Oligopoly

An oligopolist is a firm in a market with only a few close competitors.

Concentration ratios (or CRs) can be used to help identify whether the firm operates under conditions of oligopoly.

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),

which makes the three-firm CR is 70% - indicating oligopoly conditions. The Herfindahl-Hirschman Index (HHI) can also be used to assess the level of oligopoly and market concentration.

It is calculated by squaring the market share of each firm in a market and then adding the result. The result can range from near-zero to 10,000.

Characteristics of oligopoly

Interdependence

Oligopolists are highly dependent on each other, a condition called mutual ‘interdependence’. The oligopolist faces two demand scenarios:

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

Profit maximisation occurs where MC cuts MR, which is the vertical section between A and B. The level of profit depends upon the position of the ATC curve.

Price ‘stickiness’

The so-called ‘kinked-demand curve’ helps explain the phenomenon of price stickiness. Once set, the price sticks at P.

Oligopoly

Changes in costs do not affect price if MC remains between A and B. Even when MC moves outside of this range, price hardly changes.

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

Game theory

Video on oligopoly

Numerical example

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

Oligopoly

Here we can see that the firm's average revenue curve falls with price, 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 an MR curve with 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

Market power

Oligopolists can retain their dominance through the benefit of barriers to entry, including:

  • The power of the existing brand
  • Extensive spending on advertising
  • The benefit of economies of scale
  • Market integation and control of the supply chain
  • Collusion between market members
  • Pricing strategies, including 'limit' pricing

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 integrating with a firm nearer to the final consumer (such as a farmer acquiring a food store.)


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Oligopoly

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