What is oligopoly in microeconomics

Oligopolies are also characterised by their interdependent. In other words, they are highly responsive to competitors actions. For instance, if one firm reduces prices, all the others will follow suit to maintain their position in the market. A market may have thousands of sellers, but if the top 5 firms have a combined market share of over 50 percent, it can be classified as an oligopolistic market.

This is because the power is concentrated between a few sellers who are able to exercise power over the market. Oligopolistic firms maintain their position through a number of barriers to entry. For instance, brand loyalty, patents, and high start-up costs are but to name a few. These make it difficult for new entrants to build a presence in the market and attract customers.

In industries such as retail — brand loyalty is a significant barrier to overcome. These barriers to entry make it difficult for new firms to join and sets it apart from perfect competition. As a result, these barriers to entry allow oligopolies to make higher profits due to limited competition. Any action a firm takes in an oligopolistic market will strongly affect the actions of its competitors.

For those who are not familiar with these terms: an oligopolistic firm will operate based on how they believe competitors will react. In other words, Company A expects Company X to reduce its prices, so will do so as well. This can be sub-optimal as it reduces the power of a competitive market.

So when Apple looks to take that decision, they will consider how they will benefit. Often this can lead oligopolistic firms to just maintain the status quo and keep prices constant. Leading on from interdependence; each firm has little market power, because other firms are quick to take advantage. For example, an oligopolistic firm cannot raise prices in fear that customers will flee to its competitors.

On an individual basis, this keeps the firm in check. Yet it equally incentivises collusion as one firm is unable to get ahead. Under perfect competition, prices are just above marginal cost , leaving firms with small profits — if any. As oligopolies have combined market power, they tend to keep prices higher to obtain larger profits.

If any firms were to reduce prices, others would also follow suit, thereby reducing profits for all. This is where it becomes tricky in distinguishing between collusion and a natural state of oligopolistic competition.

Do firms naturally keep prices higher due to fear that their actions will reduce their profits? Or, do they collude to keep prices and profits high? Oligopolistic firms benefit from high levels of market share.

At the same time, they benefit from economies of scale — meaning it can produce at a lower cost. For instance, there are markets that have high fixed costs such as car manufacturers.

If new competitors want to enter, they have to spend millions on new factories and other infrastructure. Consequently, this would increase costs for exisiting firms as the benefit they receive from economies of scale would decline. This means higher prices for customers and it is for this reason that such markets are better served under an oligopolistic market structure. In fact, the device you are using now may very well be part of an oligopoly.

With that said, it is important to realise that an oligopoly is generally defined by its market concentration. With just four companies controlling nearly two-thirds of all domestic flights in the U. According to a report compiled by the White House, "reduced competition contributes to increasing fees like baggage and cancellation fees. These fees are often raised in lockstep, demonstrating a lack of meaningful competitive pressure, and are often hidden from consumers at the point of purchase.

Prior to this time, the airline industry operated much like a public utility, while fare prices had declined 20 years before the deregulation was introduced. The White House. Investing Essentials. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

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Types of Antitrust Violations. Table of Contents Expand. What Is an Oligopoly? Understanding Oligopolies. Conditions That Enable Oligopolies. Why Are Oligopolies Stable? The Prisoner's Dilemma. Special Considerations. Oligopoly FAQs. Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution, of oligopolies. The major difficulty that oligopolies face is the prisoner's dilemma that each member faces, which encourages each member to cheat.

Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to limit competition. What Is an Example of a Current Oligopoly? Is the U. Airline Industry an Oligopoly? Article Sources. Investopedia requires writers to use primary sources to support their work.

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. Cost-plus pricing is very useful for firms that produce a number of different products, or where uncertainty exists.

It has been suggested that cost-plus pricing is common because a precise calculation of marginal cost and marginal revenue is difficult for many oligopolists. Hence, it can be regarded as a response to information failure. Cost-plus pricing is also common in oligopoly markets because it is likely that the few firms that dominate may often share similar costs, as in the case of petrol retailers.

However, there is a risk with such a rigid pricing strategy as rivals could adopt a more flexible discounting strategy to gain market share. Cost-plus pricing can also be explained through the application of game theory. If one firm uses cost-plus pricing — perhaps the dominant firm with the greatest market share — others may follow-suit so that the strategy becomes a shared one, which acts as a pricing rule.

This takes some of the risk out of pricing decisions, given that all firms will abide by the rule. This could be considered a form of tacit collusion.

Non-price competition is the favoured strategy for oligopolists because price competition can lead to destructive price wars — examples include:. The theory of oligopoly suggests that, once a price has been determined, will stick it at this price.

This is largely because firms cannot pursue independent strategies. For example, if an airline raises the price of its tickets from London to New York, rivals will not follow suit and the airline will lose revenue — the demand curve for the price increase is relatively elastic. Rivals have no need to follow suit because it is to their competitive advantage to keep their prices as they are. However, if the airline lowers its price, rivals would be forced to follow suit and drop their prices in response.

Again, the airline will lose sales revenue and market share. The demand curve is relatively inelastic in this context. The reaction of rivals to a price change depends on whether price is raised or lowered. The elasticity of demand, and hence the gradient of the demand curve, will be also be different. The demand curve will be kinked , at the current price. Even when there is a large rise in marginal cost, price tends to stick close to its original, given the high price elasticity of demand for any price rise.

If marginal revenue and marginal costs are added it is possible to show that profits will also be maximised at price P. Even when MC moves out of the vertical portion, the effect on price is minimal, and consumers will not gain the benefit of any cost reduction. Pricing strategies can also be looked at in terms of game theory ; that is in terms of strategies and payoffs.

There are three possible price strategies, with different pay-offs and risks:. The choice of strategy will depend upon the pay-offs, which depends upon the actions of competitors.