Abstract
The essay examines the case of the UK banking industry and price setting mechanisms. The
analysis begins with a theoretical discussion of the various price setting strategies with a focus on
the possible price setting mechanisms under imperfect competition. For this purpose, the kinked
demand curve situation and Nash equilibrium are discussed. Following the theoretical remarks,
the analysis explores the specific case of the UK banking industry. The hypothesis for the
existence of an oligopoly is proven by examining the degree of market concentration and overall
price levels. In addition, the analysis supports the decisive role of the market leader – Lloyds – in
determining industry prices.
Table of Contents
1 Introduction...................................................................................................................................1
2. Price setting strategies: Theoretical overview..............................................................................2
2.1 Kinked demand curve model..................................................................................................2
2.2 Nash Equilibrium....................................................................................................................3
2.3 Dominant firm model.............................................................................................................4
3 The UK banking sector: an overview............................................................................................5
4. Evidence for Lloyds......................................................................................................................7
5. Conclusion..................................................................................................................................10
Bibliography...................................................................................................................................11
1 Introduction
The essay will examine an example of oligopoly market structure with a focus on the UK
banking sector. A theoretical overview of oligopoly is presented together with a discussion of the
optimal pricing decisions that firms pursue in such a market structure. By focusing on the Lloyds
Banking Group (Lloyds) case, the essay will explore the empirical evidence in order to find a
confirmation of the hypothesis for oligopoly behaviour in the UK banking industry.
1
, 2. Price setting strategies: Theoretical overview
Oligopoly is a market structure type which is characterised with the dominance of a small number
of large firms. As a result, several market players exercise a significant degree of market control.
The total number of firms in an oligopolistic industry is not of critical importance; instead, the
distinguishing feature is the degree of market control by the few largest ones. Usually, in
oligopolies the largest five companies tend to control more than half of the industry output.
Furthermore, companies often collude by forming cartels. Thus, they are able to coordinate their
output and pricing decisions in order to drive prices even higher. Oligopolies are also
characterised with high barriers of entry which prevent new competitors from entering and
benefiting from profitable industries (Rittenberg and Tregarthen, 2011). In the UK banking
sector, some of the major entry barriers are the complex regulatory burdens related to establishing
a financial institution and the significant capital needs for developing a dense network of
branches across the UK and satisfying all capital requirements.
As already mentioned, oligopolies are associated with a high degree of interdependence among
market participants. From a theoretical point of view, there are four distinct models aiming at
explaining market behaviour of firms: 1) Kinked demand curve model; 2) Cournot duopoly
model; 3) Nash equilibrium (“prisoner’s dilemma”), as well as, 4) Stackelberg dominant firm
model (Bishop et al., 2013). For simplicity, the Cournot duopoly model will be ignored from the
analysis because it is very specific and has a narrow empirical application. In addition, the model
refers to industries with two market participants which is not the case with the UK banking
sector.
2.1 Kinked demand curve model
The major assumption behind the model is the existence of a kinked demand curve. The kink is
caused by market participants’ action in respect to pricing. If prices are increased from the
current level, competitors may not necessarily follows and vice versa: a price decrease by a single
firm is likely to make competitors reduce their prices, as well. As a result of these hypothetical
actions, demand is expected to be flatter, if prices are increased from the current level due to the
unwillingness by others to follow. As the model suggests, the firm that initiates the price increase
will lose market share. The scenario with a price decrease leads to a price war where all
2
The essay examines the case of the UK banking industry and price setting mechanisms. The
analysis begins with a theoretical discussion of the various price setting strategies with a focus on
the possible price setting mechanisms under imperfect competition. For this purpose, the kinked
demand curve situation and Nash equilibrium are discussed. Following the theoretical remarks,
the analysis explores the specific case of the UK banking industry. The hypothesis for the
existence of an oligopoly is proven by examining the degree of market concentration and overall
price levels. In addition, the analysis supports the decisive role of the market leader – Lloyds – in
determining industry prices.
Table of Contents
1 Introduction...................................................................................................................................1
2. Price setting strategies: Theoretical overview..............................................................................2
2.1 Kinked demand curve model..................................................................................................2
2.2 Nash Equilibrium....................................................................................................................3
2.3 Dominant firm model.............................................................................................................4
3 The UK banking sector: an overview............................................................................................5
4. Evidence for Lloyds......................................................................................................................7
5. Conclusion..................................................................................................................................10
Bibliography...................................................................................................................................11
1 Introduction
The essay will examine an example of oligopoly market structure with a focus on the UK
banking sector. A theoretical overview of oligopoly is presented together with a discussion of the
optimal pricing decisions that firms pursue in such a market structure. By focusing on the Lloyds
Banking Group (Lloyds) case, the essay will explore the empirical evidence in order to find a
confirmation of the hypothesis for oligopoly behaviour in the UK banking industry.
1
, 2. Price setting strategies: Theoretical overview
Oligopoly is a market structure type which is characterised with the dominance of a small number
of large firms. As a result, several market players exercise a significant degree of market control.
The total number of firms in an oligopolistic industry is not of critical importance; instead, the
distinguishing feature is the degree of market control by the few largest ones. Usually, in
oligopolies the largest five companies tend to control more than half of the industry output.
Furthermore, companies often collude by forming cartels. Thus, they are able to coordinate their
output and pricing decisions in order to drive prices even higher. Oligopolies are also
characterised with high barriers of entry which prevent new competitors from entering and
benefiting from profitable industries (Rittenberg and Tregarthen, 2011). In the UK banking
sector, some of the major entry barriers are the complex regulatory burdens related to establishing
a financial institution and the significant capital needs for developing a dense network of
branches across the UK and satisfying all capital requirements.
As already mentioned, oligopolies are associated with a high degree of interdependence among
market participants. From a theoretical point of view, there are four distinct models aiming at
explaining market behaviour of firms: 1) Kinked demand curve model; 2) Cournot duopoly
model; 3) Nash equilibrium (“prisoner’s dilemma”), as well as, 4) Stackelberg dominant firm
model (Bishop et al., 2013). For simplicity, the Cournot duopoly model will be ignored from the
analysis because it is very specific and has a narrow empirical application. In addition, the model
refers to industries with two market participants which is not the case with the UK banking
sector.
2.1 Kinked demand curve model
The major assumption behind the model is the existence of a kinked demand curve. The kink is
caused by market participants’ action in respect to pricing. If prices are increased from the
current level, competitors may not necessarily follows and vice versa: a price decrease by a single
firm is likely to make competitors reduce their prices, as well. As a result of these hypothetical
actions, demand is expected to be flatter, if prices are increased from the current level due to the
unwillingness by others to follow. As the model suggests, the firm that initiates the price increase
will lose market share. The scenario with a price decrease leads to a price war where all
2
