TutorChase logo
IB DP Economics Study Notes

2.11.2 Oligopoly

Delving into the realm of oligopolies, we uncover a market structure that exhibits both competitive and monopolistic characteristics. This duality, combined with the unique behaviours of firms operating within this framework, makes oligopoly a fascinating topic in economics.

Definition

An oligopoly exists when a market is dominated by a limited number of large producers. These firms hold significant market power, and their decisions about production, pricing, and other factors significantly influence market conditions. Key features of oligopolies include:

  • Few Dominant Firms: While the exact number can vary, typically a handful of companies dominate the market share.
  • Product Type: Products may be homogeneous, where every firm's product is identical, or differentiated, where products are diverse but serve the same purpose.
  • High Barriers to Entry: Due to established brand loyalty, economies of scale, or other factors, it's challenging for new firms to break into the market. Understanding barriers to entry and exit can provide further insight into the dynamics of oligopolies.
  • Mutual Interdependence: Every decision (e.g., pricing, advertising) taken by one firm directly affects, and is affected by, the decisions of its rivals.

Kinked Demand Curve

This concept seeks to elucidate the pricing stability often observed in oligopolies. The kinked demand curve stems from specific assumptions about the reactions of competitors to a firm's price changes.

  • Above the Kink: If Firm A decides to increase its price above the current equilibrium, it is assumed other firms won't follow suit. Consequently, Firm A loses customers to its rivals, resulting in a significant drop in sales. Thus, the demand for Firm A's product becomes highly elastic above the kink.
  • Below the Kink: Conversely, if Firm A reduces its price below the equilibrium, other firms are likely to match this price drop to maintain their customer base. As a result, Firm A gains minimal additional customers, rendering the demand inelastic below the kink.
A graph of kinked demand curve in oligopoly

A graph illustrating kinked demand curve in oligopoly.

Image courtesy of boycewire

Stemming from the kinked curve is the realisation that marginal revenue (MR) becomes discontinuous. The stability of prices in oligopolies, even amidst fluctuating costs, can be attributed to this curve.

Collusive Oligopoly

Collusion denotes a scenario where firms, instead of competing, decide to cooperate with each other. This cooperative approach usually yields higher prices and profits as compared to a competitive setting. To explore this further, consider the mechanisms of monopolies and how they relate to oligopolistic behaviours.

An image illustrating OPEC as an example of collusive oligopoly

Image courtesy of weforum

  • Cartel: A group of firms that come together to make collective decisions regarding the price and supply of products. OPEC, which controls a significant portion of the world's oil supply, serves as a prime example.
An image illustrating a cartel agreement

Image courtesy of educba

  • Issues with Cartels:
    • Cheating Temptations: Firms might break the agreement, covertly slashing prices to increase market share.
    • Economic Fluctuations: Variations in demand or costs might destabilise the agreed-upon terms.
    • Regulatory Scrutiny: Many jurisdictions label cartels as illegal, considering their potential to harm consumer interests.
  • Tacit Collusion: Even in the absence of formal agreements, firms might adopt a cooperative stance. This often results in scenarios like price leadership, where a primary firm sets the tone and others follow suit. The concept of price discrimination demonstrates how subtle forms of collusion can affect market dynamics.

Non-Collusive Oligopoly

Here, firms remain competitive, with no cooperation or coordination in their strategies. Given the mutual interdependence, the market often experiences unpredictable oscillations. The strategies adopted in a non-collusive oligopoly can be contrasted with those in monopolistic competition, where many firms compete with differentiated products.

  • Price Wars: To outdo rivals and gain a more significant market chunk, firms might aggressively drop prices. Such wars, while beneficial for consumers, can severely dent industry profits.
  • Non-Price Competition: Beyond price, firms might vie for customer attention through enhanced advertising, improved product features, superior customer service, and other non-price avenues.
  • Game Theory: This mathematical tool proves invaluable in understanding the intricate dynamics of oligopolies. Given that firms' outcomes hinge on collective actions, game theory models scenarios to predict potential moves and counter-moves of rivals. The relevance of cross-elasticity of demand (XED) in understanding the competitive strategies within oligopolies cannot be overstated.

Role of Advertising

Within an oligopoly, advertising takes on a paramount role. As firms often grapple with product differentiation, compelling advertising can steer customer preferences.

  • Brand Loyalty: Through continuous advertising, firms aspire to forge a loyal customer base, ensuring steady sales even amidst price alterations.
  • Barrier to Entry: Successful advertising campaigns further solidify a firm's position, raising the entry barriers for potential new entrants.

Barriers to Entry in Oligopoly

Oligopolies often shield themselves from potential competition through barriers:

  • Economies of Scale: Large firms can produce goods more cheaply per unit than smaller firms.
  • Ownership of Key Resources: If a few firms hold exclusive rights to a crucial resource, it impedes others from entering the market.
  • Patents and Licenses: Holding patents can deter competitors for a set duration.
  • Network Economies: Products become more valuable as more people use them. Think of social media platforms; the more friends on a platform, the more likely you are to join.
  • Aggressive Tactics: Established firms might deliberately slash prices temporarily to deter new entrants.

In essence, the study of oligopolies offers a window into the nuanced interactions between competing firms in a market with limited key players. The balancing act between collaboration and competition, coupled with the strategic manoeuvres to maintain dominance, makes oligopolies a rich tapestry of strategic interplay in the world of economics.

FAQ

Cartels, a form of collusive oligopoly, are often deemed illegal due to their anti-competitive practices. By joining forces and making collective decisions on price and output, cartel members effectively eliminate competition in the market. Such behaviour results in artificially high prices, reduced product quality, and limited choices for consumers. Moreover, cartels can stagnate innovation since member firms are not incentivised to improve or diversify their offerings, knowing that their position in the market is secured through the cartel. The net welfare loss to society, through reduced consumer surplus and potential deadweight losses, makes cartels undesirable from an economic perspective. As a result, many jurisdictions actively monitor and penalise cartels to maintain market competition.

Price leadership refers to a form of tacit collusion in oligopolistic markets where one dominant firm, often the industry leader or the largest player, sets the price, and other smaller firms in the market simply follow. The leading firm's price becomes the benchmark for others. This pattern might arise to avoid explicit collusion, which is illegal in many regions, while still achieving some degree of pricing stability in the market. Smaller firms find it beneficial to match the leader's price rather than engage in competitive pricing, which might ignite price wars. However, it's essential to understand that while price leadership resembles collusive behaviour, it doesn't involve formal agreements among firms.

Brand loyalty plays a pivotal role in shaping pricing strategies in oligopolistic markets. When consumers are loyal to a specific brand, it provides the firm with a degree of pricing power. Such firms can maintain or even raise prices without losing a significant portion of their customer base. This is particularly beneficial in an oligopolistic setting where price reactions of competitors can be unpredictable. A strong brand loyalty can act as a buffer against price-based competition, allowing firms to focus on other aspects like product quality, innovation, or service improvements. Moreover, brand loyalty can deter new entrants into the market, as they might find it challenging to sway loyal customers of established brands.

In a non-collusive oligopoly, firms actively compete against one another, rather than cooperate. This intense competition can lead to several benefits for consumers. Firstly, it can result in competitive pricing, ensuring that products or services are available at reasonable rates. Secondly, in an attempt to differentiate themselves, firms might innovate, leading to improved product quality, features, or newer product offerings. Additionally, non-collusive oligopolies might engage in non-price competitions, such as advertising, promotions, or improved customer service. Overall, the competition in non-collusive oligopolies can foster an environment where consumers enjoy better prices, quality, and choices.

Price wars in oligopolistic markets can be detrimental for all involved parties. When one firm aggressively reduces its prices to capture a larger market share, competitors, due to the interdependent nature of an oligopoly, are compelled to follow suit. While consumers might benefit from lower prices in the short run, the firms face shrinking profit margins. Over time, these reduced profits can inhibit reinvestment, research and development, and overall growth of the industry. Moreover, prolonged price wars might lead to financial distress for some firms, particularly those with lesser financial reserves. Therefore, to maintain sustainable profit levels, oligopolistic firms often avoid engaging in price wars.

Practice Questions

Explain the significance of the kinked demand curve in the context of oligopolies and its impact on pricing decisions.

The kinked demand curve is instrumental in understanding the pricing behaviour within oligopolies. Given an oligopolistic market's interdependence, if one firm decides to raise its prices, its competitors might not follow suit. Consequently, the firm risks losing a significant portion of its customer base, leading to highly elastic demand above the kink. On the other hand, if the firm drops its prices, rivals are likely to match the reduction, ensuring minimal market share gain, causing inelastic demand below the kink. This duality leads to price rigidity within oligopolies, wherein prices remain stable, even in the face of fluctuating costs.

Distinguish between collusive and non-collusive oligopolies, highlighting the key features of each.

Collusive oligopolies are characterised by firms that opt for cooperation over competition. Such firms might form cartels to decide collectively on price and production levels, ensuring higher profits than a purely competitive scenario. Tacit collusion can also emerge, where firms synchronise actions without explicit agreements, often observed in price leadership models. On the contrary, non-collusive oligopolies see firms competing fiercely, devoid of any cooperation. Their actions are unpredictable, often leading to situations like price wars or non-price competitions. The core distinction lies in collaboration: collusive oligopolies engage in coordinated actions to maximise joint profits, while non-collusive ones operate independently, often resulting in aggressive market strategies.

Dave avatar
Written by: Dave
Profile
Cambridge University - BA Hons Economics

Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.

Hire a tutor

Please fill out the form and we'll find a tutor for you.

1/2 About yourself
Still have questions?
Let's get in touch.