Oligopoly definition

In an oligopoly market structure, few firms are interdependent. They collectively dominate the market. These firms are individually powerful in controlling the market yet these firms also depend upon other firms as they could bring some change in the market control.

In an oligopoly market, the products are somewhat differentiated from what the other firms may produce. These competing firms are likely to change their price as per their rivals. A classic example of an Oligopoly is Coco-Cola and Pepsi. They dominate the soft drinks market. They have similar products slightly differentiated. Therefore if Coco-Cola was to lower its prices Pepsi would do the same so that it doesn’t lose its market.

Why Oligopolies exist?

A combination of barriers to enter the market for other players is created to maintain oligopoly competition. For example, the government may give a patent for an invention. There could be three pharmaceutical firms that have their drugs to reduce blood pressure, they obtain a patent on it and these three firms then become oligopolies.

Natural oligopoly can arise when there are only a few firms that can operate at minimum average cost. Other small businesses cannot compete at this minimal cost and hence, cannot enter the market. Giving rise to oligopoly.

So if we were to conclude some of the main features of oligopoly-

  • Few firms- there is generally less number of firms in an oligopoly. The exact number is not defined yet in the UK market with 5 or fewer players are considered to be an oligopoly. Every firm produces a significant amount of production. Therefore, there is severe competition among the players. They can both control the prices as well the availability of goods available in the market. For example in India automobiles and airlines have an oligopolistic market.
  • Interdependence- In an oligopoly action of one firm affects the action of other firms. All the firms consider their rivals’ actions before setting their prices and targets. Therefore a small change by even one player will invoke some sort of reaction from other players.
  • Non-price competitions- since, all the players have an impact on the market they tend not to enter into price wars. They follow the price of rigidity. Price rigidity refers to a situation in which prices tend to remain the same despite the demand and supply conditions. The firms try to compete with each other using other techniques like advertising, better services to their customers, etc.
  • Barriers to entry of firms- patents, requirements of large capital, control over rare raw materials, etc. these are some of the reasons that it is difficult for new firms to enter the market which leads to oligopoly.

Types of oligopoly

  • Pure or perfect oligopoly- if the firms produce homogeneous products then it is called a perfect or pure oligopoly. In reality, it is rare to find a pure oligopoly situation yet cement, aluminium, steel industries do come close.
  • Imperfect or differentiated oligopoly- if the firms produce differentiated products then it is called an imperfect or differentiated oligopoly. Examples can be automobile industries with their different models etc.
  • Non-collusive oligopoly- when firms compete with each other then it is called a non-collusive oligopoly.
  • Collusive oligopoly- when firms come together to set the price so that they can maximize their profits collectively it is known as a collusive oligopoly. Collusion is illegal in many countries. However, tacit collusion may be hard to spot. We have anti-trust laws for the prevention of collusion. In the US Anti-trust division of the Justice Department and the Federal Trade Commission have this responsibility. The problem of enforcement is that it is hard to find evidence. Cartels are the formal agreement of collusion. OPEC is an example of a Cartel where the countries try to control the price of the oil industry making the maximum profit.

From collusive oligopoly, we understand that if the players in the market cooperate then they can benefit more. However, this type of partnership might be difficult to maintain. It is explained using a game theory called the prisoner’s dilemma. Let’s look into detail what it means and how it is connected to oligopoly.

Prisoner’s Dilemma and Oligopoly

Prisoner’s dilemma shows why two individuals might not cooperate, even if it is collectively in their best interest to do so. So in this game, two members of a criminal gang are arrested and imprisoned. Both the prisoners are kept in solitary confinement. They have no means of speaking to each other. The police officer offers them this bargain-

  • If both of them confess to the crime, each of them will serve 2 years of term in imprisonment.
  • If one of them confesses (say A) but the other denies the crime (say B) then he will be released (A) while the other has to serve a term of 3 years. (and vice versa)
  • If both of them deny the crime, then both will serve only one year in prison.

For both, the players to betray each other by confessing is the dominant strategy. It is a better strategy for each player regardless of what the other player does. This strategy is therefore a Nash equilibrium that is no payer will be better off by changing his strategy. Therefore, purely self-interested prisoners would betray each other resulting in a two years sentence for both. This is not Pareto efficient (which means there is scope for improvement).

Similar to the prisoner’s dilemma cooperation between firms is difficult. They might be motivated by their self-interest. However, the collective outcome can be much better if they cooperated leading to higher profits.

Now that we have a fair understanding of oligopoly and how it works, let’s look at a famous case of an illegal cartel. 

Lysine, a $600 million a year industry, is an amino acid used by farmers. Primarily it is produced in the US by Archer Daniels Midland (ADM). Some Europeans as well as Japanese firms also produce it. In the first half of the 1990s, the world’s major Lysine producers met together and decided upon how much each firm would sell and charge. The price of Lysine doubled when the cartel was in effect. However, the FBI soon wired them and found about the cartel. Archer Daniels Midland pled guilty in 1996 and paid a fine of $100 million. Several top executives, both at ADM and other firms, later paid fines of up to $350,000 and were sentenced to 24–30 months in prison.

Conclusion

Oligopoly is a market structure characterized by few market players with control over prices and production. It is one of the most common forms of the market that exists today. Oligopolists can earn the highest profits if they enter into a cartel. However, collusion is illegal. Many tacit collusion is still practiced.

The prisoner’s dilemma is an example of game theory showing that cooperative behavior is more beneficial than self-interest driven. However, bringing parties to cooperative terms is a challenge.

REFERENCES

  1. Oligopolistic Market- Corporate Finance Institute
  2. Oligopoly Market Structure- Intelligent Economist
  3.  The Oligopoly Market: Example, Types and Features | Micro Economics
  4. Oligopoly- Investopedia
  5. Oligopoly- Tejvan Pettinger
  6. Oligopoly-book reference

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