Oligopoly 1

Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers
(oligopolists). The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι (oligoi) "few" + πωλειν
(polein) "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others. The
decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by
oligopolists needs to take into account the likely responses of the other market participants.

Description
Oligopoly is a common market form. As a quantitative description of oligopoly, the four-firm concentration ratio is
often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. For
example, as of fourth quarter 2008, Verizon, AT&T, Sprint Nextel, and T-Mobile together control 89% of the US
cellular phone market.
Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may
employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the
same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary
example of such a cartel is OPEC which has a profound influence on the international price of oil.
Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for
investment and product development. There are legal restrictions on such collusion in most countries. There does not
have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual
communication between companies)–for example, in some industries there may be an acknowledged market leader
which informally sets prices to which other producers respond, known as price leadership.
In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high
production. This could lead to an efficient outcome approaching perfect competition. The competition in an
oligopoly can be greater than when there are more firms in an industry if, for example, the firms were only
regionally based and did not compete directly with each other.
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.
Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies:
• Stackelberg's duopoly. In this model the firms move sequentially (see Stackelberg competition).
• Cournot's duopoly. In this model the firms simultaneously choose quantities (see Cournot competition).
• Bertrand's oligopoly. In this model the firms simultaneously choose prices (see Bertrand competition).

Characteristics
Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue equals
marginal costs.[1]
Ability to set price: Oligopolies are price setters rather than price takers.[1]
Entry and exit: Barriers to entry are high.[2] The most important barriers are economies of scale, patents, access to
expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy
nascent firms.[3]
Number of firms: "Few" – a "handful" of sellers.[2] There are so few firms that the actions of one firm can influence
the actions of the other firms.[4]
Oligopoly 2

Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms
from entering market to capture excess profits.
Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles).[3]
Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic actors can
be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions but
their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price,[2] cost and
product quality.
Interdependence: The distinctive feature of an oligopoly is interdependence.[5] Oligopolies are typically composed
of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms
will be aware of a firm's market actions and will respond appropriately. This means that in contemplating a market
action, a firm must take into consideration the possible reactions of all competing firms and the firm's
countermoves.[6] It is very much like a game of chess or pool in which a player must anticipate a whole sequence of
moves and countermoves in determining how to achieve his objectives. For example, an oligopoly considering a
price reduction may wish to estimate the likelihood that competing firms would also lower their prices and possibly
trigger a ruinous price war. Or if the firm is considering a price increase, it may want to know whether other firms
will also increase prices or hold existing prices constant. This high degree of interdependence and need to be aware
of what the other guy is doing or might do is to be contrasted with lack of interdependence in other market
structures. In a PC market there is zero interdependence because no firm is large enough to affect market price. All
firms in a PC market are price takers, information which they robotically follow in maximizing profits. In a
monopoly there are no competitors to be concerned about. In a monopolistically competitive market each firm's
effects on market conditions is so negligible as to be safely ignored by competitors.

Modeling
There is no single model describing the operation of an oligopolistic market.[6] The variety and complexity of the
models is due to the fact that you can have two to 102 firms competing on the basis of price, quantity, technological
innovations, marketing, advertising and reputation. Fortunately, there are a series of simplified models that attempt
to describe market behavior under certain circumstances. Some of the better-known models are the dominant firm
model, the Cournot-Nash model, the Bertrand model and the kinked demand model

Dominant firm model

In some markets there is a single firm that controls a dominant share of the market and a group of smaller firms. The
dominant firm sets prices which are simply taken by the smaller firms in determining their profit maximizing levels
of production. This type of market is practically a monopoly and an attached perfectly competitive market in which
price is set by the dominant firm rather than the market. The demand curve for the dominant firm is determined by
subtracting the supply curves of all the small firms from the industry demand curve.[7] After estimating its net
demand curve (market demand less the supply curve of the small firms) the dominant firm maximizes profits by
following the normal p-max rule of producing where marginal revenue equals marginal costs. The small firms
maximize profits by acting as PC firms–equating price to marginal costs.

Cournot-Nash model
The Cournot-Nash model is the simplest oligopoly model. The models assumes that there are two “equally positioned
firms”; the firms compete on the basis of quantity rather than price and each firm makes an “output decision
assuming that the other firm’s behavior is fixed.”[8] The market demand curve is assumed to be linear and marginal
costs are constant. To find the Cournot-Nash equilibrium one determines how each firm reacts to a change in the
output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a
point is reached where neither firm desires “to change what it is doing, given how it believes the other firm will react
Oligopoly 3

to any change.”[9] The equilibrium is the intersection of the two firm’s reaction functions. The reaction function
shows how one firm reacts to the quantity choice of the other firm.[10] For example, assume that the firm 1’s demand
function is P = (60 - Q2) - Q1 where Q2 is the quantity produced by the other firm and Q1 is the amount produced by
firm 1.[11] Assume that marginal cost is 12. Firm 1 wants to know its maximizing quantity and price. Firm 1 begins
the process by following the profit maximization rule of equating marginal revenue to marginal costs. Firm 1’s total
revenue function is PQ = Q1(60 - Q2 - Q1) = 60Q1- Q1Q2 - Q12. The marginal revenue function is MR = 60 - Q2 -
2Q.[12]
MR = MC
60 - Q2 - 2Q = 12
2Q = 48 - Q2
Q1 = 24 - 0.5Q2 [1.1]
Q2 = 24 - 0.5Q1 [1.2]
Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2.
To determine the Cournot-Nash equilibrium you can solve the equations simultaneously. The equilibrium quantities
can also be determined graphically. The equilibrium solution would be at the intersection of the two reaction
functions. Note that if you graph the functions the axes represent quantities.[13] The reaction functions are not
necessarily symmetric.[14] The firms may face differing cost functions in which case the reaction functions would not
be identical nor would the equilibrium quantities.

Bertrand model
The Bertrand model is essentially the Cournot-Nash model except the strategic variable is price rather than
quantity.[15]
The model assumptions are:
There are two firms in the market
They produce a homogeneous product
They produce at a constant marginal cost
Firms choose prices PA and PB simultaneously
Firms outputs are perfect substitutes
Sales are split evenly if PA = PB[16]
The only Nash equilibrium is PA = PB = MC.
Neither firm has any reason to change strategy. If the firm raises prices it will lose all its customers. If the firm
lowers price P < MC then it will be losing money on every unit sold.[17]
The Bertrand equilibrium is the same as the competitive result.[18] Each firm will produce where P = marginal costs
and there will be zero profits.[15]
Oligopoly 4

Kinked demand curve model

According to this model, each firm faces a demand curve kinked at the existing price.[19] The conjectural
assumptions of the model are; if the firm raises its price above the current existing price, competitors will not follow
and the acting firm will lose market share and second if a firm lowers prices below the existing price then their
competitors will follow to retain their market share and the firm's output will increase only marginally.[20]
If the assumptions hold then:
The firm's marginal revenue curve is discontinuous, and has a gap at the kink[19]
For prices above the prevailing price the curve is relatively elastic [21]
For prices below the point the curve is relatively inelastic [21]
The gap in the marginal revenue curve means that marginal costs can fluctuate without changing equilibrium price
and quantity.[19] Thus prices tend to be rigid.

Examples
In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with
unprecedented levels of competition fueled by increasing globalization. Market shares in an oligopoly are typically
determined by product development and advertising. For example, there are now only a small number of
manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have participated in the
small passenger aircraft market sector. Oligopolies have also arisen in heavily-regulated markets such as wireless
communications: in some areas only two or three providers are licensed to operate.

Australia
• Phone lines are controlled by Telstra, then rented to other providers and further rented to customers. Any rate
hikes by Telstra are felt by all customers with a phone line no matter the provider.
• Most media outlets are owned either by News Corporation, Time Warner, or by Fairfax Media[22]
• Grocery retailing is dominated by Coles Group and Woolworths.
• Banking is dominated by ANZ, Westpac, NAB, and Commonwealth Bank

Canada
• Three companies (Rogers Wireless, Bell Mobility and Telus) share over 94% of Canada's wireless market.[23] [24]

United Kingdom
• Four companies (Tesco, Sainsbury's, Asda and Morrisons) share 74.4% of the grocery market.[25]
• The detergent market is dominated by two players, Unilever and Procter & Gamble.[26]

United States
• Many media industries today are essentially oligopolies.
• Six movie studios receive 90% of American film revenues.
• The television industry is mostly an oligopoly of eight companies: The Walt Disney Company, CBS
Corporation, Viacom, NBC Universal, Comcast, Hearst Corporation, Time Warner, and News Corporation.[27]
See Concentration of media ownership.
• Four major music companies receive 80% of recording revenues.
• Four wireless providers (AT&T, Verizon Wireless, T-Mobile, Sprint Nextel) control 89% of the cellular
telephone market.[28]
• There are six major book publishers.
Oligopoly 5

• Healthcare insurance in the United States consists of very few insurance companies controlling major market
share in most states. For example, California's insured population of 20 million is the most competitive in the
nation and 44% of that market is dominated by two insurance companies, Anthem and Kaiser Permanante.[29]
• Anheuser-Busch and MillerCoors control about 80% of the beer industry.[30]
• Detroit's Big Three were leaders in the auto industry for many years. However globalization and demand for
foreign imports have driven down sales sharply in recent years.

Worldwide
• The accountancy market is controlled by PriceWaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu, and Ernst
& Young (commonly known as the Big Four)[31]
• Three leading food processing companies, Kraft Foods, PepsiCo and Nestle, together achieve a large proportion
of global processed food sales. These three companies are often used as an example of "The rule of 3",[32] which
states that markets often become an oligopoly of three large firms.
• Boeing and Airbus have a duopoly over the airliner market[33]

Demand curve
In an oligopoly, firms operate under
imperfect competition. With the fierce price
competitiveness created by this
sticky-upward demand curve, firms use
non-price competition in order to accrue
greater revenue and market share.

"Kinked" demand curves are similar to

traditional demand curves, as they are
downward-sloping. They are distinguished
by a hypothesized convex bend with a
discontinuity at the bend–"kink". Thus the
first derivative at that point is undefined and
leads to a jump discontinuity in the marginal
revenue curve. Above the kink, demand is relatively elastic because all other firms' prices remain
unchanged. Below the kink, demand is relatively inelastic because all other firms
Classical economic theory assumes that a
will introduce a similar price cut, eventually leading to a price war. Therefore, the
profit-maximizing producer with some best option for the oligopolist is to produce at point E which is the equilibrium
market power (either due to oligopoly or point and the kink point. This is a theoretical model proposed in 1947, which has
monopolistic competition) will set marginal failed to receive conclusive evidence for support.

costs equal to marginal revenue. This idea

can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping
marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per
unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit)
or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected
in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump
discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or
quantity.

The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will
not raise their prices because even a small price increase will lose many customers. This is because competitors will
generally ignore price increases, with the hope of gaining a larger market share as a result of now having
Oligopoly 6

comparatively lower prices. However, even a large price decrease will gain only a few customers because such an
action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less
so for price decreases. Firms will often enter the industry in the long run.

Notes
[1] Perloff, J. Microeconomics Theory & Applications with Calculus. page 445. Pearson 2008.
[2] Hirschey, M. Managerial Economics. Rev. Ed, page 451. Dryden 2000.
[3] Negbennebor, A: Microeconomics, The Freedom to Choose CAT 2001
[4] Negbennebor, A: Microeconomics, The Freedom to Choose page 291. CAT 2001
[5] Melvin & Boyes, Microeconomics 5th ed. page 267. Houghton Mifflin 2002
[6] Colander, David C. Microeconomics 7th ed. Page 288 McGraw-Hill 2008.
[7] Samuelson, W & Marks, S: 100. Managerial Economics page 403. 4th ed. Wiley 2003.
[8] This statement is the Cournot conjectures. Kreps, D.: A Course in Microeconomic Theory page 326. Princeton 1990.
[9] Kreps, D. A Course in Microeconomic Theory. page 326. Princeton 1990.
[10] Kreps, D. A Course in Microeconomic Theory. Princeton 1990.
[11] Samuelson, W & Marks, S. Managerial Economics. 4th ed. Wiley 2003
[12] MR = 60 - Q2 - 2Q. can be restated as MR = (60 - Q2) - 2Q.
[13] Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. Prentice-Hall 2001
[14] Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. Prentice-Hall 2001
[15] Samuelson, W. & Marks, S. Managerial Economics. 4th ed. page 415 Wiley 2003.
[16] There is nothing to guarantee an even split. Kreps, D.: A Course in Microeconomic Theory page 331. Princeton 1990.
[17] This assumes that there are no capacity restriction. Binger, B & Hoffman, E, 284-85. Microeconomics with Calculus, 2nd ed.
Addison-Wesley, 1998.
[18] Pindyck, R & Rubinfeld, D: Microeconomics 5th ed.page 438 Prentice-Hall 2001.
[19] Pindyck, R. & Rubinfeld, D. Microeconomics 5th ed. page 446. Prentice-Hall 2001.
[20] Simply stated the rule is that competitors will ignore price increases and follow price decreases. Negbennebor, A: Microeconomics, The
Freedom to Choose page 299. CAT 2001
[21] Negbennebor, A. Microeconomics: The Freedom to Choose. page 299. CAT 2001
[22] Media Industry Profile: Australia, Datamonitor, October 2008
[23] http:/ / cwta. ca/ CWTASite/ english/ facts_figures_downloads/ SubscribersStats_en_2008_Q4. pdf
[24] http:/ / www. crtc. gc. ca/ eng/ publications/ reports/ policymonitoring/ 2008/ cmr2008. pdf
[25] Probe says 'too few supermarkets' (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 4785544. stm), BBC News, 31 October 2007, , retrieved
2009-04-03
[26] Textile Washing Products Industry Profile: United Kingdom, Datamonitor, November 2008
[27] Rodman, George. Mass Media in a Changing World. New York (2nd ed.), McGraw Hill, 2008
[28] http:/ / www. slideshare. net/ chetansharma/ us-wireless-market-q4-2008-and-2008-update-mar-2009-chetan-sharma-consulting
[29] http:/ / www. cnbc. com/ id/ 32918263
[30] Beer Industry Profile: United States, Datamonitor, Dec. 2008
[31] Accountancy Industry Profile: Global, Datamonitor, September 2008
[32] The Rule of Three, New York: Boston Publishing Co.
[33] Airlines Industry Profile: United States, Datamonitor, November 2008, pp. 13–14

External links
• Microeconomics (http://www.egwald.ca/economics/index.php) by Elmer G. Wiens: Online Interactive
Models of Oligopoly, Differentiated Oligopoly, and Monopolistic Competition
• Vives, X. (1999). Oligopoly pricing, MIT Press, Cambridge MA. (A comprehensive work on oligopoly theory)
• Oligopoly Watch (http://www.oligopolywatch.com) A blog on current oligopoly issues from a business and
social perspective
• Simulations in Managerial/Business Economics (http://www.economicsnetwork.ac.uk/teaching/simulations/
managerialbusinesseconomics.htm)
• Simulations in Principles of Economics (http://www.economicsnetwork.ac.uk/teaching/simulations/
principlesofmicroeconomics.htm)
Article Sources and Contributors 7

Article Sources and Contributors

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