The definition and characteristics of oligopoly

An oligopoly describes a market where a small number of firms control most of the output. This structure is common in many industries, but it does not always lead to clear predictions about prices or production levels.

Key characteristics of oligopoly

• Dominance by a few firms - Only a handful of businesses hold the majority of market share, giving them significant influence.
• Interdependent decisions - Actions by one firm, such as changing prices, directly affect competitors, who may respond in kind.
• Barriers to entry - High obstacles, like large startup costs or strong brand loyalty, make it difficult for new firms to join the market.
• Product differentiation - Goods or services can be similar (undifferentiated) or varied (differentiated) to appeal to different customer preferences.
• Price rigidity and uncertainty - Firms often avoid aggressive price changes due to risks like starting conflicts, leading to stable prices over time.

Measuring market concentration with concentration ratios

A concentration ratio assesses how much power is held by the largest firms in a market. It helps identify if a market is oligopolistic by showing the combined market share of a select number of top firms.

Calculating a concentration ratio

$\text{Concentration ratio}=\frac{\text{combined market share of selected firms}}{\text{total market size}}\times 100$

Where:

• Combined market share of selected firms = Total sales (or output) of the chosen firms (usually the top 3, 4, or 5)
• Total market size = Overall sales (or output) in the market

Concentration ratios are often based on sales value but can use units sold or number of employees. A 4-firm ratio above 60% suggests a highly oligopolistic market.

Worked example - Calculating a concentration ratio

In a market for streaming services, the total annual sales are £3,000 million. The top four firms have sales of £900 million, £750 million, £500 million, and £450 million. Calculate the 4-firm concentration ratio.

Step 1: Identify the values

• Total market sales = £3,000 million
• Sales of top four firms = £900 million + £750 million + £500 million + £450 million = £2,600 million

Step 2: Apply the formula

$\text{Concentration ratio}=\frac{\pounds \mathrm{2,600}\text{ million}}{\pounds \mathrm{3,000}\text{ million}}\times 100=\frac{\mathrm{2,600}}{\mathrm{3,000}}\times 100\approx 87\%$

Step 4: Interpretation

An 87% ratio indicates a highly oligopolistic market, as the top four firms control most of the sales.

Oligopolistic behaviour including price wars and the kinked demand curve

Firms in an oligopoly can compete aggressively or cooperate to avoid risks. They set their own prices as price makers, but this can lead to instability if not managed carefully.

Types of oligopolistic behaviour

• Aggressive competition - Firms may cut prices or innovate to gain an edge, but this risks escalating into broader conflicts.
• Cooperation or collusion - Businesses might work together informally to stabilise the market and protect profits.

Price wars

Triggers for price wars:

• These often start when one firm has much lower costs.
• There is excess capacity in the industry.
• New competitors enter.
• A firm defends its declining market share.

Outcomes of price wars:

• They can lead to short-term low prices for consumers but may force weaker firms out.
• Diversified companies might accept losses in one sector to protect overall position.

The kinked demand curve model

This model illustrates why prices in oligopolies often remain stable. It assumes firms watch each other closely without formal agreements.

Key features:

• The demand curve has a "kink" at the current price level, with a steeper section above (if one firm raises prices, others may not follow) and a flatter section below (if one lowers prices, rivals likely match it).
• This creates price rigidity, as small cost changes do not prompt price adjustments.

Criticisms:

• The arbitrary positioning of the kink.
• Its failure to match some real-world behaviours where prices do fluctuate.

Non-price competition and changing firm objectives

In oligopolies, firms often avoid price battles and focus on other strategies to attract customers. Uncertainty can also lead them to adjust their main goals away from pure profit-seeking.

Methods of non-price competition

• Advertising and promotions - Campaigns to build brand loyalty and highlight unique features.
• Product innovation - Developing new or improved items to appeal more to consumers.
• Brand proliferation - Launching multiple brands to fill market gaps and limit space for rivals.
• Market segmentation - Tailoring products to specific customer groups with different needs.
• Process innovation - Improving production methods to cut costs without changing prices.

Shifts in firm objectives

• From profit maximisation - High uncertainty may push firms towards safer aims, like steady growth.
• Satisficing - Managers might aim for enough profit to keep shareholders content rather than the maximum possible.
• Market share focus - Maintaining or growing share becomes key to long-term survival in competitive environments.

The prisoner's dilemma and collusion in oligopolistic markets

The prisoner's dilemma shows why firms might not cooperate even when it benefits them. It applies to oligopolies where self-interest can undermine group gains.

The prisoner's dilemma explained

This concept uses a scenario of two suspects who can either stay silent or betray each other.

Pay-off matrix for the prisoner's dilemma:

The rational choice for each is to betray, leading to a worse outcome (1 year each) than if both cooperated (6 months each). This illustrates why firms might break agreements for personal gain.

Collusion in oligopolies

Collusion happens when firms cooperate to boost profits, often in sectors with high research costs or fast tech changes, like developing treatments during a global health crisis.

Types of collusion:

• Formal collusion (cartels) - Illegal agreements to fix prices or output, acting like a monopoly to maximise joint profits.
• Informal collusion - Legal but subtle, such as price leadership where smaller firms follow a dominant one's price changes.

Factors influencing collusion:

• Incentives to cheat - As in the prisoner's dilemma, a firm might secretly increase output (e.g., in a fuel cartel) to gain more profit at others' expense.
• Price leadership models - Could involve a dominant firm setting prices or a typical firm that others mimic.
• Detection challenges - Similar prices might stem from competition rather than collusion, making it hard to prove.