Three characteristics of oligopoly

·        There are a few firms selling a similar product.

·        There are barriers to entry.

·        Firms are interdependent, the actions of one firm will affect the others in the industry.

An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high (i.e. a large percentage of the market is taken up by the leading firms). Firms within an oligopoly produce branded products (advertising and marketing is an important feature of competition within such markets) and there are also barriers to entry.

The barriers may take on a number of forms, depending upon the nature of the industry; this allows firms to make abnormal profits in the long run.

Interdependence between firms means that each firm must take into account the likely reactions of other firms in the market when making pricing and investment decisions. This creates uncertainty in such markets - which we seek to model through the use of game theory.

Examples of oligopoly are the sale of petrol, supermarkets, telecommunications, banks and building societies.

Theories About Oligopoly Pricing

There are four major theories about oligopoly pricing: 

• Oligopoly firms collaborate to charge the monopoly price and get monopoly profits 

• Oligopoly firms compete on price so that price and profits will be the same as a competitive industry 

• Oligopoly price and profits will be between the monopoly and competitive ends of the scale 

• Oligopoly prices and profits are "indeterminate" because of the difficulties in modelling interdependent price and output decisions

• When one firm has a dominant position in the market the oligopoly may experience price leadership. The firms with lower market shares may simply follow the pricing changes prompted by the dominant firms. We see examples of this with the major mortgage lenders and petrol retailers.

The Importance Of Price And Non-Price Competition

Firms compete for market share and the demand from consumers in lots of ways. We make an important distinction between price competition and non-price competition.

Price competition can involve discounting the price of a product (or a range of products) to increase demand. 

Non-price competition focuses on other strategies for increasing market share. Consider the example of the highly competitive UK supermarket industry where non-price competition has become very important in the battle for sales

• Mass media advertising and marketing 
• Store Loyalty cards 
• Banking and other Financial Services (including travel insurance) 
• In-store chemists / post offices / creches 
• Home delivery systems 
• Discounted petrol at hyper-markets 
• Extension of opening hours (24 hour shopping in many stores) 
• Innovative use of technology for shoppers including self-scanning machines
• Financial incentives to shop at off-peak times 
• Internet shopping for customers

Kinked demand curve theory

This was developed in the late 1930s by the American Paul Sweezy. The theory aims to explain the price rigidity that is often found in oligopolistic markets. It assumes that if an oligopolist raises its price its rival will not follow suit, as keeping their prices constant will lead to an increase in market share. The firm that increased its price will find that revenue falls by a proportionately large amount, making this part of the demand curve relatively elastic (flatter).

Conversely if an oligopolist lowers its price, its rivals will be forced to follow suit to prevent a loss of market share. Lowering price will lead to a very small change in revenue, making this part of the demand curve relatively inelastic (steeper).

The firm then has no incentive to change its price, as it will lead to a decrease

in the firm's revenue. This causes the demand curve to kink around the present market price. Prices will further stabilize as the firm will absorb changes in its costs as can be seen in the diagram below. The marginal revenue jumps (vertical discontinuity) at the quantity where the demand curve kinks, the marginal cost could change greatly - e.g., MC1 to MC2 (between prices a and b)- and the profit maximizing level of output remains the same.