How does oligopoly work

When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers.

Oligopolies are often buffeted by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers.

Monopoly and Antitrust Policy discusses the delicate judgments that go into this task. The result? An uneasy and tenuous relationship. How did this soap opera end? A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model.

After the agreements, each firm was the sole supplier of bagged ice to a region; there were profits in both the long run and the short run. Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior.

However, the challenge for the parties is to find ways to encourage cooperative behavior. Assuming that the payoffs are known to both firms, what is the likely outcome in this case? Review Questions Will the firms in an oligopoly act more like a monopoly or more like competitors? Briefly explain. Explain briefly. What stops oligopolists from acting together as a monopolist and earning the highest possible level of profits? Critical Thinking Questions Would you expect the kinked demand curve to be more extreme like a right angle or less extreme like a normal demand curve if each firm in the cartel produces a near-identical product like OPEC and petroleum?

What if each firm produces a somewhat different product? Explain your reasoning. When OPEC raised the price of oil dramatically in the mids, experts said it was unlikely that the cartel could stay together over the long term—that the incentives for individual members to cheat would become too strong. More than forty years later, OPEC still exists. Why do you think OPEC has been able to beat the odds and continue to collude?

Hint: You may wish to consider non-economic reasons. Problems Mary and Raj are the only two growers who provide organically grown corn to a local grocery store. They know that if they cooperated and produced less corn, they could raise the price of the corn.

Table 6 represents the choices available to Mary and Raj. What is the best choice for Raj if he is sure that Mary will cooperate?

If Mary thinks Raj will cheat, what should Mary do and why? What is the preferred choice if they could ensure cooperation? Jane and Bill are apprehended for a bank robbery. They are taken into separate rooms and questioned by the police about their involvement in the crime.

The police tell them each that if they confess and turn the other person in, they will receive a lighter sentence. If they both confess, they will be each be sentenced to 30 years. If neither confesses, they will each receive a year sentence. In order to compete, new entrants will have to match, or exceed, this level of spending in order to compete in the future.

This deters entry, and is widely found in oligopolistic markets such as pharmaceuticals and the chemical industry. Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals out of the market. Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants cannot make a profit at that price.

This is best achieved by selling at a price just below the average total costs ATC of potential entrants. This signals to potential entrants that profits are impossible to make.

An incumbent may, over time, have built up a superior level of knowledge of the market, its customers, and its production costs. The superior knowledge of an incumbent can give it considerable competitive advantage over a potential entrant.

Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete buy-out. As with other deliberate barriers, regulators, like the Competition and Markets Authority CMA , may prevent this because it is likely to reduce competition. Advertising is another sunk cost — the more that is spent by incumbent firms the greater the deterrent to new entrants.

These make entry difficult as they favour existing firms who have won the contracts or own the licenses. For example, contracts between suppliers and retailers can exclude other retailers from entering the market. Another key feature of oligopolistic markets is that firms may attempt to collude, rather than compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher profits over the long term. Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form trade associations like the Association of Petrol Retailers.

Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid detection by regulators, such as when fixing prices. For example, it may be accepted that a particular firm is the price leader in an industry, and other firms simply follow the lead of this firm.

If firms do collude, and their behaviour can be proven to result in reduced competition, they are likely to be subject to regulation. In many cases, tacit collusion is difficult or impossible to prove, though regulators are becoming increasingly sophisticated in developing new methods of detection. When competing, oligopolists prefer non-price competition in order to avoid price wars.

A price reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but the danger is that rivals will simply reduce their prices in response. This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more beneficial strategy may be to undertake non-price competition. Firms in an oligopoly set prices , whether collectively—in a cartel —or under the leadership of one firm, rather than taking prices from the market.

Profit margins are thus higher than they would be in a more competitive market. The conditions that enable oligopolies to exist include high entry costs in capital expenditures , legal privilege license to use wireless spectrum or land for railroads , and a platform that gains value with more customers such as social media. The global tech and trade transformation has changed some of these conditions: offshore production and the rise of "mini-mills" have affected the steel industry, for example.

In the office software application space, Microsoft was targeted by Google Docs, which Google funded using cash from its web search business. An interesting question is why such a group is stable. The firms need to see the benefits of collaboration over the costs of economic competition, then agree to not compete and instead agree on the benefits of co-operation.

The firms have sometimes found creative ways to avoid the appearance of price-fixing , such as using phases of the moon. Price-fixing is the act of setting prices, rather than letting them be determined by the free-market forces. Another approach is for firms to follow a recognized price leader ; when the leader raises prices, the others will follow.

The main problem that these firms face is that each firm has an incentive to cheat; if all firms in the oligopoly agree to jointly restrict supply and keep prices high, then each firm stands to capture substantial business from the others by breaking the agreement undercutting the others.

Such competition can be waged through prices, or through simply the individual company expanding its own output brought to market. Game theorists have developed models for these scenarios, which form a sort of prisoner's dilemma. When costs and benefits are balanced so that no firm wants to break from the group, it is considered the Nash equilibrium state for oligopolies.

This can be achieved by contractual or market conditions, legal restrictions, or strategic relationships between members of the oligopoly that enable the punishment of cheaters. Companies in an oligopoly benefit from price-fixing, setting prices collectively, or under the direction of one firm in the bunch, rather than relying on free-market forces to do so. It is interesting to note that both the problem of maintaining an oligopoly and the problem of coordinating action among buyers and sellers in general on the market involve shaping the payoffs to various prisoner's dilemmas and related coordination games that repeat over time.

As a result, many of the same institutional factors that facilitate the development of market economies by reducing prisoner's dilemma problems among market participants, such as secure enforcement of contracts, cultural conditions of high trust and reciprocity, and laissez-faire economic policy, might also potentially help encourage and sustain oligopolies.

Governments sometimes respond to oligopolies with laws against price-fixing and collusion. Yet, a cartel can price fix if they operate beyond the reach or with the blessing of governments. OPEC is one example of this since it is a cartel of oil-producing states with no overarching authority.

Alternatively, in mixed economies, oligopolies often seek out and lobby for favorable government policy to operate under the regulation or even direct supervision of government agencies. An oligopoly is when a few companies exert significant control over a given market. Together, these companies may control prices by colluding with each other, ultimately providing uncompetitive prices in the market. Among other detrimental effects of an oligopoly include limiting new entrants in the market and decreased innovation.

A company in this market structure has enough authority and power to prevent competitors from entering the marketplace. There might be various reasons that make it difficult to enter the industry, such as technology, patents, government regulation, or capital requirements. In a monopoly, we can find only one seller, a price maker that can set high prices and reduce the choice for customers. Nevertheless, buyers will pay the price if there are no substitutes available. Companies in oligopolies can use predatory pricing, which means keeping prices very low, sometimes even under the full cost of production.

This strategy is used to force competitors out of the market. Besides, firms also implement a limit-pricing strategy to hinder new companies from entering the market. In this scenario, firms reduce the price sufficiently and make it unprofitable for other players to enter.

You can also encounter cost-plus pricing in this market structure. It is useful for oligopolies and firms that manufacture different products since a few companies that dominate the market often share the same expenses.

One of the examples is petrol retailers. Nevertheless, there is always a risk because competitors can adopt a more flexible method to obtain a bigger market share. The interdependence that exists within an oligopoly determines the way companies compete.

The decisions on the price and output of the firms within this market system depend on the behavior of other companies. They usually take into account the actions of their closest competitors when making decisions.

Say, the company wants to get a bigger market share by cutting down the price. If their competitors Shell and BP find out about this, they can reduce their prices as well. The way firms compete in an oligopoly depends on their objectives, the nature of their goods or services, and the contestability of the market.

Some firms compete on the price, and others try to enhance the quality of their products. When trying to demonstrate their benefits to the leads and customers, oligopolists prefer to implement non-price competition.