Oligopoly

Definition

An oligopoly is a market structure characterized by a small number of firms that dominate the industry, each having significant market power. This means that the actions of one firm can directly influence the others, leading to strategic behavior among the firms. Oligopolies often result in limited competition and can lead to higher prices and reduced innovation compared to more competitive markets.

5 Must Know Facts For Your Next Test

1. Oligopolies are common in industries where high startup costs or significant barriers to entry prevent new competitors from entering the market.
2. Firms in an oligopoly may engage in non-price competition, such as advertising and product differentiation, to gain an edge over competitors.
3. Price rigidity is often observed in oligopolistic markets, where firms are reluctant to change prices due to fear of losing market share or triggering price wars.
4. The concentration ratio is a measure used to assess the level of market concentration in an oligopoly, indicating the percentage of market share held by the largest firms.
5. Oligopolistic firms may engage in tacit collusion, where they indirectly coordinate their actions without formal agreements, leading to outcomes similar to those of a cartel.

Review Questions

• How does the small number of firms in an oligopoly affect market dynamics compared to more competitive market structures?
  • In an oligopoly, the small number of firms means that each firm's decisions can significantly impact the others, leading to strategic interdependence. This dynamic creates a situation where firms must consider their competitors' potential reactions when setting prices or output levels. Unlike in perfectly competitive markets where many firms operate independently, oligopolistic firms may find themselves engaging in tactics like price stability or non-price competition to avoid detrimental price wars, resulting in less aggressive competition overall.
• Discuss the implications of price rigidity in oligopolistic markets and how it affects consumers.
  • Price rigidity in oligopolistic markets implies that firms are hesitant to change prices due to concerns over losing customers or provoking price wars. As a result, consumers may face higher prices than they would in more competitive markets. The reluctance to lower prices can lead to sustained profit margins for oligopolistic firms at the expense of consumer welfare. Additionally, since price changes are infrequent, consumers may find themselves stuck with stagnant pricing despite changing economic conditions.
• Evaluate the role of game theory in understanding strategic decision-making among firms within an oligopoly.
  • Game theory plays a crucial role in analyzing strategic decision-making in oligopolies as it helps model how firms interact and anticipate each other's actions. It provides insights into scenarios such as price setting, product launches, and marketing strategies, where each firm's payoff depends on the choices made by others. By using game theory, firms can evaluate potential outcomes based on different strategies, leading to more informed decision-making that considers both competitive threats and collaborative opportunities.

Related terms

Market Power: The ability of a firm to influence the price of its product or the terms of its sale in the market.

Cartel: A formal agreement among firms in an oligopoly to coordinate pricing and production decisions to maximize joint profits.

Game Theory: A mathematical framework used to model strategic interactions among rational decision-makers, often applied in analyzing competition in oligopolistic markets.