Oligopoly Competition Meaning, Features, Price and Output determination

Oligopoly is a market structure where a small number of large firms dominate the market, making up the majority of the industry’s total output. These firms produce either homogeneous or differentiated products and have significant control over pricing and production decisions. Due to the limited number of firms, each company’s actions (e.g., pricing, output, or advertising) directly affect the others. Oligopolies often lead to strategic behavior, including competition, collusion, or cooperation, and are analyzed using game theory. High barriers to entry and economies of scale typically characterize oligopolistic markets. Examples include the automobile and telecommunications industries.

Features of Oligopoly Competition:

• Few Dominant Firms

An oligopoly consists of a small number of large firms that collectively dominate the market. These firms hold substantial market share, and each firm’s actions have a significant impact on the market. Examples of oligopolies include industries like automobiles, telecommunications, and airlines.

• Interdependence

In an oligopoly, firms are highly interdependent. A decision made by one firm, such as a price change or new product introduction, affects the others. Firms must consider the likely reactions of competitors before making strategic decisions. This interdependence often leads to mutual recognition of market power.

• Barriers to Entry

High barriers to entry protect the firms in an oligopoly from potential competitors. These barriers can include economies of scale, capital requirements, strong brand loyalty, and control over key resources. As a result, new firms find it difficult to enter the market, allowing the dominant firms to maintain control.

• Product Differentiation

Firms in an oligopoly may produce either homogeneous or differentiated products. While homogeneous products (e.g., steel, oil) are identical in nature, differentiated products (e.g., automobiles, smartphones) have unique features or brand identities. Product differentiation allows firms to compete in ways other than price, such as through advertising or innovation.

• Price Rigidity

Prices in oligopolistic markets tend to be rigid or sticky. Firms avoid changing prices frequently because they anticipate reactions from their competitors, leading to price wars. As a result, firms may opt for non-price competition strategies, such as improving quality or marketing, rather than adjusting prices.

• Non-Price Competition

Given the fear of triggering price wars, oligopolists often focus on non-price competition. This includes tactics like advertising, product differentiation, packaging, and customer service. By creating brand loyalty, firms attempt to capture a larger market share without directly altering their prices.

• Collusion and Cartels

Firms in an oligopoly may engage in collusion, either explicitly or implicitly, to set prices or limit production in order to maximize profits collectively. In some cases, this leads to the formation of cartels. One of the most famous examples is OPEC, where member countries coordinate oil production levels. While illegal in many countries, collusion can occur in oligopolistic markets.

• Kinked Demand Curve

The kinked demand curve theory explains the price rigidity in oligopolies. If one firm raises its price, competitors do not follow, causing a large loss of market share. Conversely, if a firm lowers its price, competitors match the price cut, leading to a minimal gain in market share. This creates a kink in the demand curve, which results in price stability despite changes in cost.

Price and Output determination under Oligopoly Competition:

The price and output determination is complex due to the interdependence between firms. Unlike perfect competition, where the market price is determined purely by supply and demand, or monopoly, where one firm controls the price, oligopolistic firms must consider the likely reactions of their competitors when making decisions about pricing and output. Several models explain how price and output are determined in oligopoly markets, with the most common being the Cournot model, the Bertrand model, and the kinked demand curve model.

1. Cournot Model (Quantity Competition)

The Cournot model assumes that firms in an oligopoly decide their output levels simultaneously, considering the output of competitors as fixed. Firms aim to maximize their profits given the total market output.

• Process:
  • Each firm chooses the quantity of output it will produce, taking into account the output decisions of its competitors.
  • The total quantity in the market is the sum of all firms’ outputs, which determines the market price.
  • The firms adjust their quantities until they reach a Nash equilibrium, where no firm can improve its profit by changing its output.
• Outcome: The market price in the Cournot model is typically higher than in perfect competition but lower than under a monopoly. The total output is also less than in perfect competition, but more than under a monopoly.

2. Bertrand Model (Price Competition)

In the Bertrand model, firms compete by setting prices rather than output. The model assumes that firms produce homogeneous products, and consumers will buy from the firm with the lowest price.

• Process:
  • Each firm sets its price, assuming the prices of competitors are fixed.
  • The firm with the lowest price captures the entire market demand, while the higher-priced firms get no sales.
  • In the case of identical prices, firms split the market equally.
• Outcome: The Bertrand model predicts that prices will tend toward marginal cost in a competitive market. If firms can set prices equal to marginal cost, the outcome is essentially the same as perfect competition, leading to zero economic profits for each firm.

3. Kinked Demand Curve Model

The kinked demand curve model focuses on the price rigidity observed in many oligopolistic markets. This model suggests that firms in an oligopoly may face a “kink” in their demand curve, resulting in price stability.

• Process:
  • Firms assume that if they raise their price, competitors will not follow, leading to a significant loss in market share.
  • On the other hand, if they lower their price, competitors will match the price cut, resulting in a minimal gain in market share.
  • This creates a kink in the demand curve at the current price, with a relatively elastic portion above the kink (if prices are raised) and a relatively inelastic portion below the kink (if prices are lowered).
• Outcome: Due to the kink in the demand curve, firms in an oligopoly tend to avoid price changes, leading to price stability despite changes in cost or demand. This is often referred to as price rigidity, where firms maintain their prices even when market conditions change.

4. Collusion and Cartels

In some cases, firms in an oligopoly may collude (either overtly or tacitly) to set prices or limit output in order to maximize collective profits. This is often done through the formation of cartels.

• Process:
  • Firms in a cartel agree to reduce production and set higher prices, which benefits all members.
  • The cartel behaves like a monopoly, acting as a single firm to maximize total industry profit.
  • However, collusion is illegal in many countries, and enforcement agencies monitor markets to prevent such practices.
• Outcome: Cartels lead to higher prices and lower output, similar to a monopoly, but the firms share the profits. However, the incentive to cheat on cartel agreements and the threat of government intervention make this arrangement unstable in the long run.