What is an oligopoly?

An oligopoly is a market in which a small number of firms each have a large share of that market. Good examples include the soft drink market, which is dominated by Pepsi and Cola, or the smartphones market, which is dominated by Apple and Samsung.

Depending on the specific good (or service), oligopolies may have different market practices and different characteristics.

For example, in an oligopoly market for metals or fuel, firms will produce an identical product. However, in an oligopoly market for soap power or soft drinks, firms may produce differentiated products.

Despite this, there are a number of defining characteristics in oligopoly markets:

1. Competition - subject to the discussion on cartels below, there is ordinarily competition between a small number of firms; both price and non-price competition (e.g product differentiation, advertising etc). For example, a can of Pepsi and Coke will cost around the same amount, and historically there has been fierce advertising competition to sell their products;
2. Interdependence of firms - the actions of one firm in an oligopoly may affect the strategy and actions of another, such as a change in price or the level of advertising. Sticking with the Pepsi and Coke example, in the historic marketing war, if one firm ran a super successful advertising campaign then the other may have strategically been forced to do the same.

Competitive Oligopoly

An oligopoly market maybe competitive, or collusive.

In a competitive oligopoly, the leading firms will compete to obtain a higher market share.

Due to interdependence of firms, firm will try to predict the actions of each other. This may include how much of a good other firms are going to produce, price and advertising levels etc.

Firms may also try and predict the market's reaction to any action other firms might take, and use this to develop their own strategy. The theory of how a firm should react in light of the actions of another is called game theory.

Collusive Oligopoly (Cartel)

However, competition may be unfavourable. The profit margin of a firm may be reduced by always having to compete on prices, levels of advertising, and having to constantly monitor the actions of the competition and react.

Accordingly, there may be an incentive for firms to collude to set the quantity of production and pricing points, levels of advertising, and overall strategy. By doing this, each firm in the collusive agreement may generate a higher profit than if they were in competition.

Where firms enter into an express collusive arrangement, this is called a cartel.

All of the firms will act as if there was only one firm operating in the market, similar to that of a monopoly. Alternatively, members of the cartel might set quotas for production to divide the market between them.

Cartels may drive up prices and can be considered abusive and against the public interest. As such, cartels are illegal in many countries, and countries may adopt strict competition laws to prevent them from occurring (under risk of sanction). However, there are some legal cartels within the world, usually with such market power or outside the jurisdiction of any single purchasing country to attract regulatory action - take the Organization of the Petroleum Exporting Countries ("OPEC"), for example. OPEC is an organisation formed of certain oil producing counties that collude to influence oil production, and therefore prices, in order to maximise their profit.

Alternatively to entering into an express collusive arrangement, oligopoly firms may engage in tacit collusion.

This means that firms follow set market tactics, but without formally agreeing to do so. For example, firms may keep to the prices established by the leading firm within the industry, or the prices of the most reliable firm within the industry. Alternatively, firms may follow rules of thumb, such as how much to mark-up each good over their costs of producing.

Whether oligopoly firms will decide to engage in competition or collusion (express and tacit) will depend on the characteristics of that market. An oligopoly will favour collusion if there are:

1. No government restrictions on collusion;
2. A small number of firms all well known to each other; and
3. Significant barriers to entry, so it is unlikely for other firms to enter the market and disrupt the collusion.

Pros

In a competitive oligopoly, firms will be forced to keep their prices low in order to compete with the other firms in the market, thereby increasing allocative efficiency. In order to keep prices down, firms will have to keep their costs down, thereby increasing productive efficiency.

Depending on the level of competition/collusion, the firms in an oligopoly may generate super-normal profits which can be used for R&D

Cons

There may be an incentive to engage in collusion, which could drive prices higher within a market, thereby reducing allocative efficiency.

In a collusive oligopoly, there may also be less incentive to keep costs low, thereby reducing productive efficiency.

Depending on the level of competition/collusion, the firms in an oligopoly may not generate enough profits to be used for R&D.