5. Monopoly and Oligopoly
We have already learned about the operation of two very different types of markets: perfectly competitive markets and monopolists. However, most markets don’t fall into either category. For example, think of the market for soda - both Pepsi and Coke are major producers, and they dominate the market. This type of market structure is known as an oligopoly.
In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well.
An Oligopoly is an industry dominated by a few firms, e.g. supermarkets, petrol, car industry e.t.c.
The main features of oligopoly:
An industry which is dominated by a few firms.
UK definition of an oligopoly is a five firm concentration ratio of more than 50% (this means they have more than 50% of the market share)
Interdependence of firms, firms will be affected by how other firms set price and output.
Barriers to entry, but less than monopoly.
Differentiated products, advertising is often important
Most common market structure
Definition of Concentration Ratios:
This is a tool for measuring the market share of the 5 biggest firms in the industry. E.g. the 5 firm concentration ratio for supermarkets is about 58%
Firms in Oligopoly
There are different possible ways that firms in oligopoly will compete and behave this will depend upon:
The objectives of the firms e.g. profit maximisation or sales maximisation
The degree of contestability i.e. barriers to entry
The Kinked Demand Curve Model
This model suggests that prices will be fairly stable and there is little incentive to change prices. Therefore, firms compete using non-price competition methods.
This assumes that firms seek to maximise profits
If they increase price, then they will lose a large share of the market because they become uncompetitive compared to other firms, therefore demand is elastic for price increases.
If firms cut price then they would gain a big increase in market share, however it is unlikely that firms will allow this. Therefore other firms follow suit and cut price as well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut.
Therefore this suggests that prices will be rigid in oligopoly
The below diagram suggests that a change in marginal Cost still leads to the same price, because of the kinked demand curve remember profit max occurs where MR = MC)
Evaluation of kinked demand curve
In real world, prices do change
Firms may not seek to maximise profits, but prefer to increase market share
Some firms may have very strong brand loyalty and be able to increase price without demand being very price elastic.
Firms in oligopoly may still be very competitive on price, especially if they are seeking to increase market share.
Another possibility for firms in oligopoly is for them to collude on price and set profit maximising levels of output.
Collusion is illegal, but tacit collusion may be hard to spot.
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