What is an oligopolistic market? How do the economic models of oligopolistic markets help our understanding of strategic interdependence?
The phrase oligopoly is derived from the Greek language and means “few sellers”. Sloman & Sutcliffe (2001) defines an oligopoly as a type of imperfect market in which a ‘few firms between them share a large proportion of the industry.’ (p.236). Thus, industries like oligopolies are dominated by a small number of manufacturers that may produce either differentiated or nearly identical products. It is necessary to distinguish between two types of oligopoly structures. Therefore Harrison, Smith & Davies (1992) suggests the distinction between perfect oligopoly and imperfect oligopoly. Perfect oligopolies feature market players that produce nearly identical products such as sugar or CD’s whereas imperfect oligopolies distinguish themselves by differentiated products like cars or airplanes.
Entry barriers and interdependences are two distinct features that differentiate oligopolies from other market structures. Oligopolies allow established firms to benefit from entry barriers similar to those of monopolies and help them to maintain a competitive edge against industry entrants. The most important barrier for entry is economies of scale, from which incumbent firms derive lower production costs per unit. Additional entry barriers that discourage many potential entrants include the technology factor, absolute costs, control over input factors of production and distribution channels as well as legal protection (Scott & Nigro, 1982).
Obviously new entrants have only limited chances if they enter an oligopoly. Usually they face strong competition and are confronted with heavy retaliation from established companies. The mentioned entry barriers facilitated the emergence of oligopolies and helped it to become the most widespread industry structure nowadays (Bilas, 1972).
Interdependences of companies are another key characteristic of oligopolies. Strong interdependences exist because of the limited amount of firms participating in oligopolistic markets. Thus, firms cannot afford to disregard the likely responses of other players in the industry. They have to presume what market participants are up to and make decisions based upon this estimation. These mutual dependences apply particularly for supply and price choices.
The interdependences of companies in oligopolies leave firms with two major strategic choices: collude or compete. In the case of collusion, companies agree to avoid competition with one another. Collusion can either be formal or informal. A formal collusion agreement is referred to as a cartel. In a cartel, firms behave like a monopolist and maximise their profits. (e.g. OPEC cartel). Figure 1 illustrates how companies engaged in a cartel can achieve profit maximisation.
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The marginal cost curve of the cartel (Industry MC) consists of all the individual marginal cost curves of its members. Profits are maximised in point a where Industry MC meets the industry marginal revenue curve MR. Therefore the cartel has to agree on price P1 and produce the quantity Q1 for maximising overall industry profits. Usually this entails a reduction of supply and increases prices. Thus, the big advantages of cartels compared to competition are increased profitability, maximised joint profits, lower industry costs and a reduced uncertainty faced by firms (Sloman & Sutcliffe, 2001).
Although firms might benefit from cartels there is always the risk that one partner within the cartel cheats in order to individually gain higher profits or increase its market share by undercutting agreed prices and quotas. This is the reason why many cartels are very weak and often fail (Harrison, Smith & Davies, (1992). Governments regard cartels as a threat to competition and a limitation of consumer sovereignty. Therefore, cartels are forbidden in many countries (e.g. Act of Competition from 1998 in UK).
Informal collusion is another possible form of cooperation in oligopolies. It is often referred to as tacit collusion and usually arises in those markets in which a large firm dominates the whole industry. This firm acts as a price leader and the other players accept its leadership role. Very often they even regard the large company as a barometer of market conditions and immediate follow or imitate its strategic steps (Sloman & Sutcliffe, 2001).
Should companies not collude but decide to compete, interdependences are an even stronger factor for the survival of firms in the long run. The concepts of kinked demand curve and game theory illustrate these strategic mutual dependencies very well. Below Figure 2 shows the model of “kinked demand curve”.
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In this model P1 marks the current market price. Suppose a firm A wants to increase its prices it automatically faces the risk that its competitors, let’s say B, C and D do not follow, but keep their prices stable. This acts as an incentive for A’s customers to switch to the market players B, C, and D. The result for A is a loss of market share and revenue. If on the other hand A decides to cut its prices firms B, C, and D will almost without doubt follow this step and match the price reduction. If they do not follow they face the danger of losing market share and customers to firm A.
Consequently, firms that are engaged in oligopolistic markets possess demand curves relatively sensitive for price rises (upper demand curve), but relatively inelastic for a fall in prices (lower demand curve). This model illustrates why oligopolistic markets are characterised by rigid prices and strong interdependences.
Concluding, in oligopolies companies tend to be afraid of increasing their prices and see no advantage in reducing them because of immediate threat of imitation by competitors. Game theory is another model that explains mutual dependencies among firms in noncolluding oligopolies. It will be explained and applied in the second part of this essay, which focuses on the issue of collusion among private British schools and why they rather tend to cooperate than to compete against each other.
- Quote paper
- Andreas Wellmann (Author), 2004, Oligopolies. A Definition of Oligopolistic Markets, Munich, GRIN Verlag, https://www.grin.com/document/22180