Oligopoly is one of the most common market structures in the modern economy.
What Is Oligopoly Market: Definition
An oligopoly is a market structure where most of the output is produced by a few large firms, each of which is so large that it can influence the entire market through its actions.
Oligopoly differs from other market structures not in the number of agents, but in the type of their behavior, where the central element is the competitors’ reaction to the firm actions. Thus, the oligopolistic firm must take into account not only the reaction of consumers but also the response of its competitors.
Examples of Oligopoly
Oligopoly is one of the most common market structures in the modern economy. Almost all technically complex industries relate to this market structure.
An oligopolistic market structure can arise in industries producing standardized goods, such as copper, aluminum, oil, cement, chemical fertilizers, and differentiated goods: cigarettes, alcohol, electrical appliances, washing powders, cars, aerospace industry.
Characteristics of Oligopoly Market
An oligopoly market is characterized by the following features:
- Few sellers and many buyers. As a rule, from 2 to 10 firms, which account for half or more of the total product sales.
- Differentiated or standardized products. In theory, a homogeneous oligopoly is more often considered. However, if the industry produces differentiated products (cars, electrical household goods) and there are many substitutes, then this set is analyzed as a homogeneous aggregate product.
- Significant barriers to market entry.
- Each firm can pursue an independent pricing policy. But due to the close interdependence of oligopolistic firms, price control is limited. Only firms with large shares in total sales can influence the price of goods.
- In their actions, firms always take into account the reaction of competitors.
- Non-price competition is of great importance.
Main Causes and Conditions That Enable an Oligopoly and the Ways of Its Formation
The main reason for the emergence of the oligopoly market is economies of scale, which gives larger companies a cost advantage over smaller firms.
When the effect of economies of scale is very pronounced, a monopoly arises in the market. But when economies of scale are less noticeable, this leads to competition between several firms. This creates an oligopolistic market structure.
So, the main ways and causes of the formation of an oligopoly are:
- Existence of different barriers to entry into the industry:
- scale effect;
- ownership of raw materials, etc.
2. Growth, capitalization of profits, the bankruptcy of competitors, absorption of competitors.
3. The merger of capital voluntarily. Such a combination can significantly increase the share of the market owned by the structure, increase control over the price, take advantage of economies of scale and allow to attract cheaper resources.
4. The existence of associations based on collusion:
- A cartel (from the Italian word cartello, which means a “leaf of paper” or “placard”) is an association of firms based on a written agreement on the division of the sales market, prices, and production quotas, provided that each participant maintains production and commercial independence.
- A syndicate (the word syndicate comes from the French word syndicate which means “trade union”) is an association of entrepreneurs or producers of goods for marketing, implementing a single pricing policy, and other types of commercial activities while maintaining legal and production independence of its constituent enterprises.
- A trust (from the English “trust”) is an association of enterprises of the same industry with the loss of both commercial and industrial independence.
- The concern is a union of legally independent firms, which is most often formed by buying up their controlling stakes by one company.
Barriers to Oligopoly Market Entry
The main reason for the formation of an oligopolistic market structure and, at the same time, a barrier to entry into the oligopoly market is economies of scale and cost savings.
Where economies of scale are significant, efficient production is only possible with a small number of producers. At the same time, efficiency requires that the production capacity of each firm occupies a large share of the total market, and small firms cannot survive in such conditions. Many competing firms go bankrupt or several firms merge.
For example, in the United States during the formation of the automotive industry, about 80 firms functioned there. But over the years, the development of mass production technologies, as well as numerous bankruptcies and mergers, have weakened the struggle between manufacturers. Now in the US, the big three: General Motors, Ford, and Chrysler account for nearly 90% of the sales of domestically produced cars.
To achieve low unit costs, the firm must be a powerful producer. Only the equipment needs to be invested in tens of millions of dollars.
In addition, there are other barriers, such as financial. Thus, entry into the cigarette industry requires huge financial expenditures on advertising.
Types of Oligopoly
There are oligopolies:
- Balanced. If several firms are of the same size.
- Asymmetric. When one seller-leader and a few small sellers.
An oligopoly consisting of 3-4 firms is called “hard“, and consisting of 4-9 firms, which account for 70-80% of the market, is called “amorphous” or soft.
Indicators of Market Concentration
An oligopolistic market is formed under conditions of a high degree of concentration of production.
The following indicators can measure the market concentration:
- The share of the largest manufacturers in total sales.
- The Herfindahl-Hirschman index, which is also based on the share of individual manufacturers in the sales market (the lower the index, the more competitive the market):
where di is the market share of the i-th firm.
Price and Output Determination Under Oligopoly Market
Individual oligopolists can influence the price themselves, as in a monopoly, but the difficulty lies in the fact that the price in an oligopoly market is determined by the actions taken by all sellers, as in a perfect competition market.
This means that each firm has to make decisions based not only on consumer reaction but also on how other oligopolistic firms in the industry will react to its actions. After all, their response can affect the profits of the company.
Several large oligopolistic firms can both fight each other for dominance in the industry and negotiate with each other to maximize their profits.
These two behaviors of oligopolists affect how the price will be formed in the market.
The first model is the Bertrand model or “price wars”. At present, such a model is quite rare, because price wars are usually fleeting and most often lead to mutual agreements or the emergence of a cartel. Thus, a second model arises, based on collusion.
Model Not Based on Collusion (Kinked Demand Curve):
In this case, firms are not bound by explicit or secret agreements.
When one of the oligopolists changes the price, others can either follow it and equalize prices, or ignore the changes.
More often than not, the oligopolist’s competitors ignore the price increase but follow the price decrease. This is the reason why the demand curve for the oligopolistic product is kinked:
A kinked demand curve gives the oligopolist reason to believe that any price change will lead to a worse outcome. A large number of consumers will leave if it raises prices. If the price is lowered, then output will increase slightly, as competitors will do the same.
Price wars continue until P=AC=MC. In this case, none of the firms would benefit from the price reduction.
The Collusive Oligopoly Model
This model occurs if two or more firms jointly set prices and output volumes, divide the market, or jointly conduct business (cartel, trust).
The creation of cartels aims to completely or partially destroy competition between firms and, on this basis, maximize profits.
The main problem that the cartel faces is the problem of coordinating decisions between member firms and establishing a system of restrictions (quotas) for these firms.
Cartels are classified into four main categories:
- Cartels control the terms of sales.
- Cartels to set prices.
- Cartels to separate activities, territories, sales, and consumers.
- Cartels to establish a stake in a particular area of business.
Some forms of cartels:
- patent pools;
- license agreements;
- consortiums for the implementation of scientific research, etc.
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