Imperfect Competition

Oligopoly

An oligopoly is a market dominated by a few large firms.
A market structure in which a few large firms, each with a degree of market power, sell either standardized products or differentiated products is called an oligopoly. Because no single firm dominates the market, there is limited competition (unlike a monopoly).

Oligopolies are common in markets that have high barriers to entry—obstacles that prevent new firms from entering the market easily. Barriers to entry include economies of scale (competitors already within the market are operating at such high volumes they can undercut the prices of new firms), high start-up costs, scarce resources, government regulations, and long-term agreements with suppliers and distributors. These factors make it difficult for new firms to enter the market.

  • Markets with existing firms that have economies of large-scale production are difficult for new firms to break into because they must start with less efficient, smaller-scale production operations.
  • Extremely high start-up costs (as in industries such as nuclear power or shipbuilding that require massive amounts of equipment to be purchased before production can commence and sales can begin) make it difficult for new firms to enter the market. In industries such as pharmaceuticals, research and development costs are extremely high, which also deters new entrants.
  • When existing operators control a scarce resource—for example, if a small number of firms control all the docks at a seaport—it is difficult for newcomers to compete in the same location.
  • Government regulations (for example, the need for a broadcasting license to set up a television broadcasting station) may limit the number of opportunities to engage in an economic activity. Local zoning regulations may restrict the physical space for new competitors. Governments can deliberately exclude foreign competition by imposing a tariff (fee exacted from the importing of a good), a quota (maximum amount of a good that can be imported by law), and an outright ban on an import, and similar restrictions on foreign investment.
  • When existing firms have long-term agreements with suppliers of production inputs and distributors of the product, newcomers may not be able to break into the supply-and-distribution chain easily, especially when such agreements include an exclusivity clause, that is, a clause that explicitly prohibits suppliers from working with other customers.

Oligopolistic firms can also take active measures to keep out new entrants, including product differentiation (the creation of distinguishing characteristics for a product so competing products are not regarded as perfect substitutes; for example, the production of "designer jeans"), advertising, customer loyalty schemes, the creation of a strong brand image, predatory pricing (temporarily lowering the price below cost to drive out weaker competitors), predatory acquisition (buying out smaller competitors), and vertical integration (buying up supplier and distributor companies of the firm's product). The degree to which oligopolistic firms dominate a market is measured by a concentration ratio. A concentration ratio is the percentage of market share controlled by a given number of firms. For example, a four-firm concentration ratio is the share of the total market held by the four largest firms in an industry. If there are only four firms in that industry, the four-firm concentration ratio is 100 percent, representing a highly concentrated oligopoly. The 2012 Economic Census of the United States shows the four-firm concentration ratio (as measured by the percentage of total revenue) of wireless telecommunications carriers (excluding satellite companies) is 89.1 percent, and the eight-firm concentration ratio is 95.2 percent. These concentration ratios show that the wireless telecommunications industry is an extreme example of oligopoly. Wired telecommunications carriers in the United States in 2012 were less concentrated but still not very competitive, with a four-firm concentration ratio of 51.3 percent and an eight-firm concentration ratio of 72.9 percent.

Given the size and dominant status of the firms in an oligopoly, each firm has to consider the response of the others to any move it makes. In other words, the firms in a oligopoly are mutually interdependent. For example, if one firm increases its prices, it will have to estimate the likelihood that its rivals will match the increase. Failure to consider the rivals' response could result in losses as customers switch to purchasing the good or service of the cheaper supplier. There is informal collusion, such as price leadership, which is legal in the United States because the firms are not necessarily working together directly. But, formal collusion, where firms directly work together to raise prices, is illegal in the United States.

The situation of oligopoly in a market creates what economists call a kinked demand curve. This means that once a price has been set for a good, if a particular firm raises the price it charges for that good, its competitors are unlikely to follow suit, whereas if a particular firm lowers the price it charges for the good, its competitors are likely to do the same. Another way of saying this is the demand curve is relatively elastic at price points higher than the price most firms are charging and relatively inelastic at price points lower than the price most firms are charging.
Under conditions of oligopoly, the demand curve (D) for a good is relatively elastic at prices higher than the price most firms are charging (P), and relatively inelastic at price points lower than the settled price. At price points lower than the price most firms are charging, marginal revenue (MR) drops steeply.

Four-Firm and Eight-Firm Concentration Ratios in Some Common Industries

Industry Four-Firm Concentration Ratio (% of Market) Eight-Firm Concentration Ratio (% of Market)
Household refrigerators/freezers 92.8 99.3
Tobacco manufacturing 90.2 95.2
Small arms ammunition 87.5 94.4
Breakfast cereal 81.1 95.3
Bottled water 75.8 86.3
Tire manufacturing 73.9 87.7
Dog and cat food 72.1 83.1
Soap and detergent 71.4 83.5
Sugar manufacturing 53.1 70.9
Footwear manufacturing 50.5 67.9
Apparel manufacturing 9.8 14.6

Markets dominated by a few firms are oligopolies. The degree to which they dominate their market (concentration ratio) is measured as their percent of market share. A four-firm concentration ratio shows the percent of market share held by the top four firms in the market. Likewise, an eight-firm concentration ratio shows the percent of market share held by the top eight firms in the market.

Duopoly

A duopoly is a market structure dominated by two large firms.
An oligopoly in which only two large firms dominate the market is called a duopoly. A duopoly is the most basic form of an oligopoly. An example is the long-distance airliner industry. Boeing and AirBus produce the majority of long-distance airplanes in the world. There are other manufacturers in this sector, but these two firms account for the vast majority of sales. A more extreme example is the mobile operating system industry, where Apple and Google dominate entirely with their iOS and Android operating systems. In these examples and other duopolies, competition is less than perfect because there is no free entry for competitors in the marketplace, and consumers have very limited choice. Online advertising is similarly dominated by two large companies.
In 2016, the market for digital advertising met the definition of a duopoly, with two firms dominating the market.
To the extent the two firms in a duopoly succeed in differentiating their products, they can exercise virtual monopoly power over their segment of the market. For example, Coca- Cola and Pepsi maintain customer loyalty by stressing the difference between their main beverages, even though the beverages have close similarities. Because consumers might otherwise consider the two alternatives to be interchangeable (perfect substitutes), both companies have invested heavily over many decades in advertising focused on creating and maintaining brand loyalty. They also have exclusive distribution agreements with many distributors. If such brand loyalty is strong, consumers will not switch to the alternative product, even when one of these firms raises its prices and the other does not. If the two dominant firms compete by lowering prices, they would eventually lower prices to the cost of production and would make no profits. To undercut the other firm and thereby steal its business, one firm will lower its prices; then, in response, the other firm will lower its prices even more, and so on. This is known as a price war. Competition in a duopoly, therefore, often takes other forms, such as loyalty schemes (for example, in supermarkets), faster delivery, or (especially for big-ticket items such as cars) more advantageous credit terms. Price fixing and price wars can occur in other oligopolies besides just duopolies if more than two companies control a large portion of market share. If the two firms in a duopoly collude, that is, work together to manipulate the market (for example, by fixing prices), they act as a monopoly (a single producer that sets market price), with all the attendant negative effects on competition.

Game theory models provide effective analyses of decisions made by firms in a duopolistic market (and, by extension, in other oligopolistic markets). These models situate a firm's possible reactions to its competitors' initiatives, such as price reductions. Duopolies can be difficult and expensive to maintain over the long term. People's tastes change and technologies advance, both of which make it easier for new firms to enter the industry and compete.

Cartel

A cartel is a group of independent producers who collude to restrict output, maintain high prices, and maximize their joint revenue.
A cartel is a group of producers who collude to restrict output, maintain high prices, and maximize their joint revenue. In doing so they act as a monopoly, a single producer that sets market price. Such collusion is usually formalized in an explicit agreement, which may or may not be published. Cartel agreements are fragile, in part because they are often illegal. The agreements are at risk of being canceled if the authorities discover them. In the United States, the 1890 Sherman Antitrust Act bans the type of collusion that leads to cartels, but enforcement of this Act and other antitrust legislation can be difficult. A common type of cartel is one where producers allocate territories to each of their members so they become local monopolies. Cartels are illegal in many countries. The infamous "drug cartels" that distribute narcotics in the United States and elsewhere are probably not formalized and so do not fully qualify as cartels, but they are likely to exhibit many of the typical characteristics of a cartel (including division of territory and price fixing).

To evade antitrust legislation, firms may form cartels in ways that are difficult to detect, such as setting common technical standards among producers to limit competition. For example, in the German car industry, the major car manufacturers—Audi AG, BMW, Daimler AG, Porsche AG, and Volkswagen—set a suboptimal common standard for diesel engine emissions and even agreed to such details as a maximum speed for closing the soft top on a convertible. International cartels that are agreed between national authorities may be tolerated even by other countries that ban cartels on their own soil simply because they are too powerful to outlaw. The Organization of the Petroleum Exporting Countries (OPEC), the largest cartel in the world, is a prominent example. OPEC meets periodically to influence the international price of crude oil by limiting or expanding national production quotas.

A cartel is inherently unstable because a producer can gain from breaking the agreement. Cartels maximize profit for the group, but if a member of the cartel sees opportunities for its individual profits to increase by breaking its agreement with the cartel, it can do so. For example, if OPEC agrees to collectively cut oil production to raise the oil price, one of its member countries can obtain higher profits by expanding output and selling it at the higher price. Another cartel, the Belarusian Potash Company (BPC), supplied one-third of the global potash production between 2005 and 2013. The cartel broke up when one of its members, the Russian potash fertilizer producer Uralkali, decided to pull out, causing the world potash price to drop. In the years since the breakup, potash prices have spiked every time there is a rumor the cartel will be restored.