An oligopoly is a market dominated by a few producers. The market can be international, national, or local. The main characteristic of an oligopoly is that they have pricing power. However, unlike a monopoly that consists of a single firm dominating the market, an oligopolistic firm must take into consideration how the other producers will react to any changes in price. It is this mutual interdependence of the few firms producing the product that make an oligopoly different from a monopoly. Pricing and output are determined by strategic decisions, based on the expected response of other members of the oligopoly to changes in price or output by one member. Sometimes, oligopolists will try to increase their market power by forming a cartel, which is a group of firms acting in unison.
An oligopolistic firm is generally a large firm that had to invest a lot of capital to produce the product, such as aircraft, cars, and household appliances. This large initial investment of capital is a major barrier to entry to oligopolistic markets. Other barriers to entry include patents, control of strategic resources, and the ability to engage in retaliatory pricing to prevent firms from entering the market.
An oligopoly produces products that exhibit large economies of scale, where the cost of producing each unit declines with large quantities. Such economies of scale prevent other firms from entering the market, since there would be little market share that could be gained, and what could be gained would not be enough to be profitable.
An oligopoly can produce either homogeneous or differentiated products. A homogeneous product is not distinguished by quality differences from products produced by other firms. Most often such products consists of elements that are mined, such as zinc, copper, aluminum, lead, or produced from these elements, such as the production of steel. Although these products are mined from the earth, large amounts of capital are required to acquire the land, since ores that can be mined economically are located only in a few places. Then there is a large expenditure for equipment required to extract the ore and to separate the elements into a usable form.
A differentiated oligopoly produces differentiated products, much as in monopolistic competition. However, because the production of the products requires large amounts capital and exhibits steep economies of scale, the entry of firms is limited. Products produced by a differentiated oligopoly include electronics, cereals, cigarettes, sporting goods, motor vehicles, and aircraft.
Some oligopolies start as independent businesses that grow with the economy, but many oligopolies are created by mergers, which are prevalent in such industries as airlines, banking, and entertainment. Mergers allow firms to attain a greater economy of scale by increasing their market share. A larger firm would also have more control over its prices and would have buying power for buying inputs to produce its products, thus, commanding lower prices from suppliers. The other main benefit to a merger is that it eliminates one or more competitors, since they are merged into the new company.
An oligopoly is said to exist when at least 40% of a market is controlled by a few firms. To determine what type of market exists, economists have developed the Standard Industrial Code (SIC) to categorize firms according to their product or service. The SIC code is 2 to 4 digits, with 2 digits describing a broad industry or major group, while 3- and 4-digit codes describes smaller industry groups within the broad definition. Example:
- furnitures and fixtures: 25
- office furniture: 252
- wood office furniture: 2521
There are 2 commonly used measures that indicate the degree of dominance by a few firms: concentration ratios and the Herfindahl Index. The concentration ratio equals the total percentage of output produced by the industry's 4 largest firms. So a concentration ratio of 55% means that the top 4 firms control 55% of the market. If the concentration ratio is less than 40%, then the market is considered monopolisticly competitive; between 40% and 60%, oligopolistic; exceeding 60%, monopolistic.
However, concentration ratios suffer from 3 flaws: localized markets, inter-industry competition, and world trade.
Since concentration ratios are generally ratios for national markets, some oligopolies may exist locally even though there are many firms across the country. For instance, the newspaper industry and TV and radio stations are dominated by a few firms in local markets, even though there are many of these firms scattered throughout the country. There are also many concrete producers nationally, but only a few firms dominate the local market, because of high transportation costs.
Concentration ratios do not measure inter-industry competition, where some oligopolistic products have close substitutes. For instance, silver, aluminum, and copper can be used in many of the same applications, and which is used will often be determined by price.
Concentration ratios do not account for import competition from foreign suppliers. For instance, the main competitor to Boeing is Airbus in Europe. Hence, importation helps to reduce the power of domestic oligopolies.
A better measure of concentration ratio is what is called the Herfindahl Index (aka Herfindahl-Hirshman index, or HHI) which is based on the following equation:
Herfindahl Index = %S12 + %S22 + … + %Sn2
The 1st term is the market share percentage of Firm 1, the 2nd term is the market share percentage of Firm 2, and so on, to the nth firm.
This yields a single concentration score that can be quickly assessed. For instance, consider a market dominated by a single firm — a pure monopoly. It would have an index of 10,000 because it would have 100% market share which, when squared = 10,000. A market dominated by 2 firms, each with a market share of 50%, would have an index of 5000, which yields 2,500 + 2,500 for a total of 5000. However, suppose the 1st firm had a 75% market share and the 2nd firm had 25%:
Herfindahl Index = 752 + 252 = 5,625 + 625 = 6,250
As can be seen, Herfindahl Index yields a better measure of the market power exhibited by the largest firms. Note that for monopolistic competition or even pure competition each firm's market share would be small, and thus, it would have a very small index, indicating that no firm has any market power.
Next: Game Theory of Oligopolistic Pricing Strategies