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An oligopoly (from Greek ὀλίγος, oligos "few" and πωλεῖν, polein "to sell") is a market structure in which a market or industry is dominated by a small number of large sellers or producers.
Oligopolies can result from various forms of collusion that reduce market competition. Such collusions can lead to higher prices for consumers and lower wages for the employees of oligopolies. In the absence of collusion and the presence of fierce competition among market participants, an oligopoly may develop into a situation similar to perfect competition. Oligopolists 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 the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants. Entry barriers include high investment requirements, strong consumer loyalty for existing brands, and economies of scale, and these barriers effectively facilitate the formation and sustainability of collusion.
The fundamental reason for the formation of oligopolies is related to future retaliation (deviation). In other words, firms will lose less for deviation and thus have more incentive to undercut collusion price (obtain short-term deviated profit) when future entry continues. There are other factors that could also facilitate collusion such as market transparency and frequent interaction. In developed economies oligopolies dominate the economy as the perfectly competitive model is of negligible importance for consumers. Specifically, oligopolists will implement a practice called price fixing to dominate the economy. Taking an example from the US in 2013 that most new prosecuted oligopolist cases were based on price-fixing. However, this will bring negative impacts since it ends up with less choices and high prices for customers.
As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized and is the most preferable ratio for analyzing market concentration. 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 the 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. These four cellular telephone firms have become the top-tier in US carriers and were protected by the US government that acted as an intervention for other firms entering the market.
Oligopolistic competition can give rise to a wide range of 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, where oligopolistic countries manipulate the worldwide oil supply and ultimately leaves a profound influence on the international price of oil.
There are legal restrictions on such collusion in most countries and relevant regulations or enforcements against cartels (anti-competitive behaviours) enacted since the late of 1990s. For example, EU competition law has prohibited some unreasonable anti-competitive practises such as directly or indirectly fix selling prices, manipulate market supply or control trade among competitors etc., either by means of formal contracts or oral agreements. In the US, the Antitrust Division of the Justice Department and Federal Trade Commission was created to fight collusion among cartels. However, a formal agreement is not a requirement for collusion to take place, as tacit collusion can be achieved through mutual understanding among firms. For the collusion to be prosecuted as a crime there must be actual and direct communication between companies. For example, in some industries there may be an acknowledged market leader that informally sets prices to which other producers respond, (known as price leadership). Tacit collusion is becoming a more popular topic in the development of anti-trust law in most countries.
In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. Hypothetically, this could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater when there are more competitors in an industry. Theoretically, it is harder to sustain cartels (anti-competitive behaviors) in an industry with a larger number of firms in that it will yield less collusive profit for each firm. Consequently, existing firms may have more incentive to deviate. However, this conclusion is a bit more intuitive and empirical evidence has shown this conclusion or relationship is a bit more ambiguous and mixed.
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, as they could gain certain marker power by offering somewhat differentiated products.
Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies:
When compared with Cournot and Bertrand's model, it can be seen that price competition is more aggressive and competitive, and also it is easier to sustain collusion under price competition.
Characteristics of oligopolies include:
For fighting collusion and cartels in an oligopoly market, competition authorities have taken measures or practices to effectively discover, prosecute and penalize them. Leniency program and economic analysis (screening) are currently two popular mechanisms.
Competition authorities prominently have roles and responsibilities on prosecuting and penalizing existing cartels and desisting new ones. Thus, authorities have created an effective tool called the leniency program, which makes antitrust firms to be more proactive participants in confessing their collusion behaviors in that they will be granted immunity from fines and still have a right to plea bargaining if not receive a full reduction. Nowadays, leniency program has been implemented by several countries like US, Japan and Canada. However, it causes negative impacts to competition authorities themselves in the wake of abusing of leniency program that there are still many cartels in society and the expected sanctions for colluded firms will experience a sharp drop. As a result, the total effect of the leniency program is ambiguous and an optimal leniency program is required.
There are two screening methods that are currently available for competition authorities: structural and behavioral. In terms of structural screening, it refers to identify industry traits or characteristics, such as homogenous goods, stable demand, less existing participants, which are prone to cartel formation. While regarding behavioral one, is mainly implemented when a cartel formation or agreement has reached and subsequently authorities start to look into firms' data and figure out whether their price variance is low or has a significant price increase or decrease.
Oligopolies become "mature" when competing entities realize they can maximize profits through joint efforts designed to maximize price control by minimizing the influence of competition. As a result of operating in countries with enforced antitrust laws, oligopolists will operate under tacit collusion, which is collusion through a mutual understanding among the competitors of a market without any direct communication or contact that by collectively raising prices, each participating competitor can achieve economic profits comparable to those achieved by a monopolist while avoiding the explicit breach of market regulations. Hence, the kinked demand curve for a joint profit-maximizing oligopoly industry can model the behaviors of oligopolists' pricing decisions other than that of the price leader (the price leader being the entity that all other entities follow in terms of pricing decisions). This is because if an entity unilaterally raises the prices of their good/service and competing entities do not follow, the entity that raised their price will lose a significant market as they face the elastic upper segment of the demand curve.
As the joint profit-maximizing efforts achieve greater economic profits for all participating entities, there is an incentive for an individual entity to "cheat" by expanding output to gain greater market share and profit. In the case of oligopolist cheating, when the incumbent entity discovers this breach in collusion, competitors in the market will retaliate by matching or dropping prices lower than the original drop. Hence, the market share originally gained by having dropped the price will be minimized or eliminated. This is why on the kinked demand curve model the lower segment of the demand curve is inelastic. As a result, in such markets price rigidity prevails.
There is no single model describing the operation of an oligopolistic market. The variety and complexity of the models exist because two to 10 firms can compete 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.
Main article: Cournot competition
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 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 = Q1 P = Q1(M − Q2 − Q1) = MQ1 − Q1 Q2 − Q12. The marginal revenue function is .[note 1]
Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2.
To determine the 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.
Main article: Bertrand competition
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 a more general cost function.
Main article: Kinked demand
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. In other words, oligopolist's pricing logic is that competitors will match and respond to any price cut - retaliating to obtain more market share, while they will stick with the current or initial price for any price rising among competitors.
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.
Many industries have been cited as oligopolistic, including civil aviation, agricultural pesticides, electricity, and platinum group metal mining. In most countries, the telecommunications sector is characterized by an oligopolistic market structure. Rail freight markets in the European Union have an oligopolistic structure. In the United States, industries that have identified as oligopolistic include food processing, funeral services, sugar refining, beer making, pulp and paper making, and automobile manufacturing.
Market power and market concentration can be estimated or quantified using several different tools and measurements, including the Lerner index, stochastic frontier analysis, and New Empirical Industrial Organization (NEIO) modeling, as well as the Herfindahl-Hirschman index.
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 cost, s could change without necessarily changing the price or quantity.
The motivation behind this kink is the idea that in an oligopolistic or monopolistic 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 (price rigidity). 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 since market price for oligopolists is more stable or 'focal' in the long run under this kinked demand curve situation.
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