A Research Paper on Oligopoly, Its Characteristics and Effects

Abstract

The purpose of this research is to look at the concept of oligopoly, its effects and characteristics on the market by using the right mix of theories and presenting real cases. The research will also show the impacts of oligopoly on the economy. Different real cases of oligopoly will be shown using different theories and models such as game theory, prisoners’ dilemma, the cartel theory and Cournot model.

Introduction

What is meant by a market structure? It is the environment in which firms produce and sell their products. A market structure has three key characteristics. The first characteristic is the number of firms in the market. Some markets have many firms competing against one another, while others have a few or even just one firm providing a product or service. The next characteristic of a market structure is the ease of entry and exit, such as the requirements to produce the product or service and the barriers of entry. An example of barrier of entry is how expensive is it to produce and sell in that market, or barriers such as government regulations. The third characteristic is the product differentiation within the market. The uniqueness of your product will determine what market structure your firm is part of. Oligopoly is a type of market structure that has small number of firms, more than one but few enough that each firm alone can influence and have an impact on the market. The maximum number of firms in an oligopoly is determined by how few firms there must be so that the actions of one has significant impact on others, this means the firms are interdependent. Examples of oligopolies are oil companies, automobile manufacturers, wireless carriers and steel manufacturers. The reason why there are few firms in this type of model is because the entry and exit are difficult. The cost of entering this type of market structure is what keeps most firms out. Due to the small number of firms in an oligopoly, firms usually spend little on product promotion. When differentiating markets, it is important to understand what makes them different. The main difference between oligopoly and other market structures is their characteristics such as the number of firms, the entry conditions, the product type and their behaviours such as their pricing strategy and promotional strategies.

Theoretical reviews

Effects on the market

Oligopoly has different economic impacts derived from its models. The effects of oligopoly are restrictions on the amount of output. Due to the small number of firms, output is small, and the prices are high compared to other market structures. Prices of the products in an oligopoly market exceed the average cost because of the barriers of entry. Effects of oligopoly can also prove negative on the national economy. Oligopoly could be described as an ‘established market’, a market where the industry and the prices are all in set. This allows existing firms to prevent access of new ones into the market by controlling the price and therefore causing the new firms to operate at a loss of revenue. Some cases of oligopoly markets even have firms sharing the market which leads to inflation of general price level. This may be good for the firms but for the consumers this is unfortunate. Why is the topic important? Understanding oligopoly and its effects on the market is important to run and regulate them. A firm in an oligopoly market must know what its competitors are doing when making its own decisions. When oligopolies act in a manner that of a monopolist they tend to cause prices to increase. This leads to economic damage. By understanding this market behaviour, policies can be formed and regulated to prevent further damage on the economy.

Advantages and disadvantages of oligopoly

An Oligopoly market has its advantages and drawbacks for both the firms and the consumers. The advantages of oligopoly:

1. High profits: Due to the small number of firms in an oligopoly, the firms can have high profits because of the low competition. The products or services under control of oligopolies are usually high in demand.
2. Simple and few choices: Consumers have the ability to carefully choose the product they desire because its easier to compare them in this type of market. In other markets with big competitors, the price ranges and product differentiation makes it difficult for the consumer to choose.
3. Competitive pricing: Usually the only differentiation between the products is the price, this causes the firms to lower their prices in order to compete with other similar firms. This is great for the consumers as prices will eventually lower.
4. Advancement in products: Due to the number of competitors and product similarities in oligopoly, advancement in products is seen very often in this type of market because each firm is trying their best to get gain the loyalty and trust of the customers in the market.

The disadvantages of oligopoly:

1. Difficulty of entry: It is very hard for a new firm to enter an oligopoly market because usually the market is already controlled by other well-known firms who already have the customers’ loyalty and the price control advantage.
2. Fixed prices: Pricing strategies are used in an oligopoly market but the difference in the prices of products are rarely far apart. This is because the firms in the market agree upon a fixed price for the products or services. Fixed prices in markets usually mean firms have control over consumers and this causes consumers to pay more.
3. Less choices: Consumers have limited options between the products and services they want.
4. No fear of competition: Firms in an oligopoly market usually aren’t motivated to come up with new products or ideas because they control the market with other firms.

The Cournot Model

The Cournot model is an economic model in which the industry that makes homogenous goods (products that are alike) decide the output of their competitors as the fixed output and choose their own output independently. The Cournot model claims that firms seek to maximize revenue based on the decision of their competitors. Also, each firm’s output is claimed to have an impact on the price of the product. This model was introduced by French mathematician Augustin Cournot in 1838. The model has its advantages. It shows logical assumptions, between low output and high price and high output and low price levels. It also presents a Nash equilibrium, which is when each firm reacts as best as they can to their competitor’s actions. However, the Cournot model has its drawbacks, sometimes the predictions are unrealistic compared to the real world. Cournot model shows that firms can operate as a cartel and gain higher profits if they join rather than compete against one another. But Game theory, which is “the study of human conflict and cooperation within a competitive situation.” shows us that such an arrangement would not be in equilibrium. Critics have also criticized the model on how firms in the market often compete on quantity rather than price, whereas the model shows the strategic point being the price rather than the quantity.

The prisoner’s dilemma

Oligopoly is an example of ‘prisoners’ dilemma’. A ‘game’ which suggests the difficulty of maintaining cooperation when cooperation is mutually beneficial. Even though sometimes cooperation would be a better scenario for two firms, often times that is not the case in oligopoly because cooperation is not in the interest of the individual player. An example of prisoner’s dilemma would be the case between Pepsi and Coca-Cola, because the two are highly competitive, a change in price from one of them would be seen as a strategic move by the other. This will cause the other firm to change their price as well in order to maintain their market share. Due to the initial price change, both companies may experience reduced profits because of the actions of one player.

Oligopoly markets in UK

A common example of an oligopoly market is the chocolate industry, more specifically in the United Kingdom the chocolates are most likely manufactured by one of the three companies; Cadbury, Mars or Nestle. These three companies make up of almost all the chocolate bars sold in the United Kingdom. Together they decide upon the quantity of chocolates produced and the price at which they’re sold given the demand curve for chocolates. This is a perfect example of an oligopoly and its aspects in action. Due to the low competition these companies face they are price takers. This is known as imperfect competition. Another example of oligopoly is the United Kingdoms’ supermarket industry, which is comprised of Tesco, ASDA, Sainsbury and Morrison’s, they are the four largest supermarkets and they account for 68% of the grocery market. You can imagine how difficult it would be for a new company to enter the supermarket industry in the UK. Each area also has two or more supermarkets for the customers to choose from. To attract customers the supermarket industry has to offer discounts, use different promotion strategies such as loyalty cards, extend opening hours and offer a better quality of service. These are some of the strategies used not only by the supermarket industry but oligopolies in general.

Cartel theory of oligopoly

A cartel is when several firms form a pact to decide on the output and the price decisions. The main goal of a cartel is to increase the profits. Game theory shows that cartels are unstable, which means each individual will cheat to make profits in the short run. Cartels tend to operate in markets with few firms with each firm having a big share of the market, such as in oligopoly. The best-known example of an international cartel would be the oil company, OPEC. Members meet often to discuss the output of oil produced between each member. By forming a cartel, firms are able to act like a monopolist because together they have the market power to determine the output and price. The price is determined by the market demand curve at the level of output placed by the cartel. Unlike a perfectly competitive market, cartels often choose to produce less output and charge a higher price. The kinked demand curve theory There is no single theory of oligopoly. The kinked demand curve is a theory which tries to explain price rigidity; the phenomenon of a price staying the same for a period of time in oligopolistic markets. It was developed in 1950s by Paul M. Sweezy. Oligopolistic firms that are independent and are concerned about the competitors tend to stay at a fixed price. They don’t want to raise their price because a higher price would face a very elastic demand curve. That means when they raise their price then they will lose a significant portion of their customers. The demand curve above the price is quite shallow, however if they lower their price then they enter a price war as their interdependent competitors take notice and also lower their price. The assumptions of the kinked demand curve theory are that there are very few firms in the market, the firms are producing close substitute products, the quality of the products is maintained and that a set price for products already exists and is doing well in the market.

Conclusion

Oligopolies tend to mimic monopolies; however, their interests are what motivates them to act and what drives them close to competition. It is up to the firms whether they want to continue acting like monopolies or a competitive market. I believe that oligopolies overall have a negative impact on the economy as well as on the markets and product advancements because of the close linked competition they face of very similar products. The prisoner’s dilemma shows how firms act on self interest rather than cooperation even when it means cooperation is more beneficial to them and the market.

References

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