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Oligopoly

An oligopoly is a market in which a few firms dominate, and an oligopolist is one of these dominant firms. While 'a few' is an imprecise number, economists generally look at the market shares of the top three, four or five firms - if these firms control most of the market, then the firms are oligopolists.

How is the degree of oligopoly measured?

Concentration ratios

Concentration ratios (or CRs) can be used to help identify whether the firm operates under conditions of oligopoly. Concentration refers to the extent to which market power is in the hands of a small number of firms. Concentration ratios show the combined market shares of the top few firms as a ratio of the total market size, expressed as a percentage.

Combined market share of top few firms  x 100 
Total market size of all firms

When markets are highly concentrated the conduct of firms and their efficiency is likely to be sub-optimal. [Read more on market structure and conduct.]

For example, the global music shares of the top producers are:

Universal Music, 31%
Sony Music, 21%
Warner Music, 18%
Independents, 27%
Artists Direct, 3%
Source: MIDIA (2019),

This makes the three-firm CR 70% - indicating oligopoly conditions.

The H-H Index

he Herfindahl–Hirschman Index (HH-Index) is an alternative measure of market concentration in an industry. It is calculated by adding the squared market shares of the top few firms in a market. The higher the number, the greater the degree of concentration.

The maximum figure possible is for a single monopolist, which is 100 (%) x 100 (%) =10,000.

For example, let's assume that the market shares of the largest three firms in a hypothetical market are: Firm A = 35%, Firm B = 25%, and Firm C = 20%.

The H-H Index would give 352 + 302 + 252, which equals:

1,225 + 625 + 400 =2350.

Example - UK Supermarkets

The top four UK supermarkets in 2022 by market share were Tesco, with 26.9%, Sainsbury, with 14.6%, ASDA with 14.1%, and Morrisons, with 9.1%. 

Supermaket market shares

The H-H Index for the top four supermarkets in the UK in 2022 was 1222.

Generally, an H-H Index of more than 1200 indicates a high degree of concentration and suggests the market is an oligopoly.

Read more: Changing concentration in the UK electricity market

Key characteristics and features of oligopoly

Firms are interdependent

As there are only a few other competitors in the market, the profit available to a single oligopolist is constrained by the actions and decisions taken by the other firms in the market.

For example, if one oligopolist - firm A - decides to reduce its price in the hope of gaining market share, and the two other firms in the market - B and C - also reduce their prices in response, firm A's strategy will have been thwarted.  An oligopolist needs to anticipate and respond to the actions and behaviour of rivals. The need to take rivals into account when making decisions is referred to as mutual interdependence.

Uncertainty

Given the importance of interdependence, oligopolists face high levels of uncertainty, perhaps never being able to fully predict the behaviour of close rivals. This explains the temptation to reduce competition and the attempt to co-operate with close rivals to reduce uncertainty.

The importance of strategy

As a result of interdependence, oligopolists must try to anticipate the likely response of rivals to any change in policy concerning price or to non-price decisions. Non-price decisions include decisions about the product itself, how it is distributed, how it is marketed and advertised.

Strategy is especially important for oligopolies that cannot easily differentiate their good or service, such as petrol retailers. If they can differentiate, they become less interdependent and more able to act independently.

Differentiated or undifferentiated?

Oligopolists may operate in markets where differentiation is difficult - such as the market for refined white sugar, or where differentiation is much easier - such as oligopolists in the motor manufacturing industry.

Competition or collusion?

It follows that a key feature of oligopolies is that key decisions must be made about whether firms actively compete with each other, or whether they limit competition. Competition can be reduced when firms collude with each other and act jointly to enable all firms to reduce uncertainty and increase the level of profits (or other benefits) available to the 'group' of firms.

Types of collusion

Oligopolists can engage in overt (open) collusion by establishing an agreement to reduce competition or to collaborate in some way. For example, members of cartels may create agreements to fix output or price, or other aspects of the market. While 'overt' collusion to fix prices is clearly anti-competitive, and therefore unlawful in most countries, other forms of collusion may be hidden and difficult to legislate for, and to police.

Covert collusion arises when oligopolists conspire to 'rig' a market by having agreements which are hidden and secret. In some cases, members may 'whistle-blow' in the hope that they may avoid any punishment if the collusion is discovered by the relevant competition authority. This is more likely if authorities offer incentives to whistle-blow.

Tacit collusion arises when firms appear to adopt a similar policy on price or non-price aspects of their business, but there is no agreement between them. This may not involve any collusion in the legal sense, and need not involve communication between firms. However, the outcomes (such as higher prices or reduced output) may well resemble those that arise from explicit collusion.

Tacit collusion may arise when firms follow rules which are understood rather than written down. For example, in an oligopoly market with three firms, it may be understood that firm A takes the lead in making a change to price, or to a non-price activity, and firms B and C simply follow the lead. This arrangement is not written and there may be no conscious attempt to rig the market. Price leadership is arguably the commonest form of tacit collusion - in this case, there is no conspiracy to act unlawfully.

From a legal perspective, anti-trust law is concerned with the process of collusion, rather than the outcome, and there must be a conscious commitment to achieve an unlawful outcome.

Types of competition

Oligopolists may prefer to compete, rather than collude, especially if the penalties for anti-competitive behaviour are significant (such as fines, being forced to wind-up, or loss of reputation if discovered.)

Competition can either involve competing on price - price competition - or competing in non-price ways - non-price competition.

For the oligopolist, price competition is risky as it can lead to retaliation, and to a price-war which can lead to falling profits for all firms in the industry. This explains the preference for non-price competition. For example, rather than compete on the price of their core product (petrol/'gas'), petrol retailers may compete through special promotions, through advertising, and by developing a respected brand.

Pricing strategies can also be introduced that reduce competition, such as cost-plus pricing. Cost-plus pricing exists when the oligopolist sets a selling price as a fixed mark-up above average production costs.

For example, insurance companies may set a fixed 20% mark-up above all their costs, including all the predicted claims costs. If all insurance companies share similar costs, then any sudden change in costs - such as following a particularly harsh winter, will result in all insurance companies raising their prices (called premiums) by the same or a very similar amount.

Barriers to entry

Oligopolists can maintain their relative dominance by benefitting from barriers to entry. These include expenditure on advertising and the strength of the brand in deterring entry; the benefit of economies of scale; collusion between oligopolists; and pricing strategies to deter entry, such as limit pricing - setting a low price to limit the entry of new firms.

Read more on barriers to entry

Price-stickiness - the oligopolists kinked-demand curve

Prices in oligopolistic markets tend to 'stick' - often for lengthy periods - even when market conditions change. This can be explained though the kinked-demand curve.

The oligopolist faces two demand scenarios:

Firstly, when demand is elastic following a price rise, and secondly when demand is inelastic in response to a price drop.

Kinked demand curve - case 1
Kinked demand curve - case 2

In both scenarios, the firm is worse off - at least in terms of revenue. Raising price creates an elastic reaction, and lowering price creates an inelastic reaction. In both case, revenue is less than achieved at the original price.

Profits will also be maximised at the original price

Profit maximisation occurs where marginal cost (MC) cuts marginal revenue (MR). For the oligopolist, this may occur in the vertical section of the MR curve, between A and B. The level of profit depends upon the position of the ATC curve.

Once price is set, the kinked demand curve implies that the price sticks at P.

the kinked demand curve for oligopolists

Even when we factor in the possibility of cost changes, the price will stick at its original level. Changes in costs have no effect at all if MC remains between A and B (the discontinuous portion of the oligopolist's MR curve). Even when MC moves outside of this range, price hardly changes.

Price stickiness and interdependence can also be explained through Game Theory.


Integration

Oligopolists tend to emerge over time through integration with other firms.

Integration can either be horizontal - between firms at the same stage of production (such as two airlines merging) - or vertical, which involves the integration of firms from different stages in production.

Vertical integration can be in one of two directions - backward, where one firm integrates with a firm which is nearer to the source of supply (such as a TV company purchasing a soccer team) or forward, which is where a producer integrates with a firm nearer to the final consumer (such as a farmer acquiring a grocery store.)



Numerical example

Why the oligopolist's demand curve is 'kinked' is a question that can be appreciated by considering a cost-revenue schedule.

Oligopoly data

Here we can see that the firm's average revenue curve falls with quantity, but because there are two different reactions to price - elastic for a rise, and inelastic for a fall - there is a kink in the demand (AR) curve and the MR curve will have a discontinuous portion (between output 6 and 7, as highlighted in the schedule).

The elastic response to the price rise results from rivals not changing their price in response, whereas the inelastic response to a price drop results in rivals being forced to 'follow suit' given that rivals would experience a considerable fall in market share if they did not reduce price.

If we transfer the figures to a graph we arrive at the classic kinked demand curve. Profits are maximised at output 6 (and price 75), which is where marginal cost (MC) equals marginal revenue (MR).

The area for super-normal profits is also highlighted.

Oligopoly example

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