Oligopolies

Characteristics

• A few large firms in the market.
• Identical or differentiated products.
• High barriers to entry (difficult for firms to enter and exit the market).
• Limited market power
• Strong interdependence between firms.
  

How to Determine if an Industry is an Oligopoly

• A concentration ratio is used to determine whether a market is an oligopoly, a monopoly or monopolistic competition.
• Concentration ratios used can vary. Some economists prefer CR4 ratios while others might prefer CR7 ratios.

• The CR4 ratio takes the 4 of the largest firms in the market and measures their combined market share concentration.
• If their market share is 0%, it would be perfect competition (only theoretical as there would need to be infinite producers)
• If below 50%, then there is monopolistic competition.
• If between 50 to 80% there is an oligopoly.
• If above 80%, then there is a likely monopoly.

Sources of Market Power

• Economies of scale
• High Start up costs
• Ownership of raw materials

Interdependence

• Firms in oligopolies have a high interdependence on another, due to the few number of producers in the market.
  
• Oligopolies have an incentive to collude (work together to set prices).
• If oligopolies collude, they essentially become a monopoly.
• Simultaneously, firms may also desire to compete with one another to gain higher market shares.
  
• As the market only has a few firms, if one firm lowers the price, it could easily lead to a price war, where the other firms also start lowering their price to sell more.
• Eventually all the firms lower their price until the other firms can no longer do so and collapse.
• This can lead to a monopoly forming in an oligopoly from a price war, especially if there is a duopoly.
  
• To avoid this outcome, which leads to losses for both firms, oligopolies tend to have very rigid pricing.
  Firms tend to observe one another in order to ensure the price is not being changed.

Game Theory

• Game theory is the study of how individuals behave in strategic conditions.
  
• When using game theory, you make decisions based on what your oppenent will likely do (interdependence).

Game Theory and Oligopolies

• Because oligopolies are interdependent, firms engage in interdependent strategic thinking.
• When oligopolies decide to collude, they work together as if they were a monopoly.

Collusions

Formal Collusion

• When firms openly agree on the price that they will charge although sometimes it may be agreement on market share or on marketing expenditure instead.

Tacit Collusion

• When firms charge the same prices without any formal collusion.
  As firms cannot be charged for formal collusion in this case, there is an incentive to cheat.

Competition

• Firms also have an incentive to compete by lowering prices to gain market share.
• Greater market share leads to more price control and greater revenue.
  However, this may lead to price wars.