Oligopoly

Definition

An oligopoly is a market structure characterized by a small number of firms that dominate the market, leading to limited competition and interdependence among the firms. This structure often results in companies being able to set prices above marginal costs due to the lack of competitive pressure. Because there are only a few players, each firm’s actions can significantly impact the others, making strategic decision-making crucial.

5 Must Know Facts For Your Next Test

1. In an oligopoly, firms may engage in collusion to set prices, leading to higher profits but potentially attracting regulatory scrutiny.
2. Price wars are less common in oligopolies due to the fear of retaliation from competitors, which can lead to reduced profits for all firms involved.
3. Oligopolistic markets often experience non-price competition, such as advertising and product differentiation, as firms strive to maintain their market share.
4. Barriers to entry are significant in oligopolies, making it difficult for new competitors to enter the market and challenge established firms.
5. Oligopolies can lead to inefficiencies in the market, such as higher prices for consumers and reduced output compared to more competitive markets.

Review Questions

• How do firms in an oligopoly interact with each other when setting prices, and what strategies do they use?
  • Firms in an oligopoly are interdependent, meaning that the pricing decisions made by one firm directly affect the others. They often use strategies such as collusion to agree on pricing and output levels to maximize their profits collectively. However, these interactions can lead to price rigidity; firms may avoid changing prices due to the potential for retaliation from competitors, leading them to focus on non-price competition methods instead.
• Discuss how barriers to entry affect the dynamics of an oligopolistic market.
  • Barriers to entry in an oligopolistic market can take many forms, including high capital requirements, brand loyalty, and control over essential resources. These barriers protect established firms from new entrants, allowing them to maintain their market power and influence over prices. Consequently, this leads to less competition and can result in higher prices and reduced innovation within the industry since new players are unable to enter the market easily.
• Evaluate the impact of oligopoly on consumer welfare compared to perfectly competitive markets.
  • Oligopoly generally results in lower consumer welfare compared to perfectly competitive markets due to higher prices and reduced output levels. In a perfectly competitive market, many firms compete fiercely, driving prices down to marginal cost levels and increasing overall consumer surplus. Conversely, oligopolies often engage in practices like collusion or limit pricing, which stifles competition and leads to inefficiencies that can harm consumers through higher prices and fewer choices.

Related terms

Market Power: The ability of a firm to influence the price of a good or service in the market, typically seen in less competitive environments like oligopolies.

Collusion: An agreement among firms in an oligopoly to set prices or output levels, effectively reducing competition and maximizing joint profits.

Kinked Demand Curve: A model used in oligopoly theory which suggests that firms face a demand curve that is more elastic for price increases and less elastic for price decreases, leading to price stability.