Oligopoly

Oligopolies can result from various forms of collusion that reduce market
competition which then typically leads to higher prices for consumers. Oligopolies
have their own market structureWith few sellers, each oligopolist is likely to be
aware of the actions of the others. According to game theory, the decisions of one
firm therefore influence and are influenced by decisions of other firms. Strategic
planning by oligopolists needs to take into account the likely responses of the
other market participants. Entry barriers include high investment requirements,
strong consumer loyalty for existing brands and economies of scale. In developed
economies oligopolies dominate the economy as the perfectly competitive model is
of negligible importance for consumers. Oligopolies differ from price takers in that
they do not have a supply curve. Instead, they search for the best price-output
combination.

Description

Oligopoly is a common market form where only a limited number of firms are in
competition on the supply side. As a quantitative description of oligopoly, the
four-firm concentration ratio is often utilized. This measure expresses, as a
percentage, the market share of the four largest firms in any particular industry.
For example, as of fourth quarter 2008, if we combine total market share of
Verizon Wireless, AT&T, Sprint, and T-Mobile, we see that these firms, together,
control 97% of the U.S. cellular telephone market.Oligopolistic competition can
give rise to both wide-ranging and diverse outcomes. In some situations,
particular companies may employ restrictive trade practices (collusion, market
sharing etc.) in order to inflate prices and restrict production in much the same
way that a monopoly does. Whenever there is a formal agreement for such
collusion, between companies that usually compete with one another, this
practice is known as a cartel. A prime example of such a cartel is OPEC, which
has a profound influence on the international price of oil.
Firms often collude in an attempt to stabilize unstable markets, so as to reduce
the risks inherent in these markets for investment and product
development.[citation needed] There are legal restrictions on such collusion in most
countries. There does not have to be a formal agreement for collusion to take place
(although for the act to be illegal there must be actual communication between
companies)–for example, in some industries there may be an acknowledged
market leader which informally sets prices to which other producers respond,
known as price leadership.
In other situations, competition between sellers in an oligopoly can be fierce, with
relatively low prices and high production. This could lead to an efficient outcome
approaching perfect competition. The competition in an oligopoly can be greater
when there are more firms in an industry than if, for example, the firms were only
regionally based and did not compete directly with each other.
Thus the welfare analysis of oligopolies is sensitive to the parameter values used
to define the market's structure. In particular, the level of dead weight loss is hard
 to measure. The study of product differentiation indicates that oligopolies might
also create excessive levels of differentiation in order to stifle competition.[citation
needed]
Oligopoly theory makes heavy use of game theory to model the behavior of
oligopolies:

 Stackelberg's duopoly. In this model, the firms move sequentially

(see Stackelberg competition).
 Cournot's duopoly. In this model, the firms simultaneously choose
quantities (see Cournot competition).
 Bertrand's oligopoly. In this model, the firms simultaneously choose prices
(see Bertrand competition).

UNDERSTANDING OLIGOPOLY

issues can be understood by looking at the simplest case: duopoly. Duopoly: an

oligopoly consisting of only two firms. Cooperation between firms may be profitable
but it is unstable.Collusion: firms cooperating to raise each others’ profits. The
strongest form of collusion is a cartel, an agreement by several producers to restrict
output in order to increase their joint profits. (OPEC)

THE PRISONERS’ DILEMMA

When each firm has an incentive to cheat but both are worse off if both cheat, the
situation is known as a prisoner’s dilemma.
The game based on two premises:
Each player has an incentive to choose an action that benefits itself at the other
player’s expense.
When both players act in this way, both are worse off than if they had acted
cooperatively.
A dominant strategy: a strategy that is a player’s best action regardless of the
action taken by the other player. Depending on the payoffs, a player may or may
not have a dominant strategy.
Nash equilibrium (also known as noncooperative equilibrium): the result when
each player in a game chooses the action that maximizes his or her payoff given
the actions of other players, ignoring the effects of his or her action on the payoffs
received by those other players.

PRODUCT DIFFERENTIATION AND PRICE

LEADERSHIP

When collusion breaks down and prices collapse, there is a price war. To limit
competition, oligopolists often engage in product differentiation, an attempt by a
firm to convince buyers that its product is different from the products of other
firms in the industry.
Oligopolists often avoid competing directly on price, engaging in the nonprice
competition through advertising and other means instead. In price leadership,
one firm sets its price first, and other firms then follow.
STUDYING OLIGOPOLY BEHAVIOR

complicated because it’s not a single firm considering its costs and pricing in a

vacuum (like perfectly competitive firms and monopolies).The profits of a large

firm depend heavily on the actions taken by other large firms.Imperfect

competition: No one firm has a monopoly, but producers can affect market prices.

MEASURING OLIGOPOLY

economists often use the Herfindahl–Hirschman Index, or HHI.The HHI for an

industry is the sum of the squares of each firm’s share of market sales. HHI of less

than 1,000 indicates a strongly competitive market.HHI of 1,000 to 1,800

indicates a somewhat competitive market.HHI above 1,800 indicates an oligopoly.