Oligopoly (Encyclopedia of Business and Finance)
An oligopoly is an intermediate market structure between the extremes of perfect competition and monopoly. Oligopoly firms might compete (noncooperative oligopoly) or cooperate (cooperative oligopoly) in the marketplace. Whereas firms in an oligopoly are price makers, their control over the price is determined by the level of coordination among them. The distinguishing characteristic of an oligopoly is that there are a few mutually interdependent firms that produce either identical products (homogeneous oligopoly) or heterogeneous products (differentiated oligopoly).
Mutual interdependence means that firms realize the effects of their actions on rivals and the reactions such actions are likely to elicit. For instance, a mutually interdependent firm realizes that its price drops are more likely to be matched by rivals than its price increases. This implies that an oligopolist, especially in the case of a homogeneous oligopoly, will try to maintain current prices, since price changes in either direction can be harmful, or at least nonbeneficial. Consequently, there is a kink in the demand curve because there are asymmetric responses to a firm's price increases and to its price decreases; that is, rivals match price falls but not price increases. This leads to "sticky prices," such that prices in an oligopoly turn out to be more stable than those in monopoly or in competition; that is, they do not change every time costs change. On the flip side, the sticky-price explanation (formally, the kinked demand model of oligopoly) has the significant drawback of not doing a very good job of explaining how the initial price,
which eventually turns out to be sticky, is arrived at.
Airline markets and automobile markets are prime examples of oligopolies. We see that as the new auto model year gets under way in the fall, one car manufacturer's reduced financing rates are quickly matched by the other firms because of recognized mutual interdependence. Airlines also match rivals' fares on competing routes.
In oligopolies, entry of new firms is difficult because of entry barriers. These entry barriers may be structural (natural), such as economies of scale, or artificial, such as limited licenses issued by government. Firms in an oligopoly, known as oligopolists, choose prices and output to maximize profits. However, firms could compete along other dimensions as well, such as advertising, location, research and development (R&D) and so forth. For instance, a firm's research or advertising strategies are influenced by what its rivals are doing. When one restaurant advertises that it will accept rivals' coupons, others are compelled to follow suit.
The rivals' responses in an oligopoly can be modeled in the form of reaction functions. Sophisticated firms anticipating rivals' behavior might appear to act in concert (conscious parallelism) without any explicit agreement to do so. Such instances pose problems for antitrust regulators. Mutually interdependent firms have a tendency to form cartels, enabling them to coordinate price and quantity actions to increase profits. Besides facing legal obstacles, cartels are difficult to sustain because of free-rider problems. Shared monopolies are extreme cases of cartels that include all the firms in the industry.
Given that mutual interdependence can exist along many dimensions, there is no single model of oligopoly. Rather, there are numerous models based on different behavior, ranging from the naive Cournot models to more sophisticated models of game theory. An equilibrium concept that incorporates mutual interdependence was proposed by John Nash and is referred to as Nash equilibrium. In a Nash equilibrium, firms' decisions (i.e., price-quantity choices) are their best responses, given what their rivals are doing. For example, McDonald's charges $2.99 for a Value Meal based on what Burger King and Wendy's are charging for a similar menu item. McDonald's would reconsider its pricing if its rivals were to change their prices.
The level of information that firms have has a major influence on their behavior in an oligopoly. For instance, when mutually interdependent firms have asymmetric information and are unable to make credible commitments regarding their behavior, a "prisoner's dilemma" type of situation arises where the Nash equilibrium might include choices that are suboptimal. For instance, individual firms in a cartel have an incentive to cheat on the previously agreed-upon price-output levels. Since cartel members have nonbinding commitments on limiting production levels and maintaining prices, this results in widespread cheating, which in turn leads to an eventual breakdown of the cartel. Therefore, while all firms in the cartel could benefit by cooperating, lack of credible commitments results in cheating being a Nash equilibrium strategy strategy that is suboptimal from the individual firm's standpoint.
Models of oligopoly could be static or dynamic depending upon whether firms take intertemporal decisions into account. Significant models of oligopoly include Cournot, Bertrand, and Stackelberg. Cournot oligopoly is the simplest model of oligopoly in that firms are assumed to be naive when they think that their actions will not generate any reaction from the rivals. In other words, according to the Cournot model, rival firms choose not to alter their production levels when one firm chooses a different output level. Cournot thus focuses on quantity competition rather than price competition. While the naive behavior suggested by Cournot might seem plausible in a static setting, it is hard to image real-world firms not learning from their mistakes over time. The Bertrand model's significant difference from the Cournot model is that it assumes that firms choose (set) prices rather than quantities. The Stackelberg model deals with the scenario in which there is a leader firm in the market whose actions are imitated by a number of follower firms. The leader is sophisticated in terms of taking into account rivals' reactions, while the followers are naïve, as in the Cournot model. The leader might emerge in a market because of a number of factors, such as historical precedence, size, reputation, innovation, information, and so forth. Examples of Stackelberg leadership include markets where one dominant firm dictates the terms, usually through price leadership. Under price leadership, the leader firm's pricing decisions are consistently followed by rival firms.
Since oligopolies come in various forms, the performance of such markets also varies a great deal. In general, the oligopoly price is below the monopoly price but above the competitive price. The oligopoly output, in turn, is larger than that of a monopolist but falls short of what a competitive market would supply. Some oligopoly markets are competitive, leading to few welfare distortions, while other oligopolies are monopolistic, resulting in dead weight losses. Furthermore, some oligopolies are more innovative than others. Whereas the price-quantity rankings of oligopoly vis-à-vis other markets are relatively well established, how oligopoly fares with regard to R and D and advertising is less clear.
Cournot, Augustin. (1963). Researches into the Mathematical Principles of the Theory of Wealth. Homewood, IL: Irwin.
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Shapiro, Carl. (1989). "Theories of Oligopoly Behavior." In Handbook of Industrial Organization, vol. 1, ed. Richard Schmalensee and Robert D. Willig. Amsterdam: North-Holland.
Oligopoly (Encyclopedia of Business)
An oligopoly is a market condition in which the production of identical or similar products is concentrated in a few large firms. Examples of oligopolies in the United States include the steel, aluminum, automobile, gypsum, petroleum, tire, and beer industries. The introduction of new products and processes can create new oligopolies, as in the computer or synthetic fiber industries. Oligopolies also exist in service industries, such as the airlines industry.
An oligopoly may be categorized as either a homogeneous oligopoly or a differentiated oligopoly. In a homogeneous oligopoly the major firms produce identical products, such as steel bars or aluminum ingots. Prices tend to be uniform in homogeneous oligopolies. In a differentiated oligopoly, similar but not identical products are produced. Examples include the automobile industry, the cigarette industry, and the soft drink industry. In differentiated oligopolies companies attempt to differentiate their products from those of their competitors. To the extent that they are able to establish differentiated products, companies may be able to maintain price differences.
Being part of an oligopoly affects a company's competitive behavior. In a competitive market situation that is not an oligopoly, firms compete by acting for themselves to maximize profits without regard to the reactions of their competitors. In an oligopoly, a firm must consider the effects of its actions on others in the industry. While smaller firms may operate at the fringes of an oligopoly without affecting the other firms in the industry, the actions of a major firm in the oligopoly typically cause reactions in the other firms in the industry. For example, if one company in the oligopoly attempts to undersell the others, then the other firms will respond by also lowering prices. As a result, price cuts in oligopolies tend to result in lower profits for all of the firms involved.
Prices in oligopolistic industries tend to be unstable to the extent that companies will shade, or lower, their prices slightly to gain a competitive advantage. It must be remembered that collusion between firms to fix prices is illegal under U.S. antitrust laws, so oligopolies must reach industry agreements on pricing indirectly. Companies can signal their pricing intentions indirectly in a variety of ways, such as through press releases, speeches by industry leaders, or comments given in interviews. In some cases there is a recognized price leader in the oligopoly, and other firms in the oligopoly set their prices according to that of the industry's price leader.
Industrial concentration is a matter of degree. This means that there is no absolute definition of an oligopoly in terms of the number of firms accounting for a certain percentage of an industry's output. In the United States the Census of Manufacturers reports on each industry's four-firm concentration ratio. This figure indicates what percentage of an industry's output is accounted for by its four largest companies. It is not uncommon for the four largest firms to account for 30 percent or more of an industry's output, and in some cases they account for more than 70 percent of production.
In the United Kingdom, for example, the top four food retailers accounted for 45 to 67 percent of the nation's $150 billion grocery market in 1998. In Russia, economic development under Boris Yeltsin has been described as a "new oligarchy," in which government officials and business leaders join together to gain control of industries such as banking, television, the business press, and other companies.
Oligopolies tend to develop in industries that require large capital investments. Studies have shown that industries with high four-firm concentration ratios tend to have higher margins than other industries. In order to maintain an oligopoly, potential investors must be discouraged from establishing competing companies. Oligopolies are able to perpetuate themselves and discourage new investments in several ways. In some cases the oligopoly is the result of access to key resources, which may be either natural resources or some patented process or special knowledge. New firms cannot enter the industry without access to those resources.
The established, experienced firms in an oligopoly also enjoy significant cost advantages that make it difficult for new firms to enter the industry. These cost advantages may be the result of the large scale of production required as well as of experience in keeping manufacturing or operating costs down. Another factor that tends to perpetuate oligopolies is the difficulty of introducing new products into an oligopoly characterized by a high degree of product differentiation. Prohibitively large expenditures would be required of a new firm to overcome consumer reluctance to try a new product over an established one. Finally, oligopolies perpetuate themselves through predatory practices such as obtaining lower prices from suppliers, establishing exclusive dealerships, and predatory pricing aimed at driving smaller competitors out of business.
SEE ALSO: Competition
[David P Bianco]
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