An oligopoly is an industry dominated by a few firms, e.g. supermarkets, petrol, car industry e.t.c.
The main features of oligopoly:
- An industry which is dominated by a few firms.
- UK definition of an oligopoly is a five firm concentration ratio of more than 50% (this means 5 biggest firms have more than 50% of the total market share) See also: Concentration ratios
- Interdependence of firms, firms will be affected by how other firms set price and output.
- Barriers to entry, but less than monopoly.
- Differentiated products, advertising is often important.
- Oligopoly is the most common market structure
Firms in oligopoly
There are different possible ways that firms in oligopoly will compete and behave this will depend upon:
- The objectives of the firms e.g. profit maximisation or sales maximisation.
- The degree of contestability i.e. barriers to entry.
- Government regulation
There are different possible outcomes for oligopoly:
- Stable prices (e.g. through kinked demand curve)
- Price wars (competitive oligopoly
- Collusion for higher prices.
The kinked demand curve model
This model suggests that prices will be fairly stable and there is little incentive to change prices. Therefore, firms compete using non-price competition methods.
- This assumes that firms seek to maximise profits
- If they increase price, then they will lose a large share of the market because they become uncompetitive compared to other firms, therefore demand is elastic for price increases.
- If firms cut price then they would gain a big increase in market share, however it is unlikely that firms will allow this. Therefore other firms follow suit and cut price as well. Therefore demand will only increase by a small amount. Therefore demand is inelastic for a price cut.
- Therefore this suggests that prices will be rigid in oligopoly
The diagram above suggests that a change in marginal cost still leads to the same price, because of the kinked demand curve remember profit maximisation occurs where MR = MC at Q1.
Evaluation of kinked demand curve
- In real world, prices do change.
- Firms may not seek to maximise profits, but prefer to increase market share and so be willing to cut prices, even with inelastic demand.
- Some firms may have very strong brand loyalty and be able to increase price without demand being very price elastic.
Firms in oligopoly may still be very competitive on price, especially if they are seeking to increase market share. In some circumstances we can see oligopolies where firms are seeking to cut prices and increase competitiveness.
- Another possibility for firms in oligopoly is for them to collude on price and set profit maximising levels of output. This maximises profit for the industry.
- Collusion is illegal, but tacit collusion may be hard to spot.
- For collusion to be effective, there need to be barriers to entry.