Oligopoly
Hi everyone,
This week we are moving on to Oligopoly, one of the most interesting and complex market structures. Understanding oligopoly will help us see how firms behave when they aren't pure monopolists but still have significant market power.
What is an Oligopoly?
An oligopoly is a market structure where a few large firms dominate the industry. In the UK, an industry is considered an oligopoly if the top five firms have more than 50% market share.
Examples of Oligopolies:
Car Industry: Major players include Toyota, Hyundai, Ford, General Motors, and VW.
Petrol Retail: The UK market is dominated by a few large firms.
Pharmaceutical Industry: Few companies dominate drug production.
Coffee Shop Retail: Starbucks, Costa Coffee, and Café Nero.
Newspapers: UK tabloids such as The Daily Mail, The Sun, and The Mirror.
Book Retail: Dominated by Amazon, Waterstones, and smaller retailers like Blackwells.
Key Characteristics of an Oligopoly
Few Large Firms: A small number of firms have a large share of the market.
Interdependence: Firms are highly aware of each other's actions and decisions. The pricing and output of one firm can significantly impact others.
Barriers to Entry: There are barriers such as economies of scale, brand loyalty, and capital requirements, but these barriers are not as high as in a monopoly.
Non-Price Competition: Firms often compete through advertising, branding, product quality, and customer service rather than changing prices frequently.
Differentiated Products: Although products may be similar, firms emphasize slight differences to stand out.
How Firms Compete in an Oligopoly
The behavior of firms in an oligopoly can vary based on several factors:
Objectives: Are firms aiming for profit maximization or sales growth?
Contestability: How easy is it for new firms to enter the market?
Regulation: Are there government policies that restrict or guide behavior?
Key Models of Oligopoly Behavior
1. The Kinked Demand Curve Model
This model suggests that prices in an oligopoly tend to be stable because firms face different elasticities for price increases and decreases:
Price Increases: If a firm raises prices, other firms are unlikely to follow, leading to a large loss of market share. This results in elastic demand.
Price Decreases: If a firm lowers its price, competitors will also reduce theirs, leading to only a small gain in market share. This results in inelastic demand.
This leads to price rigidity in oligopolistic markets, as firms have little incentive to change prices.
Source: EconomicsHelp
Evaluation of the Kinked Demand Curve Model
It doesn't explain how the price was set initially.
In reality, prices do change, so this model may not always hold.
Firms might prioritize market share over profits and be willing to change prices accordingly.
2. Price Wars
In some cases, firms engage in aggressive price competition to increase their market share. For instance, supermarkets may engage in price wars on certain products, like bread or milk, while keeping other items at higher prices.
3. Collusion
Oligopolistic firms might collude to set higher prices and restrict output, behaving more like a monopoly. By doing so, they can earn supernormal profits.
Formal Collusion: A formal agreement to fix prices or output, known as a cartel. Example: OPEC (Organization of the Petroleum Exporting Countries), which controls oil prices.
Tacit Collusion: An unspoken understanding among firms to avoid price wars and maintain stable prices.
Game Theory and Oligopoly
Game theory explores the strategic decision-making process of firms in an oligopoly. One common example is the prisoner's dilemma, which demonstrates why firms might be tempted to break a collusive agreement:
If both firms collude, they can achieve maximum profits.
However, there's always an incentive for one firm to "cheat" and increase output to gain a larger share of the market.
Regulatory agencies might offer immunity to firms that confess to collusion first, encouraging firms to "betray" the agreement.
Source: Finance & Economics Word Press
Advantages and Disadvantages of Oligopoly
Advantages
Economies of Scale: Large firms can reduce costs due to their size, potentially leading to lower prices for consumers.
Innovation: Firms in an oligopoly often have the resources for R&D, leading to new and improved products.
Stable Prices: Due to the kinked demand curve, prices tend to be more stable, reducing uncertainty for consumers.
Disadvantages
Higher Prices: Collusion can lead to higher prices than in more competitive markets.
Lack of Choice: Consumers have fewer alternatives compared to highly competitive markets.
Inefficiency: Firms might not operate at maximum efficiency, as the pressure to reduce costs is less intense than in more competitive environments.
Real-World Examples
Petrol Retail: The UK petrol market is dominated by a few major players, resulting in similar pricing across different stations.
Pharmaceutical Industry: High barriers to entry, extensive R&D costs, and patents contribute to an oligopolistic structure.
Supermarkets: The UK grocery market is dominated by Tesco, Sainsbury’s, Asda, and Morrisons, demonstrating oligopolistic behavior with price wars and promotions.
Looking Ahead: Week 14 (October 23): Monopolistic Competition
Next week, we’ll explore Monopolistic Competition, where many firms compete with differentiated products. This structure combines elements of both monopoly and perfect competition, offering a dynamic look at how firms operate in less concentrated markets.
See you next week!
Best regards,
Sam
A-Level Economics Weekly