Understanding Oligopoly

An oligopoly is a market structure with a small number of firms, none of which can keep the others from having significant influence. The concentration ratio measures the market share of the largest firms.

A monopoly is a market with only one producer, a duopoly has two firms, and an oligopoly consists of two or more firms. There is no precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the actions of one firm significantly influence

the others.

The term "oligopoly" refers to a small number of producers working, either explicitly or tacitly, to restrict output and/or fix prices, in order to achieve above normal

market returns.

Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution, of oligopolies. The major difficulty that oligopolies face is the prisoner's dilemma that each member faces, which encourages each member to cheat. Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to

limit competition.

Oligopolies in history include steel manufacturers, oil companies, railroads, tire manufacturing, grocery store chains, and wireless carriers. The economic and legal concern is that an oligopoly can block new entrants, slow innovation, and increase prices, all of which harm consumers. Firms in an oligopoly set prices, whether collectively—in a cartel—or under the leadership of one firm, rather than taking prices from the market. Profit margins are thus higher than they would be in a more competitive market.

The conditions that enable oligopolies to exist include high entry costs in capital expenditures, legal privilege (license to use wireless spectrum or land for railroads), and a platform that gains value with more customers (such as social media).

The global tech and trade transformation has changed some of these conditions: offshore production and the rise of "mini-mills"

have affected the steel industry, for example. In the office software application space, Microsoft was targeted by Google Docs, which Google funded using cash from its web

search business.

An interesting question is why such a group is stable. The firms need to see the benefits of collaboration over the costs of economic competition, then agree to not compete and instead agree on the benefits of co-operation. The firms have sometimes found creative ways to avoid the appearance of price-fixing, such as using phases of the moon. Price-fixing is the act of setting prices, rather than letting them be determined by the free-market forces. Another approach is for firms to follow a recognized price leader; when the leader raises prices, the others will follow.

The main problem that these firms face is that each firm has an incentive to cheat; if all firms in the oligopoly agree to jointly restrict supply and keep prices high, then each firm stands to capture substantial business from the others by breaking the agreement undercutting the others. Such competition can be waged through prices, or through simply the individual company expanding its own output brought to market.

investopedia.com