A market structure that contains only a small number of large dominant firms. This market structure is a form of imperfect competition and oligopolies can come in a variety of different forms:
- Pure Oligopoly - Small number of firms control the entire market
- Realistic Oligopoly - Several large firms dominating a market
- Duopoly - Two firms dominating a market
Oligopolistic markets are defined in terms of market structure and market conduct. The market structure element relates to the number of firms in the market, the extent of barriers to entry in the market and the degree of interdependence in the market. The market conduct element refers to the strategies that oligopolistic firms decide to take i.e. will firms engage in competitive pricing strategies or collusive strategies.
The main characteristics of an oligopoly market structure are as follows:
- Small Number of Large Firms - Oligopolistic markets tend to have large firms controlling most but not all of the market. The measure of dominance from a select group of firms can be measured via an n-firm concentration ratio e.g. 4-firm concentration ratio in the UK Supermarkets Industry.
- High Barriers to Entry - High barriers prevent new firms from entering and stealing the supernormal profits made by the incumbents and allows firms to continue to earn supernormal profits in the long-run. This is a characteristic similar to a monopoly market structure. These barriers to entry are either naturally formed or artificially created by incumbents. The artificial barriers to entry include: predatory pricing, non-price competition, branding, advertising and integration.
- Firm Interdependence - The market outcomes for firms depend not only on their own decisions but also upon other firms' decisions. This means that the profit that firms make depends on the strategies of rival firms. This characteristic can be represented via game theory.
From a practical point of view, an oligopoly market structure can be applied to many industries within an economy and can help explain some of the decision-making processes by firms. However, unlike in the case with perfect competition and monopoly, the theory of how oligopolies behave and act is not a definitive one. This is because the market outcomes of an oligopoly all depend greatly upon individual circumstances. This is why there are many different competing theories which seek to explain how oligopolists behave in the market and how the market equilibrium is reached (e.g. the kinked demand curve model).
The market outcomes reached can range from competitive pricing strategies (perfect competition) to non-competitive pricing strategies (monopoly). In a competitive oligopoly, each firm pursues their own strategy (pricing strategy) but the optimal strategy they take depends on the expected strategy of rival firms at the same time. Therefore, when oligopolist firms are competing amongst each other, price wars are often the outcome. Under this type of strategy, the oligopoly outcome mirrors that of a perfectly competitive one because in the long-run firms force the market price down until only normal profits are made. At this point if firms' cut price any further it will cause them to make economic losses, so the market price remains where firms make only normal profits. This matches the same outcome under perfect competition. From a welfare point of view, whilst prices are good for consumers, they are not optimal for oligopoly firms, as supernormal profits are wiped out by destructively low prices.
However, an oligopoly may not lead to this market outcome, as long as each firm can resist the temptation to start a price war. For instance, firms may use pricing strategies to re-inforce barriers to entry already in place and protect long-run supernormal profits. This strategy is created by firms engaging in non-competitive pricing strategies such as collusion. Under this type of strategy the monopoly market outcome is reached in the long-run as firms make supernromal profits. The strategy works via existing firms co-operating together to maintain a high market price. Therefore, collusion may benefit all firms by enabling them to earn supernormal profits, providing no firm has the incentive to cheat to increase their own share of supernormal profits.