Oligopoly
An oligopoly (from Ancient Greek ὀλίγος (olígos) 'few', and πωλέω (pōléō) 'to sell') is a market in which control over an industry lies in the hands of a few large sellers who own a dominant share of the market. Oligopolistic markets have homogenous products, few market participants, and inelastic demand for the products in those industries.[1] As a result of their significant market power, firms in oligopolistic markets can influence prices through manipulating the supply function. Firms in an oligopoly are also mutually interdependent, as any action by one firm is expected to affect other firms in the market and evoke a reaction or consequential action.[1] As a result, firms in oligopolistic markets often resort to collusion as means of maximising profits.
Not to be confused with Oligarchy, a form of government where few people control a country.
Nonetheless, in the presence of fierce competition among market participants, oligopolies may develop without collusion. This is a situation similar to perfect competition,[2] where oligopolists have their own market structure.[3] In this situation, each company in the oligopoly has a large share in the industry and plays a pivotal, unique role.[4]
Many jurisdictions deem collusion to be illegal as it violates competition laws and is regarded as anti-competition behaviour. The EU competition law in Europe prohibits anti-competitive practices such as price-fixing and competitors manipulating market supply and trade. In the US, the United States Department of Justice Antitrust Division and the Federal Trade Commission are tasked with stopping collusion. In Australia, the Federal Competition and Consumer Act 2010 has details the prohibition and regulation of anti-competitive agreements and practices. Although aggressive, these laws typically only apply when firms engage in formal collusion, such as cartels. Corporations may often thus evade legal consequences through tacit collusion, as collusion can only be proven through direct communication between companies.
Within post-socialist economies, oligopolies may be particularly pronounced. For example in Armenia, where business elites enjoy oligopoly, 19% of the whole economy is monopolized, making it the most monopolized country in the region.[5]
Many industries have been cited as oligopolistic, including civil aviation, electricity providers, the telecommunications sector, rail freight markets, food processing, funeral services, sugar refining, beer making, pulp and paper making, and automobile manufacturing.
Types of oligopolies[edit]
Perfect and imperfect oligopolies[edit]
Perfect and imperfect oligopolies are often distinguished by the nature of the goods firms produce or trade in.[6]
A perfect (sometimes called a 'pure') oligopoly is where the commodities produced by the firms are homogenous (i.e., identical or materially the same in nature) and the elasticity of substitute commodities is near infinite.[7] Generally, where there are two homogenous products, a rational consumer's preference between the products will be indifferent, assuming the products share common prices. Similarly, sellers will be relatively indifferent between purchase commitments in relation to homogenous products.[8] In an oligopolistic market of a primary industry, such as agriculture or mining, commodities produced by oligopolistic enterprises will have strong homogeneity; as such, such markets are described as perfect oligopolies.[9]
Imperfect (or 'differentiated') oligopolies, on the other hand, involve firms producing commodities which are heterogenous. Where companies in an industry need to offer a diverse range of products and services, such as in the manufacturing and service industries,[10] such industries are subject to imperfect oligopoly.[11]
Open and closed oligopolies[edit]
An open oligopoly market structure occurs where barriers to entry do not exist, and firms can freely enter the oligopolistic market. In contrast, a closed oligopoly is where there are prominent barriers to market entry which preclude other firms from easily entering the market.[12] Entry barriers include high investment requirements, strong consumer loyalty for existing brands, regulatory hurdles and economies of scale. These barriers allow existing firms in the oligopoly market to maintain a certain price on commodities and services in order to maximise profits.[13]
Collusive oligopolies[edit]
Collusion among firms in an oligopoly market structure occurs where there are express or tacit agreements between firms to follow a particular price structure in relation to particular products (for homogenous products) or particular transaction or product classes (for heterogeneous products).[8] Colluding firms are able to maximise profits at a level above the normal market equilibrium.[14]
Interdependence in oligopolies is reduced when firms collude, because there is a lessened need for firms to anticipate the actions of other firms in relation to prices. Collusion closes the gap in the asymmetry of information typically present in a market of competing firms.[15]
One form of collusive oligopoly is a cartel,[16] a monopolistic organisation and relationship formed by manufacturers who produce or sell a certain kind of goods in order to monopolise the market and obtain high profits by reaching an agreement on commodity price, output and market share allocation. However, the stability and effectiveness of a cartel are limited, and members tend to break from the alliance in order to gain short-term benefits.
Partial and full oligopoly[edit]
A full oligopoly is one in which a price leader is not present in the market, and where firms enjoy relatively similar market control. A partial oligopoly is one where a single firm dominates an industry through saturation of the market, producing a high percentage of total output and having large influence over market conditions. Partial oligopolies are able to price-make rather than price-take.[17]
Tight and loose oligopoly[edit]
In a tight oligopoly, only a few firms dominate the market, and there is limited competition. A loose oligopoly, on the other hand, has many interdependent firms which often collude to maximise profits. Markets can be classified into tight and loose oligopolies using the four-firm concentration ratio, which measures the percentage market share of the top four firms in the industry.[18] The higher the four-firm concentration ratio is, the less competitive the market is. When the four-firm concentration ration is higher than 60, the market can be classified as a tight oligopoly. A loose oligopoly occurs when the four-firm concentration is in the range of 40-60.[19]
Some characteristics of oligopolies include:
Sources of oligopoly power[edit]
Economies of scale[edit]
Economies of scale occur where a firm's average costs per unit of output decreases while the scale of the firm, or the output being produced by the firm, increases.[30] Firms in an oligopoly who benefit from economies of scale have a distinct advantage over firms who do not. Their marginal costs are lower, such that the firm's equilibrium at would be higher.[31] Economies of scale are seen prevalently when two firms in oligopolistic market agree to a merger, as it allows the firm to not only diversify their market but also increase in size and output production, with negligible relative increases in output costs.[32] These sorts of mergers are typically seen when companies expand into large business groups by appreciating and increasing capital to buy smaller companies in the same markets, which consequently increases the profit margins of the business.[33]
Collusion and price cutting[edit]
In a market with low entry barriers, price collusion between established sellers makes new sellers vulnerable to undercutting. Recognising this vulnerability, established sellers will reach a tacit understanding to raise entry barriers to prevent new companies from entering the market. Even if this requires cutting prices, all companies benefit because they reduce the risk of loss created by new competition.[34] In other words, firms will lose less for deviation and thus have more incentive to undercut collusion prices when more join the market. The rate at which firms interact with one another will also affect the incentives for undercutting other firms; short-term rewards for undercutting competitors are short lived where interaction is frequent, as a degree of punishment can expected swiftly by other firms, but longer-lived where interaction is infrequent.[35] Greater market transparency, for instance, would decrease collusion, as oligopolistic companies expect retaliation sooner where changes in their prices and quantity of sales are clear to their rivals.[35]
Barriers to enter the market[edit]
Large capital investments required for entry, including intellectual property laws, certain network effects,[36] absolute cost advantages,[37] reputation, advertisement dominance,[38] product differentiation,[39] brand reliance, and others, all contribute to keeping existing firms in the market and precluding new firms from entering.
Possible outcomes of oligopolies[edit]
Formation of cartels[edit]
Particular companies may employ restrictive trade practices order to inflate prices and restrict production in much the same way that a monopoly does. Whenever there is a formal agreement for such collusion between companies that usually compete with one another, the practice is known as a cartel. An example of an economic cartel is OPEC, where oligopolistic countries control the worldwide oil supply, leaving a profound influence on the international price of oil.[68]
There are legal restrictions on cartels in most countries, with regulations and enforcement against cartels having been enacted since the late 1990s.[69] For example, EU competition law has prohibited some unreasonable anti-competitive practices, such as directly or indirectly fixing selling prices, manipulating market supplies and controlling trade among competitors.[70] In the US, the Antitrust Division of the Justice Department and Federal Trade Commission was created to fight collusion among cartels.[71] Tacit collusion is becoming a more popular topic in the development of anti-trust law in most countries.[35]
Possibility of efficient outcomes[edit]
Competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. Hypothetically, this could lead to an efficient outcome approaching perfect competition.
As competition in an oligopoly can be greater when there are more competitors in an industry, it is theoretically harder to sustain cartels in an industry with a larger number of firms, as there will be less collusive profit for each firm.[67] Consequently, existing firms may have more incentive to deviate. However, empirical evidence has shown this conclusion to be ambiguous.[72] Thus, the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's structure. In particular, the level of dead weight loss is hard to measure. The study of product differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition, as they could gain certain marker power by offering somewhat differentiated products.[73]