This article is about an oligopoly. It describes the characteristics of an oligopoly market and explains why most markets are oligopolistic.
This story also describes and illustrates with a neat and accurate diagram, the Neo-classical concept of the kinked demand curve. Finally, it explains the causes of oligopoly power with reference to real world examples.
What is oligopoly?
An oligopoly is a market dominated by a small number of a few large firms. They are common in old markets since there has been enough time for weaker companies to be pushed out of the market. The majority of global markets and the markets of developed countries are oligopolies since they have had time to develop.
Most firms wish to grow in order to benefit from economies of scale, higher profits, market share and stability. In time, a firm becomes specialized in what it does and is able to defeat other weaker companies. So, eventually only a few strong companies will remain in the market. Examples in the UK are banking and mobile communication services providers such as telephone, mobile and the Internet.
Features of an oligopoly
For a true oligopoly to exist, a market needs a few large firms that control the market and are interdependent. Interdependent means the actions of one will affect the others. For example, a growth in market share often means taking it from another company, who will take defensive actions. There should also be barriers to entry such as high investment costs, e.g. car manufacturing, aircraft production, etc.
There are some features that are common amongst all oligopolies, although they do not necessarily need to be present, including
- None price competition.
- Price rigidity and stability
- Collusion.
1. None price competition
An oligopoly is not a perfectly competitive market as there are not many suppliers, but this is not the only difference. When in perfect competition, price is the only thing to compete with as all products are homogenous. However, in oligopoly markets firms compete through differentiation. Oligopoly markets may have substitute products, but they are not identical. By providing consumers with products which are differentiated, oligopolies provide a barrier to new entrants.
In order for a new firm to enter the market, they must offer something new, above and beyond that which the current market members do. A company can compete through its choices involving Marketing Mix. The typical Marketing Mix includes product, price, place and promotion. Firms in oligopoly markets mostly use product and promotional methods to differentiate their goods.
- Product. A product can be differentiated by it features or benefits. For example, a company can try to attract consumers with a huge number of features to make a product appear to be good value for money. It could also be as simple as a unique design. Differentiating from your competitors via benefits is what many companies do. They may focus on how a product improves your life – improves health or status, or reduces wasted time, etc.
- Price. Though firms will not directly compete with price, it may be used to send a signal to the consumer. A company will often base its price upon its target market demographic or the perception which consumers have of the product. A high price is aimed at high earners with a desire of buying the most exclusive product.
- Place. Although place is part of Marketing Mix, it is often not a way to differentiate. In order to remain competitive it is important to have a successful distribution channel. This usually means using a channel common to the industry. Using a distribution channel which is unusual for the industry can be costly and maybe not useful for reaching the target market. For example, it is common to find high-street banks within the same area.
- Promotion. Particularly branding is used to differentiate products. A brand is a product’s identity which takes a great deal of resources to effectively create. It is an ideal way to differentiate a product and acquire loyal customers. Gaining customer loyalty is essential for long term survival in an oligopoly. Although both Coca Cola and Pepsi Cola are very similar, most people can say which they prefer.
2. Price rigidity and stability
A habit of oligopolies is to avoid frequent changes of price. This is usually because oligopolies prefer non-price methods of competition through product differentiation. This is because price wars – lowering price to try to defeat competitors – can be very damaging to producers in oligopoly markets. They have the potential of achieving abnormal profits; price wars diminish this benefit and could drive down long term prices. For these reasons oligopolies normally exist in harmony. Therefore, they do not seek to drive each other out of the market.
Another reason for existing in relative harmony is that all of the companies within the market are very large – they all have economies of scale. Any price war would be very long and waste a great deal of resources. It is also true if a company within an oligopoly was to increase its price. It would lose market share as demand falls and other companies take advantage of the price change.
Let’s look at the following example.
Company A should increase its price, if Company B does. However, company B would not do this, since it knows that demand would fall. Company A is also aware that leaving price at the current level, will either benefit them or at the least, not damage them.
If one company lowers its price, its competitors will usually lower their price too. This is because the loss after a price reduction is usually less than not changing. Both companies can benefit from increased profits, if they lower their price. This benefit however is short term, since their competitor will also reduce the price in order to remain competitive. The first company to reduce price will find long term profits reduced, encouraging them to compete through differentiation.
This is not to say that oligopolies never reduce their price. All products have a life cycle and, like other firms, prices may be reduced in order to reduce stock for new products. Alternatively, companies which rely on the sale of complementary goods may reduce price of the primary good in order to boost sales of the profit making complementary products such as Gillette Mach 3 and additional razor blades.
3. Collusion
Collusion involves oligopolies agreeing on market prices behind closed doors. This obviously benefits participants because they can arrange to achieve abnormal profits. Companies colluding are often referred to as a cartel. Cartels may arise in order to dispose of uncertainty within a market.
However, cartels are viewed as being unstable by economists. It is natural for firms to want to benefit from abnormal profits, so they may cheat. They may pretend they have a sale or lower price unofficially through direct dealings with customers. Any cheating, no matter how small, may be enough to collapse the cartel, especially if they all cheat a little!
Another example could be, if there is falling demand in the market. Tensions may occur between cartel members as firms want to change strategy. If a new entrant overcomes barriers to entry, they increase supply and put pressure on cartels to change price. Collusion is illegal in many economies. However, Organisation of the Petroleum Exporting Countries (OPEC) is an example of a legal oligopoly.
Kinked demand curve
This model shows why an oligopoly has price rigidity. According to the kinked demand curve hypothesis, the demand curve facing oligopolies has a kink at the level of the prevailing price as shown Diagram 1:
Diagram 2: The segment above the prevailing price level is highly elastic. If price is increased a little bit from P1 to P2, the demand will decrease drastically from Q1 to Q2. This will result in the firm losing sales revenue because competitors will not react to this price change.
Diagram 3: The segment below the prevailing price level is inelastic. If the price is decreased drastically from P1 to P2, the demand will increase a little from Q1 to Q2. This will result in lower sales revenue for the firm because competitors will lower their price too.
Any extra profit and gains in market share are only short-lived.
Summary
An oligopoly is a market with a few large firms.
The choices of one firm affect and be reacted to by other businesses as they are all interdependent. They do not compete on price because it can damage market harmony. Instead, they compete for sales and market share through product differentiation.
