OLIGOPOLY ECON 1020

1. Where do you think an oligopoly exists in your local community or country?

Oligopoly is one of four common market structures. The other three are: perfect competition, monopoly,
and monopolistic competition. The below illustrates how these four market structures form a continuum
based on the relative degree of market control and the number of competitors in the market. In the
middle of the market structure continuum, near the right end, is oligopoly, characterized by a few
competitors and extensive market control.

An oligopolistic market is one where the market is dominated by a small number of larger firms (usually
under ten). These firms gain the majority of total sales revenue and market share. As in monopolistic
competition, firms in an oligopolistic market sell similar goods and services which are close substitutes,
and thus price sensitive.

However, the barriers to entry in an oligopolistic market are quite high compared to perfect competition
or monopolistic competition. Many Australian markets are dominated by a few, large firms.

OLIGOPOLY CONCENTRATION CAUSES

The most notable causes for the high concentration in oligopoly type of markets are
- economies of scale present in production of certain goods,
- business cycles eliminating weak competitors,
- benefits from firms merging, and
- other barriers such as technological development and advertising.

The grocery market in Australia is an oligopoly. This market is dominated by Woolworths, Coles, IGA
and Aldi nationally. These companies have extensive distribution systems, with stores in most urban and
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regional areas across Australia. To compete with these firms would require a large investment; in the
billions of dollars, conservatively.

2. Explain how this monopoly or oligopoly affects you and your community? Use
diagrams and/or equations in your explanation.

Economists measure the seller concentration ratio of an industry to determine whether it is an oligopoly.
Seller concentration ratios are based on the percentage of sales of the four largest firms in the market, as
a percentage of all sales in the market. This ratio is then compared to the total sales of the twenty largest
firms in the market.

The seller concentration ratio in the grocery market is about 80%; the four largest firms (Woolworths,
Coles, Aldi, and IGA) account for 80% of all grocery sales in Australia.

Competition in an oligopolistic market is intense. Both price and non-price methods of competition are
used. You have probably seen, read or heard advertisements along these lines ... ''We will not be beaten
on price. If our competitor is selling item X for less, we will match their prices, whether the item's price
has been reduced for a special sale or not''. They can do so through Economies of Scale.

Firms in oligopolies are said to be mutually interdependent. If one firm changes its prices, this will
have an effect on the sales of all other firms in the market.

Consider the diagram below. Woolworths and Coles are initially selling tomatoes at $6 per kilogram.
Woolworths decides to lower its price to $5 per kilogram. Sales increase from 20,000 kilograms per
week to 30,000 kilograms per week (from point E to E1). The Demand curve for tomatoes is elastic at
this stage; the percentage increase in sales volume (a 50% increase) is greater than the percentage
decrease in sales price (a 17% decrease). Coles is unhappy losing so many sales to Woolworth's, and
matches Woolworth’s price of $5 per kilogram.
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Coles then decides to go further, reasoning ''When Woolworths decreased its price, it made less profit
per kilogram, but it sold so many more kilograms of tomatoes, overall it made greater profits. If we do
the same, we will end up making greater prodits, too.''
However, this is not the case. When Coles decreases the price of its tomatoes to $3 per kilogram (a 40%
decrease), sales volume only increased from 30,000 kilograms per week to 35,000 kilograms per week
(a 17% increase). This is shown as the movement from (from point E1 to E2).

Kinked-Demand Curve
Short-run production activity of an oligopolistic firm is often illustrated by a kinked-demand curve
(shown below). A kinked-demand curve has two distinct segments with different elasticities that join to
form a kink. The primary use of the kinked-demand curve is to explain price rigidity in oligopoly. The
two segments are: (1) a relatively more elastic segment for price increases and (2) a relatively less

Kinked-Demand Curve
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elastic segment for price decreases. The relative elasticities of these two segments is directly based on
the interdependent decision-making of oligopolistic firms.
The kink of the demand curve exists at the current quantity (Qo) and price (Po).
 Because competing firms ARE NOT likely to match the price increases of an oligopolistic firm,
the firm is likely to lose customers and market share to the competition. Small price increases
result in relatively large decreases in quantity demanded.

 However, because competing firms ARE likely to match the price decreases of an oligopolistic
firm, the firm is unlikely to gain customers and market share from the competition. Large price
decreases are needed to gain relatively small increases in quantity demanded.

Each segment of the demand curve has its own marginal revenue segment. This actually means that the
marginal revenue curve facing an oligopolistic firm, labeled MR in the exhibit, contains three distinct
segments.
 Top Segment: The flatter top portion of the marginal revenue corresponds to the more elastic
demand generated by price increases.

 Bottom Segment: The steeper bottom portion of the marginal revenue corresponds to the less
elastic demand generated by price decreases.

 Middle Segment: The vertical middle segment connecting the top and bottom segments that
occurs at the output quantity Qo corresponds with the kink of the curve.

The vertical segment is key to the analysis of short-run production by an oligopolistic firm. It means that
the firm can equate marginal revenue with marginal cost, and thus maximize profit, even though
marginal cost increases or decreases. If marginal cost increases a bit, the profit-maximizing price and
quantity remain at Po and Qo. If marginal cost decreases a bit, the profit-maximizing price and quantity
also remain at Po and Qo.

We can see that this provides direction towards lower costs for the consumer and a variety of choice in
products at a lower cost which ultimately leads to offers and specials (such as Dollar Dazzlers at Coles).
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The nature of Australia’s market is favorable for sustaining high barriers of entry and high market
concentration, thus retaining oligopoly structure. The implication of such a structure is that the firms are
price taker and welfare of society is not maximised.

3. If you would be advising the government, how would you address this issue? You
may use diagrams to further explain your ideas.

Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the
firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict
production in much the same way as a monopoly. Where there is a formal agreement for such collusion,
this is known as a cartel. An example of such a cartel is OPEC which has a vast 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. 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, this is known as price leadership.

This collusion agreement or cartel can ultimately lead to a raise in prices for competitors (relatively
unknown) who enter the market and can restrict trade practices leading to monopolistic traits in the
market (which is illegal in selected countries – incl Australia).

Barriers to entry in an oligopolistic market are factors such as patents, economies of scale, access to
expensive & complex technology, and strategic actions made by existing companies designed to
discourage & destroy emerging firms.

The need for government policy that could be introduced to restrict barriers of entry in the market place
is fundamental in ensuring that monopolistic traits in the oligopoly market are eliminated and that the
large concentration of larger firms do not deter new competitors entering the market and failing – being
eaten (taken over by a larger company), or forced out of business due to large set up costs, insignificant
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supplier relationships and the disposable income to establish marketing campaigns such as the bigger
firms. Example – Coles – Dollar Dazzlers. Moreover, these entry barriers can change over time,
transforming oligopoly into monopolistic competition or vice versa.

Government aid such as reimbursements and funding could be instituted in order to address this issue in
that they have the sufficient funds to perhaps compete with the bigger firms, and have a chance of
survival. With this government funding the market can move more into a perfect competition/
monopolistic competition. This would ensure market change to a perfect competition or a monopolistic
competition, ensuring that a much more fair-minded entry into the market is available for emerging
small companies.

Since it is large firms which tend to profit from economies of scale, this causes the emergence of
oligopoly (or monopoly), where a few firms or a single firm dominate the market. In order to combat
this, government intervention to standardise prices could help create smaller gaps between the larger and
smaller firms ( as depicted in the LRAC graph below).

Other ways to address the issue would be to implement legislation to restrict collusions/cartels (as was
seen in the case of VISY).