Oligopolistic Market

Do you remember the last time you traveled by plane? It might have been a while for some of us due to the recent global pandemic. However, if you remember some of the names of the airline companies, what would they be? Perhaps, you would remember American Airlines, Delta Air Lines, Southwest Airlines, or United Airlines! You remember some of those names because only a few firms dominate the market.

The airline industry in the United States and around the world resembles an oligopolistic market, which has a few interesting effects on the entire industry! Keep scrolling if you are keen on learning more about how firms compete in an oligopolistic industry, the characteristics of an oligopolistic market, and more!

Oligopolistic Market Definition

Let's jump straight into the definition of an oligopolistic market!

Oligopoly lies between monopoly and monopolistic competition on the spectrum of market structures.

This is shown in Figure 1 below.

Fig. 1 - The spectrum of market structures

The most differentiating factor of oligopolistic industries lies in their characteristics and structure, which we will explore below.

Oligopolistic Market Characteristics

What are some of the characteristics of oligopolistic market structures?

Well, there are several, and they are listed below.

• Oligopoly market structure characteristics:- Firm interdependence;- Significant barriers to entry;- Differentiated or homogeneous products;- Strategic behavior.

Let's take a look at each of them in turn!

Oligopolistic Market Characteristics: Firm Interdependence

Firms in an oligopolistic market are interdependent. This means they consider what their competitors will do and factor it into their decisions. The firms are rational, and likewise, the competitors of that firm are themselves doing the same thing. The resulting market outcome will depend on the players' collective action.

Oligopolistic Market Characteristics: Significant Barriers to Entry

There are significant barriers to entry in oligopolistic markets. These may result from the economies of scale or the firms colluding. In the case of economies of scale, there may be natural industry advantages for only a few firms to dominate the market. The entry of new firms would increase the average long-run costs for the industry. Strategic barriers to entry result from the firms' cooperation, which limits new entrants' ability to successfully compete in the industry. Ownership of raw materials and patent protections are two other forms of barriers to entry for new firms.

Oligopolistic Market Characteristics: Differentiated or Homogeneous Products

Products in an oligopolistic market can either be differentiated or homogeneous. In many cases in the real world, the products are at least slightly differentiated through branding and advertising, which increases customer loyalty. Differentiated products allow for non-price competition to prevail and for firms to enjoy their own customer bases and significant profit margins.

Oligopolistic Market Characteristics: Strategic Behavior

Strategic behavior in the oligopolistic industry is prevalent. If the firms choose to compete, they consider how their competitors will react and take it into their decisions. If the firms compete, we can model the competition with the firms setting prices or quantities in the case of homogeneous products. Or they can engage in non-price competition and try to retain customers through quality and advertising in the case of differentiated products. If the firms collude, they can do so tacitly or explicitly, like forming a cartel.

Oligopolistic Market Structure

Oligopolistic market structure can be best described with the kinked demand curve model. The kinked demand curve model contends that the prices in an oligopoly will be relatively stable. It provides an explanation of how firms in an oligopoly might compete.Consider Figure 2 below.

Fig. 2 - The kinked demand curve model of oligopoly

Figure 2 above shows a kinked demand curve model.The firm's demand and corresponding marginal revenue curves have two sections. What are these two sections? The upper section of the demand curve is elastic for a price increase. If the firm increases its price, its competitor will likely not follow, and the firm will lose a lot of its market share. The bottom section of the demand curve is inelastic for a price decrease. When the firm decreases its price, its competitor will likely follow and drop its price as well, so the firm won't gain too much market share. This means that the firms will operate in the region of discontinuity on the marginal revenue curve, and the prices will be relatively stable.

This model does not explain why sometimes there are price wars. Price wars often occur in oligopolies and are characterized by firms bidding down prices aggressively to undercut their opponent.

Oligopolistic Market vs. Monopolistic Market

What are some similarities and differences between the oligopolistic market vs. the monopolistic market? If the firms in an oligopoly collude, they will act as monopolists to increase the price and restrict quantity.

Let's take a look at Figure 3 below!

Fig. 3 - Collusive oligopoly vs. perfect competition

Figure 3 above shows a collusive oligopoly's demand and marginal revenue curves. Oligopolists will price where MC=MR and read the price from the demand curve to maximize profit for the industry. The corresponding price will be Pm, and the quantity supplied will be Qm. This is the same outcome as in a monopoly!

If the industry was perfectly competitive, the output would be at Qc and the price at Pc. By colluding, oligopolists create inefficiency in the market by increasing their profits at the expense of consumer surplus.

Explicit collusion is an illegal practice, and firms that are proven to have colluded can face significant penalties!

Let's look at some examples of the oligopolistic market through game theory!In oligopolistic markets, firms need to consider their opponents' strategies before making their decisions. Likewise, the competitors are undergoing the same thought process. This behavior is usually described using game-theory modeling.

Consider Table 1 below.

Table 1 - Payoff matrix example for an oligopolistic market

Table 1 above shows a payoff matrix for firms in an oligopoly. There are two firms - Firm 1 and Firm 2, and they are interdependent. The payoff matrix represents the thinking behind firms' strategic behavior. The payoffs for Firm 1 are represented in green, and the payoffs for Firm 2 are represented in orange in each cell.

There are two options that each firm faces:

1. to set a high price;
2. to set a low price.

If both firms set a high price, their payoffs are represented in the left uppermost quadrant, with both firms enjoying high profits of 20,000. There is a strong incentive to defect from this strategy, though. Why? Because if a firm undercuts its opponent and sets a low price, then it can double its payoffs! The payoffs from deviating and setting a low price are indicated in the lower left quadrant (for firm 1) and the upper right quadrant (for firm 2) of the payoff matrix. The defector gets 40,000 as they get a higher market share by setting a low price, whilst the competitor that keeps a high price loses out and gains only 5,000.

However, there is a punishment for such action because should the competitor set a low price as well, then both firms would only get half of the profits they could - 10,000. In this case, they would hope they'd kept their prices high because their profits could be doubled.

Although this example may seem like a simplistic view of strategic behavior in an oligopolistic market, it gives us certain insights and conclusions. Game-theory models allow for modifications and the introduction of government regulation, for example, with repeated games and sequential scenarios.