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Definition- Oligopoly

An oligopoly market exists when barriers to entry result in a few


mutually dependent companies controlling a substantial portion of a
market.
Assumptions of Oligopoly
Few firms dominate an industry.
Large proportion of industry's output is shared by a few firms.
High barriers to entry may be due to economics of scale, legal
barriers, aggressive tactics such as advertising or high startup
costs
Products may be identical or differentiated.
Firms are interdependent and take careful notice of each other's
actions.
Concentration Ratio
Concentration ratios are usually used to show the extent of market
control of the largest firms in the industry and to illustrate the degree
to which an industry is oligopolistic.
A concentration ratio is a measure of the total output produced in an
industry by a given number of firms in the industry. The most
common concentration ratios are the CR4 and the CR8, which means
the four and the eight largest firms.

concentration-ratio
LOW CONCENTRATION
0% to 50%. This category ranges from perfect competition to
oligopoly.
MEDIUM CONCENTRATION
50% to 80%. An industry in this range is likely an oligopoly.
HIGH CONCENTRATION
80% to 100%. This category ranges from oligopoly to monopoly.
Collusive and non-collusive oligopoly
Many a times, firms under oligopoly collude in order to coordinate
prices, limit competition between them and to reduce uncertainties.
This is known as collusive oligopoly. This results in firms acting like
a monopoly and thus making abnormal profits.
Collusive Oligopoly
Watch a Video - Collusion

There are two types of collusion:


FORMAL COLLUSION
It is a formal agreement among firms to undertake planned actions to
prevent competition. It is also known as a cartel.
It might include
o Setting production quotas to control output
o Price fixing

o Dividing markets among each other on geographical basis or other


factors
Formal collusion is considered illegal in most of the countries which
have strict competition/anti-trust laws to prevent and control formal
collusion. However, Formal collusion between governments may be
permitted. Example, OPEC (Organisation of Petroleum Exporting
Countries).
DIFFICULTIES IN MAINTAINING CARTELS
There are a number of difficulties or obstacles in forming and
maintaining cartels. Some of them are discussed below:
Different firms may have different cost curves: Since, in a cartel the
price fixed is common, it might lead to different levels of profits for
different firms. Firms with higher AC will have lower profits, whereas
firms with lower AC will enjoy higher profits.
Number of firms: An industry with large number of firms will have
less chances of having a cartel as it is always difficult to bring them
all on consensus in terms of price and output.
Different firms may face different demand curves: Demand curve for
a firm depends on the level of market share and product
differentiation it commands. This makes it difficult for firms with
different demand curves to arrive at a common price.
Incentive to cheat: Colluding firms have an incentive to cheat on the
agreement as it might lead to higher profits. This may be in the form
of secretly offering lower prices or other concessions. This might lead
to the collapse of cartel.
Economic conditions: During recessions, it is difficult to run cartels as
the firms may want to lower prices in order to attract more sales. This
would also lead to price war and the collapse of a cartel.

Cartels depend of high barriers to entry: Abnormal profits attract more


firms to the industry which in turn lowers the industry prices.
However, in order to sustain a cartel in the long run, there should be
high barriers to entry so that potential new entrants are blocked from
entering the industry.
Legal barriers: Most of the countries round the world have strong
competitive/anti-trust laws to restrict cartels.
INFORMAL/TACIT COLLUSION
A collusive situation where the firms are again charging same price
and limiting competition, however without any formal agreement.
Types of informal collusion
Price leadership: This occurs when one firm has a clear dominant
position in the market and the firms with lower market shares follow
the pricing changes driven by the dominant firm.
Limit pricing: It occurs where firms informally agree to set a price
that is lower than the profit maximising price. Firms experience lower
profits than the highest possible profits and therefore discourage new
firms from entering the industry.
Game Theory

Non Collusive Oligopoly


In a non collusive oligopoly the firms do not collude however, they
this requires them to be aware of the reactions of the other firms while
making pricing decisions.
A non collusive oligopoly will experience price rigidity as the firms
are always conscious of the competitors' actions while making price

decisions. This can be explained with the helped of a kinked demand


curve.
Kinked Demand Curve
Kinked Demand curve was devised by Paul Sweezy, an American
economist in the 1930s. The Kinked Demand curve gives an
explanation to underlying reason why an oligopolistic market
experiences price rigidity.
Lets assume that a firm is selling at price P.
The firm as three options
If the firm increase the Price: If the firm increase the price above its
present price P, it is more likely that other firms will not increase their
prices. The firm will end up losing customer to other firms. The firm
will lose relatively large demand as compared to the price increase.
Thus, a firm will face a relatively elastic demand curve above the
point 'a'.
If the firm lowers the Price: If the firm lowers the price, it will start a
price war and other firms will lower their prices too. It is more likely
that the competitors will set their prices even lower than the firm. The
firm will not see much increase in its demand even with a relatively
high price cut. Thus, the firm will face less elastic demand below the
point 'a'.
It should therefore not change the price and should continue to sell at
price 'P'.
If we combine both the demand curves we will get a demand curve
kinked at point 'a'.
The MR curve will be twice as steeply sloping.
oligopoly-1oligopoly-2

What does Kinked Demand Curve explain?


Kinked demand curve explains the price inflexibility of oligopolistic
firms that do not collude.
If the firm lowers its prices the competitors will lower their prices
even further and the firm will lose demand and if the firm increase its
price, the competitors will not follow by increasing their prices and
thus the firm will again lose demand. Therefore, the best strategy is to
stick to the existing price level.
In order to avoid a price war firms will compete on other factors
rather than price. This is known as non-price competition.