2.30 - Oligopoly
Characteristics of oligopoly markets
Oligopoly is a market structure where a small number of firms dominate the industry. These firms have significant influence over prices and output, but their decisions are closely linked to those of their competitors.
Key features of oligopolies
- Few firms - Only a small number of companies operate in the market, giving each one considerable market power.
- Product types - Firms may produce identical products (e.g., aluminium, cement, natural gas, or silver) or differentiated products (e.g., fridges, TVs, video game consoles, or services in investment banking or retail banking).
- High barriers to entry - New firms face challenges entering the market due to factors such as:
- Economies of scale, where large firms produce at lower costs.
- Licensing requirements that restrict who can operate.
- Strong brand names that make it hard for newcomers to compete.
- Limit pricing, where existing firms set low prices to deter entrants.
- Product proliferation, flooding the market with many similar products to crowd out competition.
- Interdependence - Firms' decisions depend on rivals' reactions; for example, a price cut by one firm might prompt others to respond similarly.
Measuring market concentration with ratios
Concentration ratios help assess how much market power is held by the largest firms in an industry. They indicate the level of competition and whether a market is oligopolistic.
Formula for concentration ratio
Where:
- Sales of the largest n firms = Combined sales revenue of the top n companies (£)
- Total market sales = Overall sales revenue in the industry (£)
- n = Number of largest firms being measured (e.g., 4 for CR4)
Interpreting concentration ratios
- A higher ratio suggests a more oligopolistic market, with greater control by a few firms.
- Examples include a CR4 of 95% in the beverage industry, a CR3 of 52% in the airline industry, or a CR2 of 98% in digital payment systems.
- Using a series of ratios (e.g., CR4, CR8, CR20) gives a fuller picture of concentration.
- Historical data on ratios shows trends, such as increasing concentration over time if large firms grow dominant.
Worked example - Calculating concentration ratio
In the smartphone industry, total market sales are £150 billion. The four largest firms have sales of £40 billion, £30 billion, £25 billion, and £15 billion. Calculate the CR4 for this market.
Step 1: Identify the values
- Sales of largest 4 firms = £40bn + £30bn + £25bn + £15bn = £110 billion
- Total market sales = £150 billion
Step 2: Apply the formula
Step 3: Interpretation
A CR4 of 73.3% indicates high market concentration, typical of an oligopoly where these four firms dominate.
Game theory and the prisoner's dilemma in oligopolies
Game theory examines how firms in an oligopoly make decisions, considering rivals' potential responses. The prisoner's dilemma is a key example that highlights the challenges of interdependence.
How the prisoner's dilemma applies to oligopolies
- Interdependence - Firms' outcomes depend on others' actions, much like prisoners deciding whether to confess or stay silent without knowing their partner's choice.
- Risk of price wars - If one firm cuts prices to gain market share, rivals may retaliate, leading to lower profits for all.
- Incentive to collude - Firms may agree to cooperate (e.g., keep prices high) to maximise joint profits, avoiding destructive competition.
- Temptation to cheat - Even in agreements, a firm might secretly undercut prices to boost its own sales, breaking the deal and potentially sparking retaliation.
This model shows why stable cooperation is difficult in oligopolies without formal agreements.
Collusive and non-collusive behaviour in oligopolies
In oligopolies, firms may either cooperate to limit competition or compete aggressively. This behaviour affects prices, output, and market dynamics.
Features of collusive oligopoly
- Firms agree to fix or increase prices to reduce competition and boost profits.
- Agreements can be formal (written), informal (verbal), or implied through similar actions.
- Colluding firms act like a monopoly, setting output where marginal revenue (MR) equals marginal cost (MC) to maximise combined profits.
- Formal collusion forms cartels, while tacit collusion involves unspoken coordination.
Features of non-collusive oligopoly
- Firms compete independently, often leading to price wars where one cuts prices to gain market share, prompting rivals to do the same.
- Retaliation can escalate, with firms sustaining short-term losses if they have substantial financial reserves ("deep pockets").
- To avoid damaging price wars, firms prefer non-price competition strategies.
Forms of non-price competition
- Advertising and branding - Heavy promotion to build loyalty (e.g., in the beverage industry).
- Product development - Introducing new features (e.g., in consumer electronics).
- Differentiation - Making products unique (e.g., varied breakfast foods).
- Discounts and offers - Volume deals or coupons (e.g., household cleaning products or retail stores).
- Service enhancements - After-sales support (e.g., in the automotive industry).
- Extended warranties - Guarantees on products (e.g., electronic devices).
- Promotional offers - Special deals to attract customers (e.g., media firms).
Efficiency issues, price stickiness, and limitations of concentration ratios
Oligopolies can lead to inefficiencies and stable prices, while tools like concentration ratios have drawbacks in fully capturing market structures.
Allocative efficiency in oligopolies
- Firms face downward-sloping demand curves, meaning they set prices above marginal cost.
- Profit maximisation occurs where MR = MC, but since price (P) exceeds MR, P > MC.
- This results in output below the socially optimal level, where allocative efficiency requires P = MC.
Causes of price stickiness
- Firms avoid price changes, even if costs fall, to prevent sparking price wars.
- Collusive agreements help maintain stable prices, reducing uncertainty.
Limitations of concentration ratios
- They do not reveal the size distribution among firms (e.g., one dominant firm versus equal shares).
- The same ratio can hide different market structures (e.g., balanced competition or near-monopoly).
- They ignore import competition, which can influence domestic prices despite high ratios.