A market structure with only a small number of large sellers or producers.

Author: Zihang Tang
Zihang Tang
Zihang Tang
My name is Zihang Tang. I'm a senior student at NYU majoring in Economics and minoring in Business Studies.
Reviewed By: Hassan Saab
Hassan Saab
Hassan Saab
Investment Banking | Corporate Finance

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside M&A, restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a BS from the University of Pennsylvania in Economics.

Last Updated:November 28, 2023

What Is an Oligopoly?

An oligopoly is a market structure with only a small number of large sellers or producers. Typically, this market structure only consists of two or more firms, resulting from the desire for profit maximization and collusion between firms. 

No single firm can change the price by itself in this market structure. Instead, all firms must simultaneously collude and raise or down the price to achieve a higher profit.

During the Industrial Revolution, the production of goods and services and the competition between companies increased, as did the formation of both monopolies and oligopolies.

In the 1900s, several large companies dominating the US automobile and steel industries were the first oligopolies.

Due to antitrust policy, which prevents monopolistic power. The major difficulty that oligopolies face is the prisoner’s dilemma. The firms in this market structure will not only think of themselves but also consider other firms’ actions.

Government policies can discourage or encourage oligopolistic behavior, and companies in mixed economies often seek government approval to find ways to limit competition. 

Many industries, such as civil aviation, electricity providers, telecommunications, steel manufacturers, oil companies, and railroads, are considered oligopolies. 

There are still some economic concerns about the oligopoly market, which include preventing small and new companies from entering the industries and setting high prices. 

Under this market structure, firms can negotiate prices instead of taking the market price. This leads to a high-profit margin than a competitive market.

Why do oligopolies exist?

A few big businesses dominate sales for the whole or almost entire sector and frequently work together to stifle competition. As a result, within this market system, there is less competition between businesses, but monopolies give monopolists more power and bigger profits.

Several conditions enable this market structure:

  • Large Investment of Capital
  • Legal Restriction and Patents
  • Control of Indispensable Resources

The firms see the high-profit margin in this market at a specific price. By maintaining this price, firms can raise the barriers to entering this industry and protect themselves from new entrants. In this way, it’s hard for new firms to invest large amounts of capital.

Some industries, like the telecommunications sector, need a country’s certification or patent rights. In this way, it’s extremely difficult for the new company to get the certification or patent to enter the industry. In addition, some industries have a large investment at first. Investing such a large amount of money into capital is impossible for new entrants. 

Some companies gain more cost advantages than others because they have control over some key resources. This allows them to make money at prices that others cannot survive.

Oligopoly Characteristics

There are many characteristics to enable this kind of market structure, which explains how to maintain this market structure and how to set a price. 

Here are some examples of characteristics:

1. Interdependence

One of the key features is interdependence. As we know, the oligopolistic market only consists of a few large firms. 

The action made by each firm will affect the whole market condition. Therefore, when a firm makes any decision, it will consider all other competitors’ actions. 

For example, if the industry consists of firm 1, firm 2, and firm 3. If firm 1 raises the price but firms 2 and 3 not, firm 1 will lose all of the markets. 

If firm 1 decreases the price, firms 2 and 3 will also decrease the price to maintain the market share. This will cause all the firms in the industry to lose high-profit margins. 

Therefore, the best strategy is to keep the price. The relationship between firms is called interdependence.

2. High Barrier to entry

The firms maintain their position through many barriers to entry, such as certification, patents, and high cost of capital. 

These barriers prevent new firms from entering the industry and thus set this industry apart from the competitive market. In this way, the firms can maximize their profit.

3. Non-price competition

The reason that the price is the same is that firms in this market structure have non-price competition. Instead, they compete through factors other than price, including advertisement and product differentiation.

Oligopolies and Game Theory

When it comes to oligopoly, game theory is how we understand it. Game theory is the ideal framework for understanding the interdependence between firms.

How does it work? Let’s begin by getting to an example. There are only two companies in an oligopoly, Company A and Company B. These companies sell similar products. Here’s the game theory pay-off matrix. 

  Company B
Company A   Low Price High Price
Low price $800, $700 $400, $800
High Price $600, $500 $200, $400

From the matrix, we can see the strategies for each company first. Then, each company can choose either a low-price or high-price strategy on the top and left of the matrix. 

The numbers within the matrix are the pay-off of each firm. The number on the left is the profit for Company A in the particular situation, and the number on the right is the profit for Company B in the particular situation.

There are four possible outcomes. First, each firm can choose either a low or a high price. For example, the quadrant on the upper left means Companies A and B choose low-price strategies. The total profit for this situation will be $800+$700=$1500.

What is the collusion outcome? The collusion outcome is the outcome that is best for both firms together. We simply find the largest combined profit among the four possible outcomes in this question. 

The answer is on the upper left quadrant, which is $800 + $700 = $1500.

But in the real world, due to the antitrust policy, which prevents monopolistic power in oligopolies, this situation won’t happen.

What is likely to happen? Instead, we need to pick the brain one by one. But remember, one key characteristic of an oligopolistic market is interdependence. We can’t just think of ourselves, but also another firm’s decision. And based on this information, make decisions.

Let’s first be Company A. If Company B chooses a low price, Company A will choose a low price because the profit of the low-price strategy($800) is greater than the high-price strategy($600). Similarly, Company A will choose a low price if Company B chooses a high price.

In this situation, Company A will always choose a low-price strategy no matter what price strategy Company B makes. So low-price strategy is the dominant strategy for Company A.

On the other hand, let’s be Company B. If Company A chooses a low price, Company B will choose a high price strategy. If Company A chooses a high price, Company B will choose a low price.

In this situation, Company B chooses two different strategies under two situations. In other words, their decision is dependent on what Company A does. Company B doesn’t have a dominant strategy.

Nash equilibrium:

  Company B
Company A   Low Price High Price
Low price $800, $700 $400, $800
High Price $600, $500 $200, $400

Nash equilibrium is the quadrant with two selected choices. Mark Company A’s choice and Company B’s choice as.

In the upper right quadrant, we see Company A’s and Company B’s choices. So the upper right quadrant is the nash equilibrium, where Company A chooses a low price and Company B chooses a high price. So it is the most likely outcome that we can see.

Advantages of an Oligopoly

A market known as an oligopoly has few enterprises, none of which can prevent the others from having a significant impact. The fixation or concentration proportion calculates the market share held by the largest companies. 

Consider commercial aviation, auto, cable television, etc.

Oligopolistic firms utilize their market influence to set the pricing and maximize profits. The enterprises in this situation either compete with one another or work together. 

Thus, customers take on the role of price takers. In an oligopoly, there are many obstacles to entry into the market, making it challenging for new businesses to get established.

The advantages include:

1. The high profit earned by the oligopolistic market can get into research and development

In an oligopolistic market, the firms set a price that enables a high-profit margin. This causes the companies in that market to earn much more profit than the competitive market. Companies could invest the extra money into research and development to help consumers.

2. Stable price in the market

As we mentioned before, oligopolistic companies maintain a stable price. This price stability helps consumers to plan and make fewer debts.

3. Able to change to a competitive market

Although an oligopoly may result in inefficiency and a lack of innovation, it also has the choice of pursuing competitive outcomes. 

The economic outcome is comparable to what is possible under more competitive market structures when the relevant enterprises take advantage of this advantage. Consumers may gain from cheaper costs and higher-quality products and services in this case. 

Although there won’t be much rivalry in the market, there may still be fierce competition in how organizations behave.

Disadvantages of an Oligopoly

A market with an oligopoly has a small number of companies. Although the number of enterprises is unclear, 3-5 dominant firms are considered typical. Therefore, in this market, there are far more buyers than sellers.

So, the disadvantages include:

1. Limited choice for consumers

In an industry like telecommunications, there are only a few firms. As a result, consumers’ choice is limited compared to the competitive market.

2. Firms are unable to make independent decisions.

Firms cannot make independent judgments and must always consider the perspectives of other dominant market participants. An oligopoly choice forces enterprises to collaborate rather than compete with one another.

3. Less Opportunity for Small Businesses to Expand

Because larger companies in an oligopolistic economy take up the majority of the market, small businesses struggle to establish themselves. 

Entry barriers prevent new businesses from entering the market. As a result, there is less competitive competition because there is little threat from new competitors.

Example of an Oligopoly

The various examples to understand this market structure are:

1. Technology

The industry of computer technology provides the clearest illustration of oligopolistic markets. Apple and Windows are two well-known names regarding computer operating software. These two firms have controlled the majority of the market share. 

In this market structure, Linux Open Source is a further player. However, since these three companies control nearly all the global market share, there aren’t many different players in this industry. 

The same applies to smartphone operating systems, with Android & iOS controlling most of the market. As a result, these businesses coexist without endangering anyone else.

2. Automobile

Ford Motor Company, Toyota Motor Corporation, and General Motors are the three largest car brands in the world. They are referred to as the Big Three in the automobile sector, which shows they hold a unique position there.

With a combined sales volume of more than 5.2 million units as of 2019, Ford Motor Company, Toyota Motor Corporation, and General Motors were the top three US automakers. Ford maintained its position as America’s largest automaker by revenue for the second year by placing 12th on the 2020 Fortune 500 list.

3. Telecommunications

AT&T once was a monopoly in the market. However, after spinoffs, AT&T, Verizon, and T-mobile are in an oligopolistic market, and they own a large percentage of the market share.

4. Airlines

Airlines in the US are an oligopolistic market. Four major American airlines: American Airlines Inc., Delta Air Lines Inc., Southwest Airlines, and United Airlines Holdings Inc. According to the survey, 65% of the passengers have flown from these companies.

5. Music Entertainment

A large portion of the music market is controlled by three major companies: Japanese-owned Sony Music, French-owned Universal Music Group, and US-owned Warner Music Group.

Oligopoly Vs. Other market structures

The many market types comprise the market structure, characterized by the nature and intensity of competition for the products and services offered. 

The concept of rivalry succeeding in a certain kind of market will determine the forms of the market, whether for the products market, the factor market, or the service market.

1. Monopoly

A monopoly is a market structure consisting of only a single producer dominating the market. 

The reason for that is the monopolistic company limits the availability of substitutes. The firm in a monopoly market can set prices and create high barriers for new firms to enter. 

2. Oligopoly

An oligopolistic market structure has only a small number of large firms dominated by most market share. Firms in oligopolies need to collude and set a price together. No single firm can change the price by itself. This market structure creates high barriers to entry.

3. Monopolistic Competitive 

This market exists when the firms offer similar products but not the same. As a result, the barriers to entry are low. 

The relationship between companies is independent, which means that firms’ decisions will not affect each other. The competing factors between firms are pricing and product difference.

4. Perfect Competitive

The market is a theoretical market structure with many firms selling identical products.

All firms in a perfectly competitive market are price-takers. The barriers to entry are the lowest among all market structures. The market share of a company does not influence the price.

Researched and authored by Bill Tang | LinkedIn

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