See Origin of Oligopoly
Many major industries are dominated by a few huge firms, which individually lack the control possessed by unregulated monopolists---they must consider other firms' reactions in setting prices, production, and marketing strategy.
Oligopolies are industries dominated by a few firms whose decisions are strategically linked; barriers to entry tend to be significant.
Models of pure competition and monopoly provide insights into oligopolistic behavior, but firms in neither of these groups base decisions on the expected reactions of other firms. Thus, theories of oligopoly cannot just blend theories of competition and monopoly.
Oligopoly models must account for interdependence in decision-making. That is, each individual firm weighs its potential rivals’ reactions when it chooses a business strategy. Theories of oligopoly abound because the dynamics of interdependence differ markedly from one industry to another. Just as proper play in poker depends as much on how well you read your opponents as it does on the cards you are dealt, oligopolists' strategies depend on their individual positions relative to those of current competitors and potential rivals.
Until recently, most specialists in industrial organizations thought that a general model should be developed to cover the behavior of all firms that operated in oligopoly markets. Most economists have concluded that this is not possible. One modern approach to analyzing oligopoly involves modeling strategic behavior.
Strategic Behavior entails ascertaining what other people or firms are likely to do in a specific situation and then pursuing tactics that maximize your gains or minimize your losses.
Less competitive than monopolistic competition, oligopolies lie closer to monopolies in the spectrum of market structures.
If entry is restricted and a few firms dominate an industry, each firm recognizes that any action it takes will be countered by others. For example, Chrysler's extended warranties were quickly matched by many carmakers. Then Chrysler equipped all its cars with air bags in 1989, and other automakers briskly followed suit. Any hit TV show or software program quickly spawns clones. Just as musicians mimic other successful musicians (Will Madonna try to switch to hip-hop?), any successful competitive technique is rapidly imitated by other firms as they try to expand their own market shares.
A market shared by two firms is certainly an oligopoly, but would 10 or 20 sellers still be considered few? The answer is not clear-cut. What matters is whether a handful of large interdependent firms consciously dominate an industry. If firms' decisions anticipate rivals' strategies, the industry is concentrated and oligopolistic.
Mutual interdependence exists when firms consider their rivals' reactions while adjusting prices, outputs, or product lines.
Consciousness of rivals' expected reactions to policy changes arises primarily from the small number of firms in an oligopoly. Success often depends on assessing rivals' responses. Failure to predict rivals' reactions may result in bad news on the bottom line of an oligopolist's annual report.
Oligopolistic Decision Making
Interactions in extended families (parents, grandparents, aunts, uncles, siblings, cousins, in-laws, etc.) range from cooperation to violence, reflecting the vagaries of the personalities involved and coalitions among family members. Similar interdependence complicates analysis of oligopolies because how firms interact depends on cost structures, the number of competitors, the nature of outputs, and the personalities and perceptions of top managers.
Different models can be used to describe patterns of cooperation and rivalry when a few firms dominate an industry. If firms compete aggressively, their pricing and output may mimic that for competitive firms so that profits are negligible. Consequently, oligopolists often try to cooperate by boosting prices and limiting outputs---this benefits these firms at the expense of the general public. Such oligopolistic scheming is generally either collusive (formal conspiracies) or noncollusive (informal, but consciously cooperative).
One obvious collusive strategy is for oligopolists to try to unite and share both the market and monopoly profits. This is known as forming a cartel. Noncollusive pricing may emerge naturally if each firm acts cooperatively because each realizes that others will offset any strategy aimed at enlarging market share and profit.
In this section, we investigate only two classic oligopoly models. The kinked demand model is noncollusive, while cartels depend on collusion. More complex oligopolistic interactions are described in our sections on game theory and strategic behavior.
The Kinked Demand Curve
Prices in highly concentrated industries were once thought to be unresponsive to changes in costs or demands. The kinked demand curve model of oligopoly pricing sought to explain "stickiness" of oligopolistic prices as a natural result of noncollusive behavior.
The kinked demand curve model assumes that firms maintain their current price if any one firm raises its price, but all firms match any price reduction by any single firm.
How these assumptions affect pricing strategy is shown in Figure 4. At point a, the price is currently Pe, and qe units of the good are sold by each firm in this oligopoly. Demand curve D0 represents the highly elastic demand facing a firm if other firms ignored its price changes. If the firm were alone in lowering its price, its sales revenues would soar (a movement along D0 to the right of qe). If this firm were to raise its price and the others did not follow, however, its sales would plummet (movement along D0 to the left of qe) because consumers will shift to competitors' products.
If rivals match all price changes, however, demand curve D1 reflects the firm's less elastic options. If it slashes prices and all other firms do the same, the firm's sales grow only slightly. The firm's sales fall little if both it and its rivals boost prices. Along D1 the firm loses few sales to other firms because their relative prices are constant. All firms merely gain or lose sales based on the elasticity of the industry's total demand. The respective marginal revenue curves for D0 and D1 are labeled MR0 and MR1.
This model's assumptions imply that only part of each curve is relevant: Price cuts will be matched by rivals, but price hikes will not. Thus, the demand curve facing a firm is the thicker part of the D0 curve for outputs less than qe and the thicker portion of D1 for outputs above qe. Matching segments are emphasized similarly for marginal revenue curves. Note that this marginal revenue curve has a gap at output qe between points b and c, corresponding to the "kink" in demand; hence the name "kinked demand curve."
This kink and the gap in the marginal revenue curve are critical. In Figure 4 profit maximizers produce where marginal revenue equals marginal cost, so qe output is sold at price Pe as long as the marginal cost curve stays between MC0 and MC1. Thus, this model explains why prices might be sticky in oligopolistic industries even if costs change. Marginal cost can rise from point c to point b without affecting the price.
Kinked demand models seem reasonable, but critics point to some flaws. First, price rigidity may be no more frequent in oligopolies than other industries. Concentrated industries appear to quickly pass along cost increases as they occur. After all, advertising, quality, and new product development may raise costs without significantly expanding market demand. If only one firm's profit is squeezed, it may be forced to maintain its current price. But if profits for all firms in an oligopoly shrink, all might follow a price hike; this yields a new kink at the higher price.
Second, kinked demand models fail to explain (a) why entry does not occur, (b) how oligopoly emerges, (c) how the equilibrium price, Pe, is initially established, or (d) how prices change. These problems have caused the model to be used sparingly by researchers. Nevertheless, the kinked demand model has the virtue of simplicity in conveying the flavor of strategic business reactions and rivalry.
How do oligopolies compare with more competitive industries? Firms in oligopolistic industries exercise considerable market power, yielding economic inefficiency similar to that described earlier for monopoly. In equilibrium, the marginal social benefit (price) of their products exceeds the marginal social cost. Compared with purely or even monopolistically competitive industries, output will tend to be lower, and at higher prices to consumers.
If oligopoly arises from economies of scale, however, it is possible that consumers pay lower prices than they would were the market more competitive. Furthermore, if research and development (R&D) leading to technological advances requires massive outlays, small competitive firms may be unable to finance adequate innovation. Some economists suggest that society gains over the long run when short-run profits reaped by oligopolistic firms are plowed back into the development and innovation of newer and better products.
Evidence on the effects of oligopolies is mixed. Economies of scale are clearly responsible for the oligopolistic nature of some industries. In other instances, however, satisfactory economies of scale can be realized by smaller firms, and oligopoly is sustained by legal or strategic entry barriers. Finally, the evidence does not support the idea that large firms are especially responsible for new inventions and technological advances in our economy. If anything, it appears that the desire for increased market power has been the driving force behind the creation of most oligopolies.
Successful collusion requires a stable environment, but unless cartels have the legal support of government, stability is unlikely. When products are significantly differentiated, or resource costs are volatile, or demands are fickle, or entry is easy, or competitors are numerous, or technology advances rapidly, or policing a cartel agreement is excessively costly, then the quiet cooperation that oligopolists would like may be replaced by strategic behavior as intense as championship chess and as hostile as war.