Oligopoly Definition Market Characteristics How It Works

Oligopoly Definition

It is one of the four market situations, including perfect competitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products.read more, monopoly, and monopolistic competition. Oligopolists offer comparable products or services, so they control prices rather than the market. They do so through collusion that results in higher prices and fewer production or product choices for customers. It encourages existing brands to improve product quality and originality by instilling a sense of rivalry.

Key Takeaways

An oligopoly is a market structure where a few large firms collude and dominate a particular market segment. Due to minimal competition, each of them influences the rest through their actions and decisions.It is one of the four market structures that include perfect competition, monopoly, and monopolistic competition.Market players in an oligopolistic market focus on non-price competition, ensure their brands are uniquely identifiable and apply hidden advertising tactics.Raised barriers to entry, price-making power, non-price competition, the interdependence of firms, and product differentiation are all oligopoly characteristics.

How Does Oligopoly Market Work?

The factors that determine a market structure include the number of businesses, control over prices, and barriers to market entry. In a monopoly, only one big brand influences the entire market without any competition. When two major players dominate a sector, the market becomes a duopolyDuopolyWhen there are two market leaders in any industry or service, this is referred to as a duopoly. Such companies have complete control of the market, earning high profits and gains in a specific sector or service. In the credit card industry, for example, Visa and MasterCard have a duopoly.read more. Here, they focus on each other and try to exceed customer expectations in every possible way. In an oligopoly, a few dominant brands offer most of the products and services and make significant decisions on behalf of the rest.

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The presence of a small number of companies in an oligopoly market structure makes it highly concentrated. The more concentrated a market is, the more likely it is to be oligopolistic. Businesses in such a market collaborate to dominate the rest of the players and maximize joint revenue.

Oligopolists do not compete with each other. Instead, they collaborate on various fronts, such as economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more, market demand, and product differentiationProduct DifferentiationProduct differentiation refers to making a product look attractive and different from other products in the same class. Marketers highlight the distinguishing features in the product commonly through packaging or a good design, which helps communicate the benefitting factors to the shoppers.read more. Also, they rely on free-market forces to earn higher profits than a competitive market. In doing so, they reduce production and increase prices, a phenomenon called collusion. The group that colludes is referred to as a cartelCartelA cartel is a group of producers of goods or suppliers of services formed through an agreement amongst themselves to regulate the supply of goods or services with the basic intent to illegally regulate the prices or restrict competition regarding the said goods or services.read more. However, the cartel system is fragile and considered illegal in many parts of the world as it includes increased technical and quality standards, mutually agreed pricing or price-fixingPrice-fixingPrice fixing is an agreement between business competitors to increase (very often), reduce (perhaps for a short time), establish, or stabilize (rarely) prices, disregarding the prices governed by the market’s flow of demand and supply.read more, etc.

Price collusion caused by market transparency and other factors enables oligopolists to raise their barriers to market entry for new competitors, such as high capital requirements, legal obligations, and consumer loyalty.

Kinked Demand Curve

Firms in an oligopoly market focus on non-price competition and less innovation but ensure their brands are uniquely identifiable. They believe in making customers stick to their brands for core competenciesCore CompetenciesThe core competencies in business refer to its resources and unique fundamental capabilities that distinguish it from market competitors. It is an essential component of marketing strategy leading to brand recognition and business growth. The concept serves to be useful for companies focusing on multiple product lines and operating more than one business unit at a time. read more rather than lower prices to gain profits and market share. Despite having the same market share, a smaller number of firms causes oligopolists to get influenced by each other’s decisions, such as price cuts and increases.

How oligopolists react to the price change by one firm can be best understood with the downward-sloping Kinked demand curve. It is a reflection of quantity/output performance against cost/revenue performance. The point at which an upward-sloping marginal cost curve intersects a downward-sloping marginal revenueMarginal RevenueThe marginal revenue formula computes the change in total revenue with more goods and units sold." The value denotes the marginal revenue gained. Marginal revenue = Change in total revenue/Change in quantity sold. read more curve results in a convex bend, known as kink.

Marginal costMarginal CostMarginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit. It is calculated by dividing the change in the costs by the change in quantity.read more is the cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more, and marginal revenue is the product price. Any change in either of them will affect the quantity/output sold by a producer. Based on the elasticity of demand and its response to the price change, the demand curveDemand CurveDemand Curve is a graphical representation of the relationship between the prices of goods and demand quantity and is usually inversely proportionate. That means higher the price, lower the demand. It determines the law of demand i.e. as the price increases, demand decreases keeping all other things equal.read more shifts.

Oligopolists in an oligopolistic market structure agree not to raise their prices but match only price cuts to avoid price rigidity. However, too much price decrease can lead to a price warPrice WarA price war is a competition among the competitors of the business in lowering the price of their products to gain an advantage over their competitors in price and capture a greater market share. It is used as one of the strategies to increase the business firm’s revenue and increase the market share.read more. As a result, each firm obligates to adhere to pre-determined price and quantity/output levels to maximize revenue.

So when an oligopolist decreases prices to increase output, others follow the path. On the other hand, if an oligopolist reduces output by raising prices, the rest refrain from doing so. Thus, each firm gains a considerable market share with minimal potential profits.

Oligopoly Business

Let us consider the following examples to understand the concept better:

Example #1

Samsung and Nokia are two big players in the Android smartphones industry, with the former trying to capture the market by keeping the price lenient. Nokia, however, offers Android phones with the same features and almost similar prices.

As their products seem visually identical, both the brands have to make sure they offer customers something that the other does not. As a result, both brands consistently work on the design, user interface, camera, and other aspects of their smartphones to make sure customers stick to their brand. This way, Samsung and Nokia ensure non-price competition by enhancing core capabilities to build a loyal customer base.

Example #2

Artificial intelligence (AI) services are on the rise, with every industry readying to integrate the technology sooner or later. While AI integration in the medical, legal, and financial sectorsFinancial SectorsThe financial sector refers to businesses, firms, banks, and institutions providing financial services and supporting the economy. It encompasses several industries, including banking and investment, consumer finance, mortgage, money markets, real estate, insurance, retail, etc.read more is in progress, the automobile industry has already introduced AI-powered self-driving cars.

Given the emergence and expected evolution of AI-driven services in various niches, it is likely that there will be a highly concentrated market devoted explicitly to the AI needs of consumers. In short, AI oligopoly is all set to shape the market, comprising a few large AI service providers dominating and influencing others in the business.

Characteristics of Oligopoly

An oligopolistic market exhibits the following oligopoly features:

#1 – High Barriers To Entry

It raises barriers for new entrants to enter into the respective sector. It thus limits the competition to only those already in the group. The control of oligopolists over specialized inputs, such as resources, price, and production, makes it difficult for a new firm to survive. Besides, high capital requirements, licensing, patents, market demand, economies of scale, limit-pricing, and customer loyalty restrict the entry of new businesses.

#2 – Price Making Power

In an oligopoly, dominant market players are influential enough to decide on the price of products and services. And rest of the businesses or minor players follow the same. It helps avoid the potential price war and price rigidity. All firms stick to what has been decided, thereby ensuring price stability in the sector.

#3 – Interdependence Of Firms

Because of their large size and minimal competition, each firm in an oligopoly market structure influences the others. It includes decisions made in concentrated markets, such as product prices, quality standards, and production planning. It also means that each firm must be aware of the reaction of others to their actions.

#4 – Differentiated Products

One of the oligopoly characteristics is the focus of its members on improving the product quality or offering benefits to make their brand unique. Even though the products of companies A and B are similar, there must be something that distinguishes them. And that is what turns out to be the unique selling proposition (USP) of the respective brands in the oligopolistic industry.

#5 – Non-Price Competition

Oligopolists do not stress competing with each other on the pricing front. Instead, they try different approaches, such as rewarding customers for their loyalty, differentiating their product offerings, providing sales promotion schemes, acting as sponsors, etc. They do it strategically so they do not lose their customers in what could be a price war.