An oligopoly is a market where there are a few large dominant firms and each firm’s actions affect each other. Examples of oligopolies include banking, supermarkets, car manufacturers and OPEC.
1) A few large firms dominate the market. Many small firms may also exist but with no market power.
2) Large firms are interdependent, their actions affect each other.
3) There are significant entry barriers.
Kinked Demand Curve Large firms face a kinked demand curve because of interdependence. Assume firms produce close substitutes. If a firm raises its price, it loses a lot of sales to rivals who do not raise their prices, so demand is elastic above P*. If a firm lowers its price, it only gains a few sales as its rivals also lower their prices to keep their market share, so demand is inelastic below P*.
Non-Price Competition Because prices are rigid firms must engage in non-price competition. For example:
1) Branding: Brand image/loyalty makes demand more inelastic and attracts new consumers as the good seems unique.
2) Advertising: Create a brand image and inform consumers of the benefits of the firm’s good.
3) Innovation: A firm could invest in Research and Development (R&D) to develop new and better products for consumers and gain a competitive advantage over rivals.
4) Quality: Better quality than rival goods.
5) Loyalty Cards: Incentivizes consumers to keep shopping with a specific firm to gain rewards.
6) Longer Opening Hours: Convenience for consumers.
7) In-Store Services: Crèche, Post-Office, chemist etc. makes it convenient for consumers.
8) Banking and Financial Services: Convenience for consumers as everything is in one place.
9) Internet Shopping: Allows consumers to shop at home.
10) After-Sales Services: Incentivizes consumers to return to that firm.
Game Theory An oligopoly allows firms the chance to compete through collusion, that is, making an agreement with each other to price-fix and set high prices.
Assume a duopoly where only two firms A and B dominate the Prisoner’s Dilemma market. A and B’s dominant strategy is Low Price, it is the best option a player has no matter what the other player chooses. If B prices high, A earns the most profit by pricing low. If B prices low, A earns the most profit by pricing low. So Low Price is A’s dominant strategy. If A prices high, B earns the most profit by pricing low. If A prices low, B earns the most profit by pricing low. So Low Price is B’s dominant strategy. Low price is also a Nash equilibrium, A’s choice is optimal given B’s choice and vice versa. At Low Price, A and B do not change their behaviour. But A and B’s dominant strategy makes them both worse off because they can earn higher profits if they both charge a high price.
Collusion Alternatively then, A and B could collude to restrict output and raise prices, both charge a high price and earn more profit than at the Nash equilibrium. A and B must ensure that neither one cheats on their collusive agreement. If A (B) prices high, B (A) has the incentive of cheating and pricing low to take most of A’s (B’s) consumers and earn higher profits than colluding. A and B cannot draw up a contract to prevent cheating because contracts are illegal. Instead, A and B could use credible threats to deter cheating. A credible threat is one that is in the best interest of a punisher to act out, so players believe it will happen. A could use the credible threat of pricing low forever if B cheats on a collusive agreement and vice versa.
Overt collusion occurs when there is a formal agreement (written or verbal) amongst firms to control the market. Basically the price-fixing agreement is open. A and B could openly collude if there are no competition authorities/laws. An example is OPEC, there is no international law to stop oil rich Arab countries colluding. A and B cannot openly collude in countries like the UK, US and in the Eurozone because collusion is illegal so A and B cannot draw up legally binding contracts. Alternatively, A and B could verbally agree to price fix and threaten each other with a credible threat to deter cheating.
Tacit collusion occurs when there is an informal or implicit agreement amongst firms to control the market. For example, price leadership, where the price leader sets a high price and then rivals follow suit.