Oligopoly refers to a market structure, which is characterized by a small number of large firms. The firms in the market produce similar products and production is concentrated to a few dominant firms in the market. The few firms take a substantial market share leading to a high degree of market concentration. A good example of oligopolistic markets in the United States includes petroleum, steel, aluminum, and beer industries.
There are two major categories of oligopolies: the homogenous and differentiated oligopoly. The homogenous oligopoly is comprised of a few dominant firms dealing with identical products (Varian, 2009). The firms tend to charge uniform prices, and competition between them is minimal; they tend towards establishing oligopolistic cartels. A good example of homogenous oligopoly is the steel and aluminum industry. On the other hand, differentiated oligopolies deal in similar but differentiated products (Varian, 2009; McConnell, Brue, and Flynn, 2010). A good example of differentiated oligopoly is the automobile, soft drink, and cigarette industries. Companies in the differentiated oligopoly compete by differentiating their products to distinguish them from those of their competitors. The differentiation is undertaken to the extent that the companies are able to produce distinctive products and charge differentiated prices.
In the competitive market, firms act to maximize their profits (Varian, 2009). However, in the oligopolistic market, firms must consider their actions on the other players in the industry. The small firms in the market may act without causing any effects on the large firms; however, the actions of the dominant firms will cause the other players in the market to react (Bergstrom, and Varian, 2010). For instance, if a dominant firm in the market tries to undercut the other firms by selling at a lower price, the other firms will learn of the action and react by lowering their prices. Thus, a reduction in price, though a competitive strategy in the oligopolistic market, it tends to reduce the profits earned by all the firms in the market.
Oligopolistic markets have unstable prices to the extent that companies tend to reduce their prices in order to gain a competitive edge. However, in many countries, collusion by firms to fix prices is illegal. Thus, oligopolistic firms are forced to reach industry-pricing agreements indirectly. Firms in oligopolistic markets signal their pricing decisions in various ways; such strategies include speeches by industry leaders, press releases, or interview comments.
Oligopolies tend to be established in industries, which require high initial capital outlay. Industries that have a high four-firm concentration ratio have higher profit margins compared to other industries. Therefore, companies establish an oligopoly and maintain it by discouraging potential investors from establishing competing companies. Oligopolies curtail new investments in various ways; they include limiting the access of key resources, which may be either a natural resource or a patented process (Mas-Colell, Whinston, and Green, 1995; Varian, 2009). New firms are not able to enter the market without access to the resource.
Firms in an oligopolistic market enjoy significant cost advantages. This curtails new firms from venturing into the market. The cost advantage may result from economies of large-scale production as well as the experience of maintaining low production and manufacturing costs. Oligopolies also maintain their dominance due to the difficulty of introducing a new product into an oligopoly, which is typified by a high scale of product differentiation. Prohibitively huge investments would be required by the new firms to coax the existing clients to try the new product; clients are often unwilling to try new products. Lastly, oligopolies maintain their dominance through predatory practices such as securing lower prices from suppliers, instituting exclusive dealerships, and undertaking predatory pricing, which is aimed at driving competitors out of the market.
Characteristics of an Oligopoly
Profit maximization: Oligopolies maximize their profits at the point where marginal revenues equal the marginal costs of production (Pindyck and Rubinfeld, 2001).
Kinked Demand Curve
Firms operating in an oligopolistic market operate at the point where MC equal MR, this is irrespective of whether marginal costs increase or decrease. In the above graph, when the marginal cost increases slightly, the profit maximizing price and output remains at point Po and Qo. On the contrary, if marginal cost decreases slightly, the profit-maximizing price and output remains at point Po and Qo.
Ability to set prices: Firms in an oligopolistic market are price setters rather than price takers.
Lack of free entry and exit: There are various barriers of entry and exit. The barriers of entry include all he measures that the firms in the industry employ to maintain their dominance in the market.
Long run profits: Oligopolies are able to maintain abnormal profits in the long run due to the barriers of entry in the market. Barriers of entry prevent competition, and allow the firms to earn abnormal profits even in the long run (Mas-Colell, Whinston, and Green, 1995).
Product differentiation: There are two main products: homogeneous products such as aluminum and steel, and differentiated products such as automobiles and cigarettes.
Perfect knowledge: The assumption of perfect knowledge is varied; however, the knowledge of various economic actors is generally selective. Oligopolies have a perfect knowledge about their production and cost functions; however, they posses imperfect information on the inter-firm activities. Furthermore, buyers have an imperfect knowledge of the prices, cost, and quality of the products.
Interdependence: A few dominant firms characterize Oligopoly markets. The firms are so large that their individual actions affect the conditions in the market. Thus, competing firms are aware of all the market actions of other firms and they undertake appropriate measures. Therefore, all the firms in an oligopoly market are forced to contemplate the counter actions of their competitors before they can undertake any action.
In conclusion, few dominant firms characterize a duopoly. These firms must take into account the counter-actions of their competitors before undertaking any action due to the high interdependence prevailing in the market. Changes in prices affect the decisions of the key players in the market. Demand is more elastic to price increases as opposed price decreases, a firm increasing its prices is more likely to lose clients to its competitors since the competitors are unlikely to match the price increase. On the other hand, demand is less elastic to price decrease since competing firms are more likely to match the price decrease. Therefore, oligopolistic firms are torn between two major options: cooperating to maximize their profits by establishing a monopoly or competing between themselves to gain a competitive edge (Pindyck and Rubinfeld, 2001; Krugman and Wells, 2004).