is mutual interdependence: each firm is acutely aware of rivals' pricing and product decisions, so a change by one firm tends to trigger similar responses from the others.

Impact on pricing and output. Because only a few large firms compete and each holds some market power and faces a relatively inelastic demand, oligopolists can set higher prices and produce at lower output than firms in a more competitive market such as monopolistic competition. They still maximise profit where marginal cost equals marginal revenue, but the resulting price is higher and the output lower than in the more competitive case.

Mutual interdependence also produces price rigidity, explained by the kinked demand curve. The curve is kinked at the prevailing price Pe. If a firm raises its price above Pe, demand is highly price elastic, because rivals hold their prices to win market share and consumers switch away, so the firm loses a large share of sales and revenue. If a firm cuts its price below Pe, demand is price inelastic, because rivals match the cut to protect their share, so the firm gains few extra sales while earning less per unit. Both responses discourage any firm from changing price, leaving prices stable at Pe and competition shifting towards non price forms.