What is an Oligopoly?

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Definition:

An oligopoly is a market structure in which a few companies control an industry and set higher prices than they typically would if there were more competition.

🤔 Understanding Oligopolies

An oligopoly occurs when it is extremely difficult for new companies to enter into an industry. This barrier results in a few companies controlling that industry. These companies sell a similar product, usually only differentiated by branding and marketing. Since only a few companies are selling that type of product, it allows them to set and keep prices high for consumers. The only competition they have is between themselves, which typically stifles innovation.

Example

Fictitious companies A, B, and C, together provide 100% of the electricity to residents of a particular city. If Company C decreased prices, customers might switch to company C. But, if Companies A and B were to decrease their prices as well, there would be no benefit for customers to switch. In this example, all three companies would have decreased their revenue. There is little incentive for any one firm to decrease prices.

Takeaway

An oligopoly is like three young siblings bickering...

Think of three siblings fighting with each other. They can continue to fight and get grounded, or they could get along and all benefit with no punishment. Oligopolies work the same way. Three companies can try to fight a price war, or they can avoid a price war and all enjoy higher profits.

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What are the characteristics of an oligopoly?

Various characteristics define an oligopolistic market. The first is interdependence. Interdependence means a company must consider the actions of the other corporations. As an example, if a company launches a new advertising campaign, other companies probably will as well. So that first company needs to take the actions of the others into account when deciding what to do — This is called game theory.

The next characteristic of an oligopoly is that a few large firms control most sales in the industry. It allows them to control the market.

Another aspect is group behavior. Any decision made by one firm will affect other firms in the oligopoly. Group behavior means the companies may behave as a single entity. It expands upon interdependence. Firms may make decisions as a group that benefits all firms.

The next characteristic is barriers to entry. Barriers to entry make it difficult for new firms to enter the industry. One significant barrier is economies of scale. Economies of scale means that as a company grows, it will be able to decrease costs. Another barrier might be an exclusive patent to a product. A patent may prevent another company from producing a very similar product. A great example of this is the pharmaceutical industry. Three different companies may develop different drugs to treat the same ailment. If all three companies receive patents, it makes it difficult for new companies to develop their own drugs.

Another characteristic is price rigidity. Price rigidity happens when firms keep the price of their products the same. Since the firms in an oligopoly are interdependent, any price decrease by one usually will lead to a price decrease by their competition — This will likely just lead to lower profits for all. So, companies in an oligopoly typically have little incentive to lower their prices.

What are some examples of oligopolies?

There are many examples of oligopolies in today’s markets.

In the technology sector, there are smartphone operating systems. There are three major smartphone operating systems, including Android, iOS, and Windows. These three systems dominate the smartphone industry.

Two long-dominant operating systems in the personal computing industry are Windows and AppleOS. For a long time, these two operating systems have controlled market share. A third major operating system now is Linux. These three together control the global market.

Another example is in the pharmaceutical industry. Three major companies control the pharmaceutical industry –- Merck, Novartis, and Pfizer. Patents and high costs allow these major pharmaceutical companies to control the industry. It is costly to develop a drug. The high costs prohibit new companies from entering the industry. When a company develops a new drug, the patent allows them to control the market for a set period.

Another example of an oligopoly is in the media industry. Six companies control the vast majority of the media industry in the United States, namely Comcast, CBS Corp., News Corp., Viacom, and Disney.

Mobile phone carriers are perhaps the purest example of an oligopoly in the modern United States. Verizon, AT&T, Sprint, and T-Mobile overwhelmingly dominate the market for cell-phone carriers — and, as of 2019, T-Mobile and Sprint are moving ahead with a merger, which will leave only three major mobile carriers in the U.S.

What are some types of oligopolies?

There are a few different types of oligopolies. The first type is a pure or perfect oligopoly. A pure oligopoly occurs when firms create comparable or similar products. An example of a pure oligopoly would be in the electric power industry. The top companies are producing exactly the same product.

The next type of oligopoly is a differentiated oligopoly. A differentiated oligopoly is when firms create similar, but slightly different products — for example, cigarette companies or soda companies.

A third type is a collusive oligopoly. A collusive oligopoly happens when firms cooperative with each other to determine prices. In most cases, collusive arrangements are illegal. A collusive oligopoly can prevent a price war. An example of a legal collusive oligopoly is in the oil industry. OPEC controls the oil industry. OPEC includes 14 countries that work together to control the output of oil and set the price. OPEC is also an example of a cartel. A cartel is a type of oligopoly where there is a formal agreement between firms to work together.

The fourth type of oligopoly is a non-collusive oligopoly. A non-collusive oligopoly occurs when firms do not work together. But the firms are still interdependent. A great example of a non-collusive oligopoly is between Coca-Cola and PepsiCo. Both companies compete in the soft drink market. The companies don’t work together, but their corporate decisions are still interdependent.

What are the advantages and disadvantages of an oligopoly?

There are advantages and disadvantages to an oligopoly.

Advantages

With little competition, firms can generate higher profits. In an oligopoly, few firms are producing a similar product. This makes it easier for consumers to choose. In a non-collusive oligopoly, companies typically don’t increase or decrease prices out of fear of their competitors’ reactions. This leads to stable prices for consumers. A company may try to improve their product to make their brand stand out. This will lead their competitors to improve their products and brands. This leads to better products for consumers from all companies.

Disadvantages

Disadvantages of an oligopoly may include the barriers to entry for a new firm to enter the market. Barriers to entry stifle competition –- which can keep prices high. Another disadvantage is for customers that want more products to choose from. Since there are only a few firms, there are fewer choices.

What are some barriers to entry for an oligopoly?

Barriers to entry are a central characteristic of oligopolies. There are many barriers to entry that prevent new firms from entering an industry.

One major barrier to entry is often capital costs. Capital costs are one-time setup costs, such as purchasing a factory or new land. These costs can get expensive. This may prohibit new companies from entering an industry.

Another barrier is economies of scale. As large firms grow, their costs may get lower. Economies of scale make it difficult for a new company (starting out small) to compete with large companies. The new companies will have higher expenses. There are also legal barriers to entry. These include patents and copyrights owned by companies. A patent will allow a company exclusive right to produce their product for a set time limit. Copyright allows a company the exclusive use of a product.

Let’s take, for example, superheroes. Two companies control the superhero marketplace, Marvel and DC Comics. (At least when it comes to most of the popular, well-known superhero characters.) No other company may create products based on Marvel’s or DC Comics’ superheroes.

Extra barriers are marketing and advertising costs; large firms can spend enormous sums of money on promoting their brand. Brands can create loyalty with consumers, and brand loyalty makes it difficult for new firms to start a competing product.

What are the differences between an oligopoly and a monopoly?

A monopoly is another type of market structure. A monopoly occurs when one company dominates an industry. A monopoly may sound like an oligopoly, but there are a few key differences.

In a monopoly, there is no competition between firms; in an oligopoly, there is a small competitive market between a few firms. In a monopoly, there is only one single firm dominating the market. An oligopoly can include a small number of firms dominating a market.

A seller in a monopoly typically sells a unique product with no known substitutes. A customer has no choice when purchasing a product. Firms in an oligopoly usually have very similar products. More products lead to more options for the consumer. A seller in a monopoly has the sole discretion of setting prices of a product. The company can increase prices and charge as much as they want (though sometimes it is restrained by government regulations). Firms in an oligopoly have to consider each other actions on pricing. Limited competition leads to fairer prices that no competition.

In an oligopoly, barriers to entry make it difficult for new companies to enter the industry, but it is not impossible. In a monopoly, the barriers to entry make it extremely difficult for any other company to enter the industry; in many cases, it may be impossible.

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