Welcome to Oligopoly: The Market of Strategic Giants!
Hello future economist! This chapter is incredibly important because it moves us away from the simple extremes of Perfect Competition and Monopoly, and into the murky, fascinating reality of how many large industries actually operate.
An Oligopoly describes a market dominated by a few large firms. Think of the soft drink industry (Coke vs. Pepsi), or major smartphone operating systems (Apple iOS vs. Google Android). The key word here is strategy. Every decision one firm makes affects the profits of the others.
Don't worry if this seems tricky at first—we'll break down how these giants play their high-stakes economic games!
1. The Core Characteristics of Oligopoly
Oligopolies sit between Monopolistic Competition (lots of small, differentiated firms) and Monopoly (just one firm). They are defined by four main characteristics:
1. Few Large Firms (High Concentration):
• The market share is dominated by a small number of firms. We measure this using Concentration Ratios. A 4-firm concentration ratio of 80% means the top four firms control 80% of the market output.
2. High Barriers to Entry:
• It is difficult for new firms to enter the market. These barriers could be huge start-up costs, strong brand loyalty, or legal protection (like patents). These barriers are what allow the existing firms to make supernormal profits in the long run.
3. Interdependence:
• This is the most defining feature. Firms are constantly watching each other. They must anticipate and react to the pricing, output, and marketing strategies of their rivals. It’s like a continuous game of economic chess.
4. Product Differentiation:
• Products are usually differentiated through branding, advertising, and quality improvements (like Samsung vs. Apple phones), although sometimes the product may be relatively standardised (like fuel). This differentiation allows firms to maintain some degree of market power (price-maker status).
Quick Review: Understanding Interdependence
Imagine two petrol stations right across the street from each other. If one lowers its price, the other must quickly follow suit or lose all its customers. If one increases its price, the other will likely ignore it, knowing they can capture all the business. This mutual reliance is interdependence, and it creates massive uncertainty in decision-making.
2. Oligopoly Behaviour: Collusion vs. Competition
Given the high interdependence and potential instability, firms in an oligopoly face a choice: do they compete fiercely, or do they collaborate to maximize their joint profits?
A. Collusive Oligopoly (Working Together)
Collusion occurs when firms agree, either formally or informally, to limit competition, often by setting prices or restricting output. This allows them to act essentially like a single monopolist, maximizing their collective profit.
1. Overt Collusion (Cartels):
• This is a formal, explicit agreement. A cartel is a group of firms that formally agree on pricing and output levels. Example: OPEC (Organization of the Petroleum Exporting Countries) is the most famous example of a cartel, fixing global oil supply and prices. In most countries, cartels are illegal because they exploit consumers.
2. Tacit Collusion:
• This is unspoken understanding or coordination, where firms observe each other's behaviour and follow suit without any formal agreement. This is much harder for regulators to prove.
Price Leadership:
• A common form of tacit collusion. One dominant firm (the price leader) sets the price, and all other firms follow suit. This maintains price stability in the market. Example: Historically, some banking sectors follow the rate changes set by the largest bank.
B. Competitive Oligopoly (Fighting for Share)
If firms cannot collude (perhaps due to strong anti-monopoly laws), they must compete. This often involves:
• Price Wars: Firms continually cut prices to gain market share. This benefits consumers but can be destructive for firms, often leading prices close to average cost (or even below) until only the strongest survive. Example: Intense price battles between major supermarket chains.
• Predatory Pricing: Setting prices below average variable cost to force a rival out of the market. This is illegal.
• Limit Pricing: Setting a price low enough to deter new firms from entering the market, but high enough to earn the existing firms abnormal profits.
3. The Kinked Demand Curve Model
The kinked demand curve model helps us understand why prices tend to be rigid (stable) in many oligopolistic markets, and it perfectly illustrates the concept of interdependence and uncertainty.
The Key Assumption: Rivals react differently to price increases than to price decreases.
Scenario 1: Price Increase (The Flatter Section)
• If Firm A raises its price, rivals will likely ignore it, knowing they can steal Firm A's customers.
• Firm A faces a very elastic demand curve for a price rise (a small rise leads to a large drop in quantity demanded).
Scenario 2: Price Decrease (The Steeper Section)
• If Firm A lowers its price, rivals will feel threatened and will immediately match the price cut to protect their market share.
• Firm A faces a very inelastic demand curve for a price fall (even a large drop in price leads to only a small increase in quantity demanded).
This combination creates a sharp "kink" in the demand curve at the current market price. Since raising prices is disastrous and lowering prices offers little reward (because rivals match quickly), firms prefer to keep prices stable—this is price rigidity.
4. Non-Price Competition and Innovation
Because price cuts are often matched immediately (leading to a price war), oligopolists prefer to compete using methods other than price. This is non-price competition.
Non-price competition includes:
• Branding and Advertising: Investing heavily to build customer loyalty, making their product appear unique (increasing product differentiation).
• Research and Development (R&D): Investing in new technology or product features to gain a competitive edge (strategic spending).
• Improved Service and Aftercare: Offering warranties, better customer support, or faster delivery.
Did you know? In oligopoly, R&D spending is extremely important. A firm needs to innovate constantly to jump ahead of its rivals and gain a temporary monopoly advantage before the rivals catch up. The pharmaceutical industry is a classic example of continuous R&D investment.
5. Evaluating Oligopoly: Advantages and Disadvantages
Advantages of Oligopoly
1. Economies of Scale: Because firms are large, they can exploit significant internal economies of scale, leading to lower average costs of production. These cost savings might be passed on to consumers as lower prices, or invested back into the business.
2. R&D and Innovation: The potential for abnormal profits, coupled with the need to stay ahead of rivals, provides strong incentive for large-scale investment in R&D and technological development.
3. Product Choice: Non-price competition through differentiation provides consumers with a wide range of differentiated products (e.g., choice between various car models or types of coffee).
Disadvantages of Oligopoly
1. Higher Prices and Lower Output: Compared to a perfectly competitive market, firms in an oligopoly have market power, leading to higher prices and restricted output.
2. Allocative and Productive Inefficiency: Oligopolies usually do not produce at the lowest point on the Long-Run Average Cost curve (productive inefficiency) and price is usually above marginal cost (allocative inefficiency).
3. Collusion and Exploitation: If firms successfully collude, they can act as a monopoly, exploiting consumers by charging monopoly prices and restricting output, leading to a misallocation of resources.
4. Barriers to Entry: High barriers ensure that supernormal profits are maintained in the long run, and potential consumer benefits from new, innovative firms are blocked.
Key Takeaway
Oligopoly is defined by interdependence. The performance of the market hinges entirely on whether firms choose to compete (which benefits consumers through lower prices and innovation) or collude (which harms consumers by imitating monopoly behaviour). Governments must use competition policy (see section 3.3.3.11) to prevent harmful collusion.