Oligopoly

Imagine you have a company, and it is doing great. You are in an industry where four other companies have a similar market share to yours. There are not many other companies out there that produce what you’re producing, and those that are, are relatively small. To what extent do you think the behaviour of the other four companies will impact the way you price your goods and the amount of output you choose? Would you choose to collude with them and set prices or continue competing if it was feasible?

This is what oligopoly is all about. In this explanation, you will learn everything you need to know about oligopoly, how firms behave in an oligopolistic market, and whether they always collude or compete.

Oligopoly definition

Oligopoly occurs in industries where few but large leading firms dominate the market. Firms that are part of an oligopolistic market structure can’t prevent other firms from gaining significant dominance in the market. However, as only a few firms have a significant share of the market, each firm’s behaviour can have an impact on the other.

There must be a lower limit of two firms for a market structure to be considered oligopolistic, but there’s no upper limit to how many firms are in the market. It is essential that there are a few and all of them combined have a significant share of the market, which is measured by the concentration ratio.

The concentration ratio is a tool that measures the market share of the leading companies in an industry. You could have maybe five firms, seven, or even ten. How do you know if it’s an oligopolistic market structure? You have to look at the concentration ratio of the largest firms. If the most dominant firms have a combined concentration ratio of more than 50%, that market is considered an oligopoly. That is to say, an oligopoly is about the dominant firms’ market power in a given industry.

When companies gain high collective market power, they can create barriers that make it significantly hard for other firms to enter the market. Additionally, as few firms have a large part of the market share, they can influence the prices in a way that harms consumers and the general welfare of society.

Oligopoly characteristics

The most important characteristics of oligopoly are interdependence, product differentiation, high barriers to entry, uncertainty, and price setters.

Firms are interdependent

As there are a few firms that have a relatively large portion of the market share, one firm’s action impacts other firms. This means that firms are interdependent. There are two main methods through which a firm can influence the actions of other firms: by setting its price and output.

Product differentiation

When firms don’t compete in terms of prices, they compete by differentiating their products. Examples of this include the automotive market, where one producer might add specific features that would help them acquire more customers. Although the car price might be the same, they are differentiated in terms of the features they have.

High barriers to entry

The market share acquired by the top companies in an industry becomes an obstacle for new companies to enter the market. The companies in the market use several strategies to keep other companies from entering the market. For instance, if firms collude, they choose the prices at a point where new companies can’t sustain them. Other factors such as patents, expensive technology, and heavy advertising also challenge new entrants to compete.

Uncertainty

While companies in an oligopoly have perfect knowledge of their own business operations, they do not have complete information about other firms. Although firms are interdependent because they must consider other firms’ strategies, they are independent when choosing their own strategy. This brings uncertainty to the market.

Price setters

Oligopolies engage in the practice of price-fixing. Instead of relying on the market price (dictated by supply and demand), firms set prices collectively and maximise their profits. Another strategy is to follow a recognised price leader; if the leader increases the price, the others will follow suit.

Oligopoly examples

Oligopolies occur in almost every country. The most recognised examples of oligopoly include the supermarket industry in the UK, the wireless communications industry in the US and the banking industry in France.

Let's take a look at these examples:

1. The supermarket industry in the UK is dominated by four major players, Tesco, Asda, Sainsbury's, and Morrisons. These four supermarkets control over 70% of the market share, making it difficult for smaller retailers to compete.

2. The wireless telecommunications industry in the US is dominated by four major carriers, Verizon, AT&T, T-Mobile, and Sprint (which merged with T-Mobile in 2020). These four carriers control over 98% of the market share, making it difficult for smaller carriers to compete.

3. The banking industry in France is dominated by a few large banks, such as BNP Paribas, Société Générale, and Crédit Agricole. These banks control over 50% of the market share and have a strong influence on the French economy.

Collusive vs non-collusive oligopoly

Not all firms face the same production costs, so how does it work for firms with higher costs? Firms that might not be as productive in the market benefit from the agreement, as the higher price helps them stay in business. Other firms enjoy abnormal profit and keep problems that come with the competition out of their head. It’s a win-win for both.

Formal collusive agreements between firms are known as cartels. The only difference between collusion and monopoly is the number of firms, and everything else is the same. Collusion enables firms to increase prices and gain abnormal profits. One of the most famous cartels is the Organization of the Petroleum Exporting Countries (OPEC), which has significant influence over oil prices worldwide.

Collusive oligopoly and cartel agreements are significantly harmful to consumers and the general welfare of society. Governments closely monitor these agreements and prevent them from taking place via anti-competitive laws.

However, when collusion is in the benefit and interest of the society, it is known as cooperation, which is legal and encouraged by governments. Cooperation does not involve setting prices to maximise profit. It instead involves actions such as improving health in a particular sector or increasing standards of labour.

Non-collusive oligopoly involves a competitive type of oligopoly where firms do not form agreements with one another. Rather, they choose to compete with one another in an oligopolistic market structure.

Firms will still depend on other firms’ actions as they share a large portion of the market, but firms are independent in their strategies. As there is no formal agreement, firms will always be uncertain how other firms in an oligopoly will react when they apply new strategies.

Simply put, in a non-collusive oligopoly, you have firms independently choosing their strategies whilst there is still interdependence amongst them.

The kinked demand curve

The dynamics in a non-collusive oligopoly can be illustrated by using the kinked demand curve. The kinked demand curve shows the possible reactions of other firms to one firm’s strategies. Additionally, the kinked demand curve helps show why firms don’t change prices in a non-collusive oligopoly.

Assume that the firm is in an oligopolistic market structure; it shares the market with a few other firms. As a result, it should be cautious of its next move. The firm is considering changing its price to increase profit further.

Figure 1 illustrates what happens to the firm’s output when it decides to increase its price. The firm is faced with elastic demand at P1, and an increase in price to P2 leads to a much higher drop in the output demanded compared to if the firm was faced with inelastic demand.

The firm then considers decreasing the price, but it knows that other firms will also decrease their prices. What do you think would happen if the firm decreased the price from P1 to P3?

As other firms will also reduce their prices, the quantity demanded will respond by very little compared to the price increase. How?

Other firms reacted by decreasing their prices too, which caused all the firms to share the total market share gained from the decrease in price amongst themselves. Therefore, none of them profits as much. That’s why there’s no incentive for firms to change their prices in a non-collusive oligopoly.

Price agreements, price wars, and price leadership in oligopoly

Price leadership, price agreements, and price wars often occur in oligopolies. Let’s study each of them independently.

Price leadership

Price leadership involves having a firm leading the market in terms of the pricing strategy and other firms following by applying the same prices. As cartel agreements are, in the majority of the cases, illegal, firms in an oligopolistic market look for other ways to maintain their abnormal profits, and price leadership is one of the ways.

Price agreements

This involves price agreements between firms and their customers or suppliers. This is especially helpful in case there is turmoil in the market as it allows firms to adjust their strategies better and address the challenges accordingly.

Price wars

Price wars in an oligopoly are very common. Price wars happen when a firm tries to either take its competitors out of business or prevent new ones from entering the market. When a firm faces low costs, it has the ability to decrease the prices. However, other firms have different cost functions and can't sustain the price decrease. This results in them having to leave the market.

Advantages and disadvantages of oligopoly

The situation when there are a few, relatively large firms in an industry has its benefits and drawbacks. Let’s explore some of the advantages and disadvantages of oligopoly for both firms and customers.

Advantages of oligopoly

Both producers and consumers can benefit from the oligopolistic market structure. The most important advantages of oligopoly include:

• Firms can gain extreme profits due to little to no competition in an oligopoly market structure, allowing them to charge higher prices and expand their margins.
• Increased profits allow firms to invest more money into research and development, which benefits consumers through the development of new and innovative products.
• Product differentiation is a significant advantage of oligopolistic markets, as firms are constantly looking to improve and differentiate their products to attract more customers.
• Consumers benefit from having firms constantly trying to offer better products.

Disadvantages of oligopoly

The most significant disadvantages of oligopoly include:

• High prices, which can harm consumers, particularly those with low incomes
• Limited choices for consumers due to high market concentration amongst a few firms
• High barriers to entry prevent new firms from joining and offering their products, reducing competition and potentially harming social welfare
• Oligopolistic firms may collude to fix prices and restrict output, leading to further harm for consumers and decreased social welfare.