Oligopoly is when a few companies dominate a market. Sometimes they behave as if they were a monopoly. To do so, they usually form a cartel. One firm depends on the other firms. That's why the behaviour of oligopolies is really hard to predict. The evidence suggests that cartels are unstable. When oligopolies compete on price, they may produce as much and charge as little as they were in a market with perfect competition. Oligopoly is a market structure in which:
- natural or legal barriers prevent the entry of new firms
- a small number of firms compete
Barriers to entry
Oligopoly can be caused by natural or legal barriers to entry. A legal oligopoly arises when a legal barrier to entry protects the small number of companies in a market. We can distinguish two types of natural oligopolies:
- natural duopoly which is a specific type of oligopoly. It's an oligopoly with two firms. There is no place in this market for three firms. If there was only one company, it would make an economic profit and a second company would enter to gain some economic and business profit.
- natural oligopoly with three firms. One firm is not able to satisfy the market demand. There has to be more than one or two companies in order to satisfy the market demand at the lowest possible price.
Because barriers to entry exist, oligopoly consists of a small number of firms, each of which has a large share of the market. Such firms are independent and they face a temptation to cooperate to increase their joint economic profit.
Examples of oligopoly
Examples of oligopolies are the automobile, car rentals, tobacco companies etc. Because there are few sellers in an oligopoly, the market actions of each seller can have a strong effect on competitors' sales and prices. If General Motors, for example, reduces prices Ford, Toyota, Nissan usually do the same to retain their market shares. In the absence of much price competition, product differentiation becomes the major competitive weapon.
Traditional oligopoly models
There are two traditional oligopoly models:
First of them The Kinked Demand Curve Model is based on the assumption that each firm believes that if it raises its price, others will not follow but if it cuts its price, other firms will cut theirs. Second type of oligopoly models explains a dominant firm oligopoly, which arises when one firm has a big cost advantage over the other firms and produces a large part of the industry output. This firm is called the dominant firm. The dominant firm sets the market price and the other firms are price takers.
- Stigler, G. J. (1964). A theory of oligopoly. The Journal of Political Economy, 44-61.
Author: Beata Ciuba