Oligopoly Flashcards
Definition of Oligopoly
A market containing few firms
Why is Oligopoly so hard to define
It can take various forms, and its characteristics can vary significantly across industries
1. Product Differentiation
2. Number of Firms
3. Collusion and Behaviour
4. Lack of Clear Boundaries
5. Interdependence
6. Market Share and Concentration
Why is Oligopoly so hard to define: Product Differentiation
Oligopolies can exist with both homogeneous products (e.g., oil, steel) and differentiated products (e.g., cars, smartphones). This diversity complicates the definition, as the market dynamics and competition vary significantly based on whether products are standardised or differentiated.
Why is Oligopoly so hard to define: Number of Firms
There is no precise number of firms that defines an oligopoly. It typically refers to a market with a “few” dominant firms, but this can range from two (a duopoly) to several firms. The threshold for what constitutes “few” is often subjective.
Why is Oligopoly so hard to define: Collusion and Behaviour
Oligopoly is often defined by **the behaviour of firms, including the potential **for collusion. However, collusion may be explicit (e.g., forming a cartel) or tacit (firms implicitly cooperating without formal agreements). Distinguishing between competitive and collusive behaviour is not always straightforward, especially when firms use price leadership or other subtle forms of coordination.
Why is Oligopoly so hard to define: Lack of Clear Boundaries
**Market boundaries **are often not clearly defined, making it difficult to determine if a market is an oligopoly. The definition can vary based on geographic location, product substitutability, and market conditions. For instance, an industry might be considered an oligopoly on a national level but could face significant competition from global markets.
Why is Oligopoly so hard to define: Interdependence
A key characteristic of oligopoly is that firms are interdependent, meaning that the actions of one firm directly affect others. This interdependence is difficult to measure or define explicitly, as it requires assessing how sensitive firms are to each other’s decisions regarding pricing, output, or strategic moves.
Why is Oligopoly so hard to define: Market Share and Concentration
Defining oligopoly requires looking at the concentration of market power among firms. However, determining the level of concentration that qualifies a market as an oligopoly can be challenging, as it varies by industry and market conditions. Metrics like the concentration ratio (CR) or Herfindahl-Hirschman Index (HHI) are used, but their thresholds can be arbitrary.
Concentration Ratio definition (oligopoly)
The sum of the market share of the biggest firms in the market.
How to calculate Concentration Ratio (CR)
- Identify the Total Market Size
- Identify the Largest Firms (typically market shares in % terms)
- Sum the Market Shares
Interpretation of Concentration Ratio
High Concentration Ratio (e.g., CR > 80%): This suggests the market is dominated by a few large firms, indicating an oligopoly. The higher the ratio, the less competitive the market is.
Low Concentration Ratio (e.g., CR < 40%): This implies a more competitive market with many firms sharing the market, closer to perfect competition.
Pros of using the Concentration Ratio as a metric to define an oligopoly
They help indicate market power: High concentration ratios imply greater market power for the leading firms, often allowing them to influence prices and output levels.
They provide insight into market structure: Markets with a high concentration ratio are typically oligopolistic, while those with low concentration ratios could be monopolistic, monopolistically competitive, or perfectly competitive.
Cons of using Concentration Ratio as a metric to define an oligopoly
Ignores Smaller Firms: Concentration ratios focus only on the largest firms and disregard the competitive role that smaller firms may play.
No Insight on Firm Behaviour: It doesn’t show whether firms are colluding or engaging in competitive practices.
Market Dynamics: The ratio doesn’t capture dynamic changes in market share over time.
Real-life industries that are commonly used to illustrate concentration ratios and the degree of market concentration (Oligopoly)
1. Telecommunications (U.S.):
In the U.S. telecommunications industry, the CR is often quite high. Companies like AT&T, Verizon, T-Mobile, and Comcast together hold a substantial share of the market.
2. Automotive Industry (Global):
Globally, a small number of companies dominate the car manufacturing industry. Companies such as Toyota, Volkswagen, General Motors, and Ford collectively have a large market share, resulting in a high CR, typically over 50% for major markets.
3. Technology (Operating Systems):
In the desktop operating system market, the concentration ratio is extremely high. The CR involving Microsoft Windows, Apple macOS, and Linux accounts for well over 95% of the market share, with Windows alone holding a dominant position (above 70%).
Market Conduct definition
The price and other market policies pursued by firms.
Competitive Oligopoly definition
When firms are interdependent and independent
Market Conduct: Price Stability
One of the defining features of oligopolistic conduct is price rigidity. Firms in an oligopoly tend to avoid changing prices frequently, as price cuts could lead to destructive price wars, while price increases might cause them to lose market share to competitors. This behavior results in stable prices over time.
Market Conduct: Competitive Oligopoly: Interdependent but Independent
Despite the interdependence, each firm in a competitive oligopoly still acts independently in trying to maximize its own profit. Firms do not formally collaborate or communicate, unlike in collusive oligopoly scenarios. Each firm has its own pricing, production, and investment strategies. Although they keep an eye on competitors, firms operate autonomously to gain a competitive advantage
Market Conduct: Competitive Oligopoly: Interdependent but Independent: Sources of Uncertainty
The independence of firms in a competitive oligopoly creates uncertainty. This uncertainty stems from the inability of each firm to predict how its rivals will react to changes in pricing, output, advertising, or other strategic decisions
Competitive Oligopoly: Sources of Uncertainty: Changes in pricing
If one firm lowers its price, it is uncertain whether rivals will follow with similar reductions, hold their prices steady, or react with increased advertising. This unpredictability makes it difficult for firms to create long-term strategies, as any move could provoke a variety of responses.
Competitive Oligopoly: Sources of Uncertainty in shifting market dynamics
Competitive oligopolies often exist in markets with multiple products, differentiated offerings, and extensive use of advertising. The sheer complexity of the competitive environment adds to the uncertainty. Firms have to continuously monitor not only their direct rivals but also changes in consumer preferences, regulatory environments, and technological advancements that could shift market dynamics.
Competitive Oligopoly: Sources of Uncertainty: cautious behavior
Due to the uncertainty of rival reactions, firms in a competitive oligopoly often adopt cautious behavior to avoid triggering a destructive price war or other unfavorable outcomes. They may prefer stable prices and rely on non-price competition like advertising and product differentiation instead of engaging in aggressive price cuts.
Competitive Oligopoly: Interdependence
Interdependence means that firms cannot make decisions in isolation—they must consider how their rivals will respond. For example, if one firm lowers its prices, others may follow to avoid losing market share. This mutual dependence leads to strategic decision-making, often modeled using game theory.
Competitive Oligopoly: Game theory
The Prisoner’s Dilemma scenario shows that while mutual cooperation might lead to better outcomes, firms often struggle to trust one another, leading to competitive behavior. The Nash Equilibrium in such scenarios can lead to sub optimal outcomes for all firms involved due to the uncertainty of each firm’s actions.
Competitive Oligopoly: Kinked Demand Curve
This model suggests that firms believe competitors will match price decreases but not price increases. As a result, prices tend to be “sticky” because a firm is reluctant to change its price due to the potential negative response from rivals.
Perfect Oligopoly definition
In a perfect oligopoly, firms produce homogeneous products that are identical in nature. Examples include industries like steel, aluminum, and cement. Since products are undifferentiated, firms compete primarily on price, and non-price factors such as branding or quality differences play a limited role.
Yes
High Capital Requirements:
Pure oligopolies often exist in industries that require substantial capital investment for production facilities, machinery, and technology. New entrants may struggle to match the financial resources of established firms.
Economies of Scale:
Existing firms often benefit from economies of scale, which allow them to produce at a lower average cost due to their large-scale operations. New entrants may find it challenging to achieve similar cost efficiency, making it difficult to compete on price.
Access to Resources:
Industries like steel or crude oil may have barriers related to access to raw materials or natural resources, such as exclusive rights or long-term contracts. Established firms might have better access to these critical inputs, making it harder for new firms to enter.
Government Regulations:
In some industries, government regulations and licensing requirements can act as barriers to entry. These restrictions often exist in sectors considered vital to the national economy, such as mining or oil production.
Imperfect Oligopoly:
In an imperfect oligopoly, firms produce similar but not identical products, which are distinguishable through branding, quality, or features. Examples include the automobile industry, the smartphone market, and soft drinks. Differentiation allows firms to have some degree of pricing power, and they compete on non-price factors like advertising, branding, and product features, in addition to price.
Are there barriers to entry in an Imperfect Oligopoly
Yes
Product Differentiation and Brand Loyalty:
One of the most significant barriers in differentiated oligopolies is brand loyalty. Established firms have already built strong brands through marketing and consumer trust, making it difficult for new entrants to attract customers.
The differentiation itself can act as a barrier since new entrants must invest heavily in R&D and advertising to create a unique product and compete effectively.
High Advertising and Marketing Costs:
Differentiated oligopolies often require substantial investments in advertising and marketing to establish a brand presence and gain market share. Established firms typically have larger budgets and established networks, putting new firms at a disadvantage.
Economies of Scale in Production and Marketing:
Similar to pure oligopolies, firms in differentiated oligopolies may also benefit from economies of scale, both in production and in marketing. Established firms can produce large quantities at a lower average cost and spread their marketing costs over more units, which new entrants cannot easily match.
Access to Distribution Channels:
In industries like consumer electronics or automobiles, having access to distribution channels can be a significant barrier. Established firms often have exclusive agreements with retailers or have developed extensive distribution networks, making it difficult for new entrants to find market access.
Patents and Intellectual Property:
In differentiated oligopolies, patents and intellectual property rights can be major barriers. Firms may hold patents that prevent competitors from producing similar products, especially in technology-driven industries like pharmaceuticals or consumer electronics.
Collusive Oligopoly
In a collusive oligopoly, firms cooperate with each other, either formally or informally, to control prices, market shares, or production levels. The goal is to maximise joint profits and reduce uncertainty by limiting competition.
The four characteristics of Collusive Oligopoly
- Reduced Competition
- Price Fixing and Output Quotas
- Barriers to Entry
- Cooperation Among Firms
Collusive Oligopoly: Reduced Competition
The goal of collusion is to minimise competition between firms, making the market function similar to a monopoly. This allows them to earn abnormal profits.
Collusive Oligopoly: Price Fixing and Output Quotas
Firms may fix prices at a higher level to ensure profits or agree on output quotas to control supply, thereby maintaining higher market prices.
Collusive Oligopoly: Barriers to Entry
Collusive oligopolies usually have high barriers to entry, which helps maintain the agreement among existing firms and prevents new competitors from entering the market.
Collusive Oligopoly: Cooperation Among Firms
Firms agree to cooperate on pricing, output levels, or market sharing. This agreement can be explicit (e.g., a formal cartel) or implicit (e.g., tacit collusion).
Oligopoly: Types of Collusion
Cartel (Formal Collusion): A formal agreement between firms to control prices and output e.g. (OPEC). Cartels are usually illegal in many countries because they restrict competition.
Tacit Collusion (Informal Collusion): This occurs when firms reach an unspoken understanding to avoid competitive behaviour, such as price wars. An example is price leadership, where one firm (usually the largest) sets a price, and others follow.
Oligopoly: Characteristics of Collusion:
Illegal: Collusion is generally illegal in most jurisdictions because it undermines the principles of fair competition and leads to higher prices or restricted supply, which harms consumers.
Price Fixing and Market Sharing: Firms engage in price fixing, agreeing to set prices at artificially high levels, or market sharing, dividing geographic areas to avoid direct competition.
Secret Agreements: Collusion often occurs in secret because it is intended to mislead regulators and consumers, creating the impression of a competitive market while acting like a monopoly.
Oligopoly: Characteristics of Cooperation
Legal: Cooperation among firms usually complies with the law and does not intend to restrict competition in a way that harms consumers.
Common Goals: Firms may work together to achieve common objectives such as improving industry standards, setting product quality benchmarks, or creating shared infrastructure.
Research and Development (R&D): Firms may cooperate on R&D projects to share costs and risks, especially when developing new technologies. Such agreements can be beneficial for both consumers and firms by fostering innovation.
Supply Chain Management: Firms may also cooperate to create more efficient supply chains, sharing logistics to cut costs and improve the speed of delivery.
Oligopoly: Characteristics of Cooperation: Example of Cooperation
Standards in Technology: Tech companies may cooperate to create industry standards, such as USB standards for charging and data transfer. This form of cooperation helps improve compatibility across products and benefits consumers.
