Oligopoly

Oligopoly is a market structure with a small number of firms, none of which can keep the others
from having significant influence. The concentration ratio measures the market share of the
largest firms. A monopoly is one firm, duopoly is two firms and oligopoly is two or more firms.
There is no precise upper limit to the number of firms in an oligopoly, but the number must be
low enough that the actions of one firm significantly influence the others.

KEY TAKEAWAYS
 Oligopoly is when a small number of firms collude, either explicitly or tacitly, to restrict
output and/or fix prices, in order to achieve above normal market returns.
 Economic, legal, and technological factors can contribute to the formation and
maintenance, or dissolution, of oligopolies.
 The major difficulty that oligopolies face is the prisoner's dilemma that each member
faces, which encourages each member to cheat.
 Government policy can discourage or encourage oligopolistic behavior, and firms in
mixed economies often seek government blessing for ways to limit competition.

Understanding Oligopoly
Oligopolies in history include steel manufacturers, oil companies, rail roads, tire manufacturing,
grocery store chains, and wireless carriers. The economic and legal concern is that an oligopoly
can block new entrants, slow innovation, and increase prices, all of which harm consumers.
Firms in an oligopoly set prices, whether collectively – in a cartel – or under the leadership of
one firm, rather than taking prices from the market. Profit margins are thus higher than they
would be in a more competitive market. What's the Difference Between Monopoly and an
Oligopoly? Learn more.

Conditions that Enable Oligopolies

The conditions that enable oligopolies to exist include high entry costs in capital expenditures,
legal privilege (license to use wireless spectrum or land for railroads), and a platform that gains
value with more customers (social media). The global tech and trade transformation has changed
some of these conditions: offshore production and the rise of "mini-mills" have affected the steel
industry, for example. In the office software application space, Microsoft was targeted by Google
Docs, which Google funded using cash from its web search business.

Why Are Oligopolies Stable?

An interesting question is why such a group is stable. The firms need to see the benefits of
collaboration over costs of economic competition, then agree to not compete and instead agree
on the benefits of co-operation. Firms have sometimes found creative ways to avoid the
appearance of price fixing, such as using phases of the moon. Another approach is to for firms to
follow a recognized price leader; when the leader raises prices, the others will follow.
The principle problem that these firms face is that each firm has an incentive to cheat; if all firms
in the oligopoly agree to jointly restrict supply and keep prices high, then each firm stands to
capture substantial business from the others by breaking the agreement undercutting the others.
Such competition can be waged through prices, or through simply expanding its own output
brought to market.

Game theorists have developed models for these scenarios, which form a sort of prisoner's
dilemma. When costs and benefits are balanced so that no firm wants to break from the group, it
is considered the Nash equilibrium state for oligopolies. This can be achieved by contractual or
market conditions, legal restrictions, or strategic relationships between members of the oligopoly
that enable the punishment of cheaters.

It is interesting to note that both the problem of maintaining an oligopoly, and the problem of
coordinating action among buyers and sellers in general on market involve shaping the payoffs to
various prisoner's dilemmas and related co-ordination games that repeat over time. As a result,
many of the same institutional factors that facilitate the development of market economies by
reducing prisoner's dilemma problems among market participants, such as secure enforcement of
contracts, cultural conditions of high trust and reciprocity, and laissez-faire economic policy,
might also potentially help encourage and sustain oligopolies.

Governments sometimes respond to oligopolies with laws against price fixing and collusion. Yet,
if a cartel can price fix if they operate beyond the reach or with the blessing of governments.
OPEC is one example, since it is a cartel of oil producing states with no overarching authority.
Alternatively, in mixed economies, oligopolies often seek out and lobby for favorable
government policy to operate under the regulation or even direct supervision of government
agencies.

( https://www.investopedia.com/terms/o/oligopoly.asp )

Defining and measuring oligopoly

An oligopoly is a market structure in which a few firms dominate. When a market is shared
between a few firms, it is said to be highly concentrated. Although only a few firms dominate, it
is possible that many small firms may also operate in the market. Considering the market for air
travel,  major airlines like British Airways (BA) and Air France often operate their routes with
only a few close competitors, but there are also many small airlines catering for the
holidaymaker or offering specialist services. Similarly, while the 'Big Six' energy suppliers
dominate the UK market, with a combined market share of 78% for electricity supply (according
to the energy regulator, Ofcom), there are currently 54 active suppliers. (2017 data).
Concentration ratios

Oligopolies may be identified using concentration ratios, which measure the proportion of total
market share controlled by a given number of firms. When there is a high concentration ratio in
an industry, economists tend to identify the industry as an oligopoly.
Example of a hypothetical concentration ratio

The following are the annual sales, in £m, of the six firms in a hypothetical market:

A = 56

B = 43

C = 22

D = 12

E=3

F=1

In this hypothetical case, the 3-firm concentration ratio is 88.3%, that is 121/137 x 100.
Examples
Fixed Broadband services

Fixed broadband supply in the UK is dominated by four main suppliers - BT (with a market
share of 32%), Virgin Media (at 20%), Sky (at 22%) and TalkTalk (at 14%), making a four-firm
concentration ratio of 86% (2015). Source: OFCOM.
Fuel retailing

Fuel retailing in the UK is dominated by six major suppliers, including Tesco, BP, Shell, Esso,
Morrisons and Sainsbury, as shown below:

The Herfindahl – Hirschman Index (H-H Index)

This is an alternative method of measuring concentration and for tracking changes in the level of
concentration following mergers. The H-H index is found by adding together the squared values
of the % market shares of all the firms in the market. For example, if three firms exist in the
market the formula is X2 + Y2 + Z2; where X, Y and Z are the percentages of the three firm’s
market shares.
 If the index is below 1000, the market is not considered concentrated, while an index above 2000
indicates a highly concentrated market or industry – the higher the figure the greater the
concentration.

Mergers between oligopolists increase concentration and ‘monopoly power’ and are likely to be
the subject of regulation.

Key characteristics

The main characteristics of firms operating in a market with few close rivals include:

Interdependence

Firms operating under conditions of oligopoly are said to be interdependent , which means they
cannot act independently of each other. A firm operating in a market with just a few competitors
must take the potential reaction of its closest rivals into account when making its own decisions.
In the case of petrol retailing, a seller like Texaco may wish increase its market share by
reducing price, but it must take into account the possibility that close rivals, such as Shell and
BP, who may also reduce their price in retaliation.

 An understanding of game theory and the Prisoner’s Dilemma helps appreciate the concept of

interdependence.

Strategy

Strategy is extremely important to firms that are interdependent. Because firms cannot act
independently, they must anticipate the likely response of a rival to any given change in their
price, or their non-price activity. In other words, they need to plan, and work out a range of
possible options based on how they think rivals might react.

Oligopolists have to make critical strategic decisions, such as:

 Whether to compete with rivals, or collude with them.

 Whether to raise or lower price, or keep price constant.
 Whether to be the first firm to implement a new strategy, or whether to wait and see what
rivals do. The advantages of ‘going first’ or ‘going second’ are respectively called 1st and 2nd-
mover advantage. Sometimes it pays to go first because a firm can generate head-start profits.
2nd mover advantage occurs when it pays to wait and see what new strategies are launched by
rivals, and then try to improve on them or find ways to undermine them.
Barriers to entry

Oligopolies and monopolies frequently maintain their position of dominance in a market might
because it is too costly or difficult for potential rivals to enter the market. These hurdles are
called barriers to entry and the incumbent can erect them deliberately, or they can exploit natural
barriers that exist.
Natural entry barriers include:
Economies of large scale production.

If a market has significant economies of scale that have already been exploited by the

incumbents, new entrants are deterred.
Ownership or control of a key scarce resource

Owning scarce resources that other firms would like to use creates a considerable barrier to
entry, such as an airline controlling access to an airport.
High set-up costs

High set-up costs deter initial market entry, because they increase break-even output, and delay
the possibility of making profits.  Many of these costs are sunk costs, which are costs that cannot
be recovered when a firm leaves a market, and include marketing and advertising costs and other
fixed costs.
High R&D costs

Spending money on Research and Development (R & D) is often a signal to potential entrants
that the firm has large financial reserves. In order to compete, new entrants will have to match, or
exceed, this level of spending in order to compete in the future. This deters entry, and is widely
found in oligopolistic markets such as pharmaceuticals and the chemical industry.
Artificial barriers include:
Predatory pricing

Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals
out of the market.
Limit pricing

Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants
cannot make a profit at that price.  This is best achieved by selling at a price just below
the average total costs (ATC) of potential entrants. This signals to potential entrants that profits
are impossible to make.
Superior knowledge

An incumbent may, over time, have built up a superior level of knowledge of the market, its
customers, and its production costs. The superior knowledge of an incumbent can give it
considerable competitive advantage over a potential entrant.
Predatory acquisition

Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to

gain a controlling interest, or by a complete buy-out. As with other deliberate barriers, regulators,
like the Competition and Markets Authority (CMA), may prevent this because it is likely to
reduce competition.
Advertising

Advertising is another sunk cost - the more that is spent by incumbent firms the greater the
deterrent to new entrants.
A strong brand

A strong brand creates loyalty, ‘locks in’ existing customers, and deters entry.
Loyalty schemes

Schemes such as Tesco’s Club Card, help oligopolists retain customer loyalty and deter entrants
who need to gain market share.
Exclusive contracts, patents and licences

These make entry difficult as they favour existing firms who have won the contracts or own the
licenses. For example, contracts between suppliers and retailers can exclude other retailers from
entering the market.
Vertical integration

Vertical integration can ‘tie up’ the supply chain and make life tough for potential entrants, such
as an electronics manufacturer like Sony having its own retail outlets (Sony Centres). Vertical
integration in the media industry is widspread, with Netflix having purchsed the US
based ABQ studios in 2018, and completing an agreement in 2019 with the UK's Pinewood
studio group giving it access to 14 sound stages, workshops, and office space.
Collusive oligopolies

Another key feature of oligopolistic markets is that firms may attempt to collude, rather than
compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher
profits over the long term.
Types of collusion
Overt

Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form
trade associations like the Association of Petrol Retailers.
Covert

Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid
detection by regulators, such as when fixing prices.
Tacit

Tacit collusion (also called 'rule-based' collusion) arises when firms act together, called 'acting in
concert'  but where there is no formal or even informal agreement. For example, it may be
accepted that a particular firm is the price leader in an industry, and other firms simply follow the
lead of this firm. All firms may ‘understand’ this, but no agreement or record exists to prove it. If
firms do collude, and their behaviour can be proven to result in reduced competition, they are
likely to be subject to regulation. In many cases, tacit collusion is difficult or impossible to
prove, though regulators are becoming increasingly sophisticated in developing new methods of
detection.
Competitive oligopolies

When competing, oligopolists prefer non-price competition in order to avoid price wars. A price
reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but the
danger is that rivals will simply reduce their prices in response.

This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more
beneficial strategy may be to undertake non-price competition.
Pricing strategies of oligopolies

Oligopolies may pursue the following pricing strategies:

1. Oligopolists may use predatory pricing to force rivals out of the market. This means
keeping price artificially low, and often below the full cost of production.
2. They may also operate a limit-pricing strategy to deter entrants, which is also called entry
forestalling price.
3. Oligopolists may collude with rivals and raise price together, but this may attract new
entrants.
4. Cost-plus pricing is a straightforward pricing method, where a firm sets a price by
calculating average production costs and then adding a fixed mark-up to achieve a
desired profit level. Cost-plus pricing is also called rule of thumb pricing.
 There are different versions of cost-pus pricing, including full cost pricing, where all
costs - that is, fixed and variable costs - are calculated, plus a mark up for profits,
and contribution pricing, where only variable costs are calculated with precision and the
mark-up is a contribution to both fixed costs and profits.

Cost-plus pricing is very useful for firms that produce a number of different products, or where
uncertainty exists. It has been suggested that cost-plus pricing is common because a precise
calculation of marginal cost and marginal revenue is difficult for many oligopolists. Hence, it can
be regarded as a response to information failure. Cost-plus pricing is also common in oligopoly
markets because it is likely that the few firms that dominate may often share similar costs, as in
the case of petrol retailers.

However, there is a risk with such a rigid pricing strategy as rivals could adopt a more
flexible discounting strategy to gain market share.

Cost-plus pricing can also be explained through the application of game theory. If one
firm uses cost-plus pricing - perhaps the dominant firm with the greatest market share -
others may follow-suit so that the strategy becomes a shared one, which acts as a pricing
rule. This takes some of the risk out of pricing decisions, given that all firms will abide
by the rule. This could be considered a form of tacit collusion.
Non-price strategies

Non-price competition is the favoured strategy for oligopolists because price competition can
lead to destructive price wars – examples include:

1. Trying to improve quality and after sales servicing, such as offering extended guarantees.
2. Spending on advertising, sponsorship and product placement - also called hidden
advertising – is very significant to many oligopolists. The UK's football Premiership has
long been sponsored by firms in oligopolies, including Barclays Bank and Carling.
3. Sales promotion, such as buy-one-get-one-free (BOGOF), is associated with the large
supermarkets, which is a highly oligopolistic market, dominated by three or four large
chains.
4. Loyalty schemes, which are common in the supermarket sector, such
as Sainsbury’s Nectar Card and Tesco’s Club Card.

Each strategy can be evaluated in terms of:

1. How successful is it likely to be?

2. Will rivals be able to copy the strategy?
3. Will the firms get a 1st - mover advantage?
4. How expensive is it to introduce the strategy? If the cost of implementation is greater
than the pay-off, clearly it will be rejected.
5. How long will it take to work? A strategy that takes five years to generate a pay-off may
be rejected in favour of a strategy with a quicker pay-off.

Price stickiness

The theory of oligopoly suggests that, once a price has been determined, will stick it at this price.
This is largely because firms cannot pursue independent strategies. For example, if an airline
raises the price of its tickets from London to New York, rivals will not follow suit and the airline
will lose revenue - the demand curve for the price increase is relatively elastic. Rivals have no
need to follow suit because it is to their competitive advantage to keep their prices as they are.

However, if the airline lowers its price, rivals would be forced to follow suit and drop their prices
in response. Again, the airline will lose sales revenue and market share. The demand curve is
relatively inelastic in this context.
Kinked demand curve

The reaction of rivals to a price change depends on whether price is raised or lowered. The
elasticity of demand, and hence the gradient of the demand curve, will be also be different. The
demand curve will be kinked, at the current price.

Even when there is a large rise in marginal cost, price tends to stick close to its original, given
the high price elasticity of demand for any price rise.

At price P, and output Q, revenue will be maximized.

 Maximizing profits

If marginal revenue and marginal costs are added it is possible to show that profits will also be
maximised at price P. Profits will always be maximised when MC = MR, and so long as MC cuts
MR in its vertical portion, then profit maximisation is still at P. Furthermore, if MC changes in
the vertical portion of the MR curve, price still sticks at P. Even when MC moves out of the
vertical portion, the effect on price is minimal, and consumers will not gain the benefit of any
cost reduction.
A game theory approach to price stickiness

Pricing strategies can also be looked at in terms of game theory; that is in terms of strategies and
payoffs. There are three possible price strategies, with different pay-offs and risks:

 Raise price
 Lower price
 Keep price constant

The choice of strategy will depend upon the pay-offs, which depends upon the actions of
competitors. Raising price or lowering price could lead to a beneficial pay-off, but both strategies
can lead to losses, which could be potentially disastrous. In short, changing price is too risky to
undertake.

Therefore, although keeping price constant will not lead to the single best outcome, it may be the
least risky strategy for an oligopolist.

The Prisoner’s Dilemma

Game theory also predicts that:

There is a tendency for cartels to form because co-operation is likely to be highly rewarding.

Co-operation reduces the uncertainty associated with the mutual interdependence of rivals in an
oligopolistic market. While cartels are ‘unlawful’ in most countries, they may still operate, with
members concealing their unlawful behaviour.

Cartels are designed to protect the interests of members, and the interests of consumers may
suffer because of:

1. Higher prices or hidden prices, such as the hidden charges in credit card transactions
2. Lower output
3. Restricted choice or other limiting conditions associated with the transaction
A classic game called the Prisoner's Dilemma is often used to demonstrate the interdependence
of oligopolists.
Examples of Oligopoly

Oligopolies are common in the airline industry, banking, brewing, soft-

drinks, supermarkets and music.  For example, the manufacture, distribution and publication of
music products in the UK, as in the EU and USA, is highly concentrated, with a 3-firm
concentration ratio of around 70%, and is usually identified as an oligopoly.

The key players in 2016 were:

Evaluation of oligopolies

Oligopolies are significant because they generate a considerable share of the UK’s national
income, and they dominate many sectors of the UK economy.
The disadvantages of oligopolies

Oligopolies can be criticised on a number of obvious grounds, including:

1. High concentration reduces consumer choice.

2. Cartel-like behaviour reduces competition and can lead to higher prices and reduced
output.
3. Given the lack of competition, oligopolists may be free to engage in the manipulation of
consumer decision making. By making decisions more complex - such as financial
decisions about mortgages - individual consumers fall back on heuristics and rule of
thumb processes, which can lead to decision making bias and irrational behaviour,
including making purchases which add no utility or even harm the individual consumer.
4. Firms can be prevented from entering a market because of deliberate barriers to entry.
5. There is a potential loss of economic welfare.
6. Oligopolists may be allocatively and productively inefficient.

Oligopolies tend to be both allocatively and productively inefficient. At profit maximising

equilibrium, P, prce is above MC, and output, Q, is less than the productively efficient output,
Q1, at point A.
The advantages of oligopolies

However, oligopolies may provide the following benefits:

1. Oligopolies may adopt a highly competitive strategy, in which case they can generate
similar benefits to more competitive market structures, such as lower prices. Even
though there are a few firms, making the market uncompetitive, their behaviour may be
highly competitive.
2. Oligopolists may be dynamically efficient in terms of innovation and new product and
process development. The super-normal profits they generate may be used to innovate, in
which case the consumer may gain.
3. Price stability may bring advantages to consumers and the macro-economy because it
helps consumers plan ahead and stabilises their expenditure, which may help stabilise the
trade cycle.

(https://www.economicsonline.co.uk/Business_economics/Oligopoly.html)

Oligopoly
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’
meaning ‘to sell’. An Oligopoly market situation is also called ‘competition among the few’. In this
article, we will look at Oligopoly definition and some important characteristics of this market
structure.
Oligopoly Definition
An oligopoly is an industry which is dominated by a few firms. In this market, there are a few firms
which sell homogeneous or differentiated products.
Also, as there are few sellers in the market, every seller influences the behavior of the other firms
and other firms influence it.
Oligopoly is either perfect or imperfect/differentiated. In India, some examples of an oligopolistic
market are automobiles, cement, steel, aluminum, etc.

Characteristics of Oligopoly
Now that the Oligopoly definition is clear, it’s time to look at the characteristics of Oligopoly:

Few firms
Under Oligopoly, there are a few large firms although the exact number of firms is undefined. Also,
there is severe competition since each firm produces a significant portion of the total output.

Barriers to Entry
Under Oligopoly, a firm can earn super-normal profits in the long run as there are barriers to entry
like patents, licenses, control over crucial raw materials, etc. These barriers prevent the entry of new
firms into the industry.

Non-Price Competition
Firms try to avoid price competition due to the fear of price wars and hence depend on non-price
methods like advertising, after sales services, warranties, etc. This ensures that firms can influence
demand and build brand recognition.

Interdependence
Under Oligopoly, since a few firms hold a significant share in the total output of the industry, each
firm is affected by the price and output decisions of rival firms. Therefore, there is a lot of
interdependence among firms in an oligopoly. Hence, a firm takes into account the action and
reaction of its competing firms while determining its price and output levels.

Nature of the Product

Under oligopoly, the products of the firms are either homogeneous or differentiated.

Selling Costs
Since firms try to avoid price competition and there is a huge interdependence among firms, selling
costs are highly important for competing against rival firms for a larger market share.
No unique pattern of pricing behavior
Under Oligopoly, firms want to act independently and earn maximum profits on one hand and
cooperate with rivals to remove uncertainty on the other hand.
Depending on their motives, situations in real-life can vary making predicting the pattern of pricing
behavior among firms impossible. The firms can compete or collude with other firms which can
lead to different pricing situations.

Indeterminateness of the Demand Curve

Unlike other market structures, under Oligopoly, it is not possible to determine the demand curve of
a firm. This is because on one hand, there is a huge interdependence among rivals. And on the other
hand there is uncertainty regarding the reaction of the rivals. The rivals can react in different ways
when a firm changes its price and that makes the demand curve indeterminate.

Firms behaviour under Oligopoly

Based on the objectives of the firms, the magnitude of barriers to entry and the nature of
government regulation, there are different possible outcomes in relation to a firm’s behavior under
Oligopoly. These are:

1. Stable prices
2. Price wars
3. Collusion for higher prices
Further, Oligopoly can either be collusive or non-collusive. Collusive oligopoly is a market
situation wherein the firms cooperate with each other in determining price or output or both. A non-
collusive oligopoly refers to a market situation where the firms compete with each other rather than
cooperating.

Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve Model (Price-Rigidity)

Usually, in Oligopolistic markets, there are many price rigidities. In 1939, Paul Sweezy used an
unconventional demand curve – the kinked demand curve to explain these rigidities.

Reason for the kink in the demand curve

It is assumed that firms behave in a two-fold manner in reaction to a price change by a rival firm. In
simple words, firms follow price cuts by a rival company but not price increases. So, if a seller
increases the price of his product, his rivals do not follow the price increase.
Therefore, the market share of the firm reduces significantly as a result of the price rise. On the
other hand, if a seller reduces the price of his product, then the rivals also reduce their price to bring
it at par with the price reduction of the firm.
This ensures that they prevent their market share from falling. Once the rivals react, the firm
lowering the price first cannot gain from the price cut.

Why the price rigidity?

As can be seen above, a firm cannot gain or lose by changing its price from the prevailing price in
the market. In both cases, there is no increase in demand for the firm which changes its price.
Hence, firms stick to the same price over time leading to price rigidity under oligopoly.

Explanation of the Kinked-Demand Curve Model

In the figure above, KPD is the is the kinked-demand curve and OP 0 is the prevailing price in the
oligopoly market for the OR product of one seller. Starting from point P, corresponding to the point
OP1, any increase in price above it will considerably reduce his sales as his rivals will not follow his
price increase.
This is because the KP portion of the curve is elastic and the corresponding portion of the MR curve
(KA) is positive. Therefore, any price increase will not just reduce the total sales but also his total
revenue and profit. On the other hand, if the seller reduces the price of the product below OPQ (or
P), his rivals will also reduce their prices.
However, even if his sales increase, his profits would be less than before. This is because the PD
portion of the curve below P is less elastic and the corresponding part of the marginal revenue curve
below R is negative. Therefore, in both price-raising and price-reducing situations, the seller is the
loser. He will stick to the prevailing market price OP0 which remains rigid.

Working of the kinked-demand curve

Let’s analyze the effect of changes in cost and demand conditions on price stability in the
oligopolistic market. Let’s suppose that the prevailing price in the market is OP0.
Therefore, if one seller increases the price above OP 0 and the rival sellers don’t and keep the prices
of their products at OP, then it will lead to the product becoming costlier than the others.
Subsequently, the demand for the costlier product will fall significantly. This is seen in the demand
curve of a firm for any price above OP0 or the KP section of the curve, is relatively elastic. The high
elasticity reduces the demand significantly as a result of the price increase.
On the other hand, if the seller reduces the price below OP 0, the rivals also follow the price cut to
prevent their demand from falling. This is seen in the demand curve of a firm for any price below
OP0 or the PD segment of the curve is relatively inelastic. The low elasticity does not increase the
demand significantly as a result of the price cut.
This asymmetrical behavioral pattern results in a kink in the demand curve and hence there is price
rigidity in oligopoly markets. The prices remain rigid at the kink (point P). In other words, the price
will remain sticky at OP0 and the output = OR at this price.
Due to the difference in the elasticities, the MR curve becomes discontinuous corresponding to the
point of change in elasticity of the demand curve. The kink represents this. At the output < OR, the
demand curve is KP and the corresponding MR curve is KA. For output > OR, the demand curve is
PD and the corresponding MR curve is BMR.

Collusive Oligopoly
Sometimes, firms may try to remove uncertainty related to acting independently and enter into price
agreements with each other. This is collusion. Collusion is either formal or informal. It can take the
form of cartel or price leadership.
A cartel is an association of independent firms within the same industry which follow the common
policies relating to price, output, sale, profit maximization, and the distribution of products.
Price leadership is based on informed collusion. Under price leadership, one firm is a large or
dominant firm and acts as the price leader who fixes the price for the products while the other firms
allow it.
(https://www.toppr.com/guides/business-economics-cs/analysis-of-market/oligopoly/)
 Oligopoly
Definition of oligopoly
An oligopoly is an industry dominated by a few large firms. For example, an industry with a
five-firm concentration ratio of greater than 50% is considered a monopoly.

Examples of oligopolies
Car industry – economies of scale have cause mergers so big multinationals dominate the
market. The biggest car firms include Toyota, Hyundai, Ford, General Motors, VW.

 Petrol retail – see below.

 Pharmaceutical industry
 Coffee shop retail – Starbucks, Costa Coffee, Cafe Nero
 Newspapers – In UK market share dominated by tabloids Daily Mail, The Sun, The
Mirror, The Star, Daily Express.
 Book retail – In UK market share dominated by Waterstones, Amazon.
The main features of oligopoly:

 An industry which is dominated by a few firms.

 The UK definition of an oligopoly is a five-firm concentration ratio of more than 50% (this
means the five biggest firms have more than 50% of the total market share) The above industry
(UK petrol) is an example of an oligopoly. See also: Concentration ratios

 Interdependence of firms – companies will be affected by how other firms set price and
output.
 Barriers to entry. In an oligopoly, there must be some barriers to entry to enable firms to
gain a significant market share. These barriers to entry may include brand loyalty or economies
of scale. However, barriers to entry are less than monopoly.
 Differentiated products. In an oligopoly, firms often compete on non-price competition.
This makes advertising and the quality of the product are often important.
 Oligopoly is the most common market structure
How firms compete in oligopoly
There are different possible ways that firms in oligopoly will compete and behave this will
depend upon:

 The objectives of the firms; e.g. profit maximisation or sales maximisation?

 The degree of contestability; i.e. barriers to entry.
 Government regulation.
 There are different possible outcomes for oligopoly:

1. Stable prices (e.g. through kinked demand curve) – firms concentrate on non-price
competition.
2. Price wars (competitive oligopoly)
3. Collusion- leading to higher prices.
The kinked demand curve model
This model suggests that prices will be fairly stable and there is little incentive for firms to
change prices. Therefore, firms compete using non-price competition methods.

 This assumes that firms seek to maximise profits.

 If they increase the price, then they will lose a large share of the market because they
become uncompetitive compared to other firms. Therefore demand is elastic for price increases.

 If firms cut price then they would gain a big increase in market share. However, it is
unlikely that firms will allow this. Therefore other firms follow suit and cut-price as well.
Therefore demand will only increase by a small amount. Therefore demand is inelastic for a
price cut.

 Therefore this suggests that prices will be rigid in oligopoly

The diagram above suggests that a change in marginal cost still leads to the same price, because
of the kinked demand curve.  Profit maximisation occurs where MR = MC at Q1.

Evaluation of kinked demand curve

 In the real world, prices do change.
 Firms may not seek to maximise profits,  but prefer to increase market share and so be
willing to cut prices, even with inelastic demand.
 Some firms may have very strong brand loyalty and be able to increase the price without
demand being very price elastic.
 The model doesn’t suggest how prices were arrived at in the first place.
Price wars
Firms in oligopoly may still be very competitive on price, especially if they are seeking to
increase market share. In some circumstances, we can see oligopolies where firms are seeking to
cut prices and increase competitiveness.
A feature of many oligopolies is selective price wars. For example, supermarkets often compete
on the price of some goods (bread/special offers) but set high prices for other goods, such as
luxury cake.
Collusion

 Another possibility for firms in oligopoly is for them to collude on price and set profit
maximising levels of output. This maximises profit for the industry.

In the above example, the industry was initially competitive (Qc and Pc). However, if firms
collude, they can agree to restrict industry supply to Q2, and increase the price to P2. This
enables the industry to become more profitable. At Qc, firms made normal profit. But, if they can
stick to their quotas and keep the price at P2, they make supernormal profit.

 Collusion is illegal, but tacit collusion may be hard to spot.

 For collusion to be effective, there need to be barriers to entry.
 A cartel is a formal collusive agreement. For example, OPEC is a cartel seeking to
control the price of oil.
See: Collusion
Collusion and game theory
Game theory is looking at the decisions of firms based on the uncertainty of how other firms will
react. It illustrates the concept of interdependence. For example, if a firm agrees to collude and
set low output – it relies on the other firm sticking to the collusive agreement. If the firm restricts
output (sets the High price), and then the other firm betrays its agreement (setting low price). The
firm will be worse off.

This shows different options. If the market is non-collusive, firms make £3m each. If they
collude, they make £8m. But, there is an incentive for firms to exceed quota and increase output.
Collusion and game theory is more complex if we add in the possibility of firms being fined by a
government regulator.
Collusion is illegal and firms can be fined. Usually, the first firm who confesses to the regulator
is protected from prosecution, so there is always an incentive to be the first to confess.

(https://opentextbc.ca/principlesofeconomics/chapter/10-2-oligopoly/)

In an Oligopoly market structure, there are a few interdependent firms dominate the market.
They are likely to change their prices according to their competitors. For example, if Coca-Cola
changes their price, Pepsi is also likely to.

Examples of Oligopolies
In the wireless cell phone service industry, the providers that tend to dominate the industry are
Verizon, Sprint, AT&T and T-Mobile. Similarly, for smartphone operating systems, Android,
iOS and Windows are the most prevalent options.

Characteristics of an Oligopoly

1. Interdependence
There are a few interdependent firms that cannot act independently. Firms operating in an
oligopoly market with a few competitors must take the potential reaction of its closest rivals into
account when making its own decisions.

2. Barriers to Entry
There are a few barriers to entry and exit. Some of these markets require large economies of
scale for firms to be viable. They could also require scarce resources to operate like slots at an
airport. Firms often try to lower their price as much as possible to deter new entrants. They also
heavily advertise and often employ loyalty programs.

3. Information
The market is characterized by imperfect knowledge, where customers don’t know the best price
or availability.

Oligopoly Revenue Curves

Oligopoly Total Revenue

Total Revenue Curve

Oligopoly Average & Marginal Revenue

Average &
Marginal Revenue
1. Total Revenue – Total Quantity x Price.
2. Marginal Revenue – the revenue earned by selling one more unit.
3. Average Revenue – total revenue/quantity. Since all the units are the same price, each new
unit would have the same average revenue, so the marginal revenue = total revenue.

Should Oligopolies Compete or Collaborate?

Since firms are interdependent, they have the choice of competing against other firms or
collaborating with them. By competing they may increase their own market share at the expense
of their competitors, but by collaborating, they decrease uncertainty and the firms together can
act as a monopoly.

Example 1: Collaborating Oligopolies

 When two or more oligopolies agree to fix prices or take part in anti-competitive
behavior, they form a collusive oligopoly. This agreement can be formal or informal.
 A formal agreement is a cartel and is illegal. The OPEC is a legal cartel because it is an
agreement signed between countries and not individual firms.
 In an informal agreement, the firms behave as a monopoly and choose the price that
maximizes output. The diagram would be like the monopoly profit maximizer.
 Collaborations are unlikely to last as firms have an incentive to cheat. They all would like
the other members to restrict their output to what everyone agreed but would want to increase
their production. However, if they are a few big firms with similar costs and rising demand,
the agreement is likely to last.

Example 2: Competing Oligopolies

 Even if there is no agreement, oligopolistic firms don’t end up changing their output with
changes in cost. This behavior can be seen in the diagram below; there is a ‘stickiness’ in
price as firms produce the same output when marginal cost is at Marginal Cost Upper or
Marginal Cost Lower.
 The assumption is that when a rival firm increases its price, other companies will not
follow, but if a competing business decreases its price, then others will follow. This behavior
leads to a ‘kink’ in the demand curve.
 The upper part of the D, AR curve is more price elastic (sensitive to price changes) than
the lower part. It is more price elastic because of the assumption that at the higher price,
firms will not follow but at the lower price, other firms will cut prices too.
 The Kinked
Demand (Non-Collusive Oligopoly)
Using the profit maximization rule, Marginal Cost = Marginal Revenue, anywhere on the vertical
MC curve works. The price and quantity don’t change regardless of cost. Price remains at P* and
output Q*, even at MC Upper or MC Lower.

Example 3: Competing excluding price

The Oligopolistic firms don’t like cutting prices because it leads to a price war, where firms
are continuously cutting prices down. They instead compete by creating a brand, providing
customer service, discounts and coupons, and product differentiation. However, bigger firms cut
prices so low that the smaller firms can’t compete. Bigger firms force smaller firms out of
business. Then the big firms raise their price up.

(https://www.intelligenteconomist.com/market-structure-oligopoly/)