Market Structure: 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.

Oligopoly

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

Oligopoly Total Revenue Curve
Total Revenue Curve

Oligopoly Average & Marginal Revenue

Oligopoly Average & Marginal Revenue Curve
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’s signed between countries and not 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 had been 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.

Oil Market Structure: Oligopoly

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 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. This is 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) Graph
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 the smaller firms out of business. Then the big firms raise its price up.

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