Oligopoly is an imperfect market structure in which few firms that dominate the industry are interdependent. It is the most realistic market structure. The bulk of the market share is concentrated in the hands of the few dominant firms. The sum of the market shares of the top firms, which is also known as the concentration ratio, is high. A market dominated by three firms may have a concentration ratio of 75%.
Features of oligopolistic market
The actions of one of the dominant firms will have an effect on the others. For example, if one firm decides to advertise, it may reduce the sales and profits of other firms. So, firms envisage the actions that competitors may take when formulating their own strategies or policies. Game theory explains the interdependence among the firms in an oligopoly.
High barriers to entry
This is why few firms dominate the market. The absence of barriers encourages new entrants to enter the industry and the market share of the few large firms will not be protected.
Firms may compete on a non-price basis leaving the price unchanged. Non-price competition comes in form of better product features, improved packaging, advertising and promotions aimed at improving product preference at the expense of competing brands. The kinked demand curve model offers an explanation for the rigidity of price that is often observed in an oligopolistic market.
Firms collude for joint profit maximisation instead of engaging in price wars or undercutting one another. With collusion, they either agree to control price or quantity to ensure profit is jointly maximised, e.g. a cartel.
They could compete based on price in which case a price war ensues. This can hamper profit maximisation because they have to undercut each other not minding their costs of production. But collusion is beneficial for all; while it pays to collude, the competitive behaviour in oligopoly will erase abnormal profit as the slim gap between players lead to lower total revenue.
The firms may pursue profit maximisation or any other objectives. If profit maximisation is the objective, it will not engage in price wars with competitors. Price competition will not result in the highest profit possible; it may even result in losses as firms attempt to undersell competitors. This is the reason firms will rather compete on other bases apart from price.
Nature of the products
The product may be homogeneous or heterogeneous. The industry may consist of firms that offer the same kind of product just like it is obtainable in perfect competition. Products may be differentiated by the firms in an oligopoly such as car manufacturers, producers of household products, etc.
Oligopoly is a type of imperfect market structure hence players are not aware of all the prevailing market conditions such as competitors’ prices, output and strategies. This contributes to the uncertainty that characterises this type of market. Consequently, the firms may opt for collusion since they may find it difficult to predict their competitors’ next move.
The kinked demand curve model
There are many models that explain the behaviour of oligopolists. One of them is the kinked demand curve theory or the Sweezy model developed by Paul Sweezy in the USA. This model explains why the price is rigid or unchanged in an oligopolistic market.
The demand curve ABF is kinked at B (Figure 1 below). If a firm increases its price, its market share will be reduced because other firms will leave their prices unchanged and take its customers. This is why the demand curve is relatively elastic above price P. But if a firm reduces its prices, other competitors will do the same in order to maintain their market share. Part BF of the demand curve is relatively inelastic; a reduction in price will result in revenue loss when demand is relatively inelastic. This is why oligopolists are always reluctant to change their prices. Therefore, prices are relatively stable and market participants may engage in non-price competition such as product features, packaging, promotion and distribution network, after-sale services and customer service.
The marginal revenue curve is ACDE (Figure 1 below). Prices and output will be unchanged by the oligopolist no matter the change in marginal cost in the discontinued part CD of the marginal revenue curve.
Figure 1: Kinked demand curve