An oligopoly (ολιγοπώλιο) (from Greek ὀλίγοι πωλητές (few sellers)) is a market form wherein a market or industry is dominated by a small number of large sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce competition and lead to higher prices for consumers. Oligopolies have their own market structure.
With few sellers, each oligopolist is likely to be aware of the actions of the others. According to game theory, the decisions of one firm therefore influence and are influenced by decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market. Entry barriers include high investment requirements, strong consumer loyalty for existing brands and economies of scale. In developed economies oligopolies dominate the economy as the perfectly competitive model is of negligible importance for consumers. Oligopolies differ from price takers in that they do not have a supply curve. Instead, they search for the best price-output combination.
Oligopoly is a common market form where a number of firms are in competition. As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This measure expresses, as a percentage, the market share of the four largest firms in any particular industry. For example, as of fourth quarter 2008, if we combine total market share of Verizon Wireless, AT&T, Sprint, and T-Mobile, we see that these firms, together, control 97% of the U.S. cellular telephone market.[ citation needed ]
Oligopolistic competition can give rise to both wide-ranging and diverse outcomes. In some situations, particular companies may employ restrictive trade practices (collusion, market sharing etc.) in order to inflate prices and restrict production in much the same way that a monopoly does. Whenever there is a formal agreement for such collusion, between companies that usually compete with one another, this practice is known as a cartel. A prime example of such a cartel is OPEC, which has a profound influence on the international price of oil.
Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development.[ citation needed ] There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual communication between companies)–for example, in some industries there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership.
In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater when there are more firms in an industry than if, for example, the firms were only regionally based and did not compete directly with each other.
Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's structure. In particular, the level of dead weight loss is hard to measure. The study of product differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition.[ citation needed ]
Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies:
Oligopolies become "mature" when they realise they can profit maximise through joint profit maximising. As a result of operating in countries with enforced competition laws, the Oligopolists will operate under tacit collusion, which is collusion through an understanding that if all the competitors in the market raise their prices, then collectively all the competitors can achieve economic profits close to a monopolist, without evidence of breaching government market regulations. Hence, the kinked demand curve for a joint profit maximising Oligopoly industry can model the behaviours of oligopolists pricing decisions other than that of the price leader (the price leader being the firm that all other firms follow in terms of pricing decisions). This is because if a firm unilaterally raises the prices of their good/service, and other competitors do not follow then, the firm that raised their price will then lose a significant market as they face the elastic upper segment of the demand curve. As the joint profit maximising achieves greater economic profits for all the firms, there is an incentive for an individual firm to "cheat" by expanding output to gain greater market share and profit. In Oligopolist cheating, and the incumbent firm discovering this breach in collusion, the other firms in the market will retaliate by matching or dropping prices lower than the original drop. Hence, the market share that the firm that dropped the price gained, will have that gain minimised or eliminated. This is why on the kinked demand curve model the lower segment of the demand curve is inelastic. As a result, price rigidity prevails in such markets.
There is no single model describing the operation of an oligopolistic market.The variety and complexity of the models exist because you can have two to 10 firms competing on the basis of price, quantity, technological innovations, marketing, and reputation. However, there are a series of simplified models that attempt to describe market behavior by considering certain circumstances. Some of the better-known models are the dominant firm model, the Cournot–Nash model, the Bertrand model and the kinked demand model.
The Cournot–Nash model is the simplest oligopoly model. The model assumes that there are two "equally positioned firms"; the firms compete on the basis of quantity rather than price and each firm makes an "output of decision assuming that the other firm's behavior is fixed." .The market demand curve is assumed to be linear and marginal costs are constant. To find the Cournot–Nash equilibrium one determines how each firm reacts to a change in the output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a point is reached where neither firm desires "to change what it is doing, given how it believes the other firm will react to any change." The equilibrium is the intersection of the two firm's reaction functions. The reaction function shows how one firm reacts to the quantity choice of the other firm. For example, assume that the firm 1's demand function is P = (M − Q2) − Q1 where Q2 is the quantity produced by the other firm and Q1 is the amount produced by firm 1, and M=60 is the market. Assume that marginal cost is CM=12. Firm 1 wants to know its maximizing quantity and price. Firm 1 begins the process by following the profit maximization rule of equating marginal revenue to marginal costs. Firm 1's total revenue function is RT = Q1P = Q1(M − Q2 − Q1) = MQ1 − Q1Q2 − Q12. The marginal revenue function is
Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2.
To determine the Cournot–Nash equilibrium you can solve the equations simultaneously. The equilibrium quantities can also be determined graphically. The equilibrium solution would be at the intersection of the two reaction functions. Note that if you graph the functions the axes represent quantities.The reaction functions are not necessarily symmetric. The firms may face differing cost functions in which case the reaction functions would not be identical nor would the equilibrium quantities.
The Bertrand model is essentially the Cournot–Nash model except the strategic variable is price rather than quantity.
The model assumptions are:
The only Nash equilibrium is PA = PB = MC.
Neither firm has any reason to change strategy. If the firm raises prices it will lose all its customers. If the firm lowers price P < MC then it will be losing money on every unit sold.
The Bertrand equilibrium is the same as the competitive result.Each firm will produce where P = marginal costs and there will be zero profits. A generalization of the Bertrand model is the Bertrand–Edgeworth model that allows for capacity constraints and more general cost functions.
According to this model, each firm faces a demand curve kinked at the existing price.The conjectural assumptions of the model are; if the firm raises its price above the current existing price, competitors will not follow and the acting firm will lose market share and second if a firm lowers prices below the existing price then their competitors will follow to retain their market share and the firm's output will increase only marginally.
If the assumptions hold then:
The gap in the marginal revenue curve means that marginal costs can fluctuate without changing equilibrium price and quantity.Thus prices tend to be rigid.
In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. Market shares in an oligopoly are typically determined by product development and advertising. For example, there are now only a small number of manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have participated in the small passenger aircraft market sector. Oligopolies have also arisen in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate.
In an oligopoly, firms operate under imperfect competition. With the fierce price competitiveness created by this sticky-upward demand curve, firms use non-price competition in order to accrue greater revenue and market share.
"Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend–"kink". Thus the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.
Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.
The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price decreases. Theory predicts that firms will enter the industry in the long run.
Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.
Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. In the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition.
In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been theoretically demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.
This aims to be a complete article list of economics topics:
In economics, profit maximization is the short run or long run process by which a firm may determine the price, input, and output levels that lead to the highest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.
In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. For example, in the standard text perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal. Market equilibrium in this case is a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes, and quantity is called the "competitive quantity" or market clearing quantity. But,the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.
Price points are prices at which demand for a given product is supposed to stay relatively high.
The following outline is provided as an overview of and topical guide to industrial organization:
In economics and commerce, the Bertrand paradox — named after its creator, Joseph Bertrand — describes a situation in which two players (firms) reach a state of Nash equilibrium where both firms charge a price equal to marginal cost ("MC"). The paradox is that in models such as Cournot competition, an increase in the number of firms is associated with a convergence of prices to marginal costs. In these alternative models of oligopoly, a small number of firms earn positive profits by charging prices above cost. Suppose two firms, A and B, sell a homogeneous commodity, each with the same cost of production and distribution, so that customers choose the product solely on the basis of price. It follows that demand is infinitely price-elastic. Neither A nor B will set a higher price than the other because doing so would yield the entire market to their rival. If they set the same price, the companies will share both the market and profits.
In economics and particularly in industrial organization, market power is the ability of a firm to profitably raise the market price of a good or service over marginal cost. In perfectly competitive markets, market participants have no market power. A firm with total market power can raise prices without losing any customers to competitors. Market participants that have market power are therefore sometimes referred to as "price makers" or "price setters", while those without are sometimes called "price takers". Significant market power occurs when prices exceed marginal cost and long run average cost, so the firm makes economic profit.
In microeconomics, marginal revenue (MR) is the additional revenue that will be generated by increasing product sales by one unit.
Bertrand competition is a model of competition used in economics, named after Joseph Louis François Bertrand (1822–1900). It describes interactions among firms (sellers) that set prices and their customers (buyers) that choose quantities at the prices set. The model was formulated in 1883 by Bertrand in a review of Antoine Augustin Cournot's book Recherches sur les Principes Mathématiques de la Théorie des Richesses (1838) in which Cournot had put forward the Cournot model. Cournot argued that when firms choose quantities, the equilibrium outcome involves firms pricing above marginal cost and hence the competitive price. In his review, Bertrand argued that if firms chose prices rather than quantities, then the competitive outcome would occur with price equal to marginal cost. The model was not formalized by Bertrand: however, the idea was developed into a mathematical model by Francis Ysidro Edgeworth in 1889.
Cournot competition is an economic model used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine Augustin Cournot (1801–1877) who was inspired by observing competition in a spring water duopoly. It has the following features:
In economics the long run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long run contrasts with the short run, in which there are some constraints and markets are not fully in equilibrium.
Partial equilibrium is a condition of economic equilibrium which takes into consideration only a part of the market, ceteris paribus, to attain equilibrium.
Tacit collusion occurs where firms undergo actions that are likely to minimize a response from another firm, e.g. avoiding the opportunity to price cut an opposition. Put another way, two firms agree to play a certain strategy without explicitly saying so. Oligopolists usually try not to engage in price cutting, excessive advertising or other forms of competition. Thus, there may be unwritten rules of collusive behavior such as price leadership. A price leader will then emerge and it sets the general industry price, with other firms following suit. For example, see the case of British Salt Limited and New Cheshire Salt Works Limited.
The Kinked-Demand curve theory is an economic theory regarding oligopoly and monopolistic competition. Kinked demand was an initial attempt to explain sticky prices.
In oligopoly theory, conjectural variation is the belief that one firm has an idea about the way its competitors may react if it varies its output or price. The firm forms a conjecture about the variation in the other firm's output that will accompany any change in its own output. For example, in the classic Cournot model of oligopoly, it is assumed that each firm treats the output of the other firms as given when it chooses its output. This is sometimes called the "Nash conjecture" as it underlies the standard Nash equilibrium concept. However, alternative assumptions can be made. Suppose you have two firms producing the same good, so that the industry price is determined by the combined output of the two firms. Now suppose that each firm has what is called the "Bertrand Conjecture" of −1. This means that if firm A increases its output, it conjectures that firm B will reduce its output to exactly offset firm A's increase, so that total output and hence price remains unchanged. With the Bertrand Conjecture, the firms act as if they believe that the market price is unaffected by their own output, because each firm believes that the other firm will adjust its output so that total output will be constant. At the other extreme is the Joint-Profit maximizing conjecture of +1. In this case each firm believes that the other will imitate exactly any change in output it makes, which leads to the firms behaving like a single monopoly supplier.
In microeconomics, the Bertrand–Edgeworth model of price-setting oligopoly looks at what happens when there is a homogeneous product where there is a limit to the output of firms which they are willing and able to sell at a particular price. This differs from the Bertrand competition model where it is assumed that firms are willing and able to meet all demand. The limit to output can be considered as a physical capacity constraint which is the same at all prices, or to vary with price under other assumptions.
A Monopoly price is set by a Monopoly. A monopoly occurs when a firm lacks any viable competition, and is the sole producer of the industry's product. Because a monopoly faces no competition, it has absolute market power, and thereby has the ability to set a monopoly price that will be above the firm's marginal (economic) cost. Since marginal cost is the increment in total required to produce an additional unit of the product, the firm would be able to make a positive economic profit if it produced a greater quantity of the product and sold it at a lower price.
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