One important source of oligopoly power are barriers to entry: obstacles that make it difficult to enter a given market. One important source of oligopoly power is barriers to entry. Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry—such as government regulation and patents, or a large, established firm taking advantage of economies of scale—or those an individual faces in trying to gain entrance to a profession—such as education or licensing requirements.
Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices. The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants.
For example, microprocessing companies face high research and development costs before possibly making a profit. This means that new firms cannot enter the market whenever existing firms are making a positive economic profit, as is the case in perfect competition. Additional sources of barriers to entry often result from government regulation favoring existing firms. For example, requirements for licenses and permits may raise the investment needed to enter a market, creating an effective barrier to entry.
In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. For example, there are now only a small number of manufacturers of civil passenger aircraft.
Oligopolies have also formed in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate. Oligopoly in Aircraft Manufacturing : Manufacturing commercial airplanes takes a very large initial investment in technology, equipment, and licensing. Consequently, the industry is dominated by two firms. Price leadership is a form of tacit collusion that oligopolies may use to achieve a monopoly-like market outcome.
When one firm changes its price or level of output, other firms are directly affected. Unlike perfect competition and monopoly, uncertainty about how rival firms interact makes the specification of a single model of oligopoly impossible.
Economists often simplify firm behavior into two strategies: firm can compete, in which case the market outcome will resemble that in perfect competition; or they can collude, in which case the market outcome will more closely resemble monopoly.
When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result. Firms can collude explicitly, as in the case of cartels, but this type of behavior is illegal in many parts of the world.
An alternative to overt collusion is tacit collusion, in which firms have an unspoken understanding that limits their competition. One way in which firms achieve this is price leadership, in which one firm serves as an industry leader and sets prices, while other firms raise and lower their prices to match.
For example, the steel, cars, and breakfast cereals industries have all been accused of engaging in tacit collusion.. Tacit collusion can be difficult to identify. After all, in a perfectly competitive industry, economists expect prices to move together because all firms face similar changes in demand and the cost of inputs.
For example, imagine that a town has three gas stations. Without any way to communicate, all three will lower their prices in an attempt to capture the entire market, stopping only when marginal cost equals marginal revenue.
Each would have slightly lower sales but would have much higher revenue. Although explicit communication about prices is illegal, the firms might tacitly agree that whenever one station raises its prices, the other two will follow suit.
In this way, all three can receive the benefits of oligopoly. The gas station that first raises its prices, and that the other two follow, is called the price leader. If Firm B sets the price above monopoly price, Firm A will set the price at monopoly level.
Bertrand Duopoly : The diagram shows the reaction function of a firm competing on price. Imagine if both firms set equal prices above marginal cost. Each firm would get half the market at a higher than marginal cost price. However, by lowering prices just slightly, a firm could gain the whole market. As a result, both firms are tempted to lower prices as much as they can. However, it would be irrational to price below marginal cost, because the firm would make a loss.
Therefore, both firms will lower prices until they reach the marginal cost limit. According to this model, a duopoly will result in an outcome exactly equivalent to what prevails under perfect competition. Colluding to charge the monopoly price and supplying one half of the market each is the best that the firms could do in this scenario. However, not colluding and charging the marginal cost, which is the non-cooperative outcome, is the only Nash equilibrium of this model.
The accuracy of the Cournot or Bertrand model will vary from industry to industry. If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition.
If output and capacity are difficult to adjust, then Cournot is generally a better model. A cartel is an agreement among competing firms to collude in order to attain higher profits. Cartels usually occur in an oligopolistic industry, where the number of sellers is small and the products being traded are homogeneous.
Cartel members may agree on such matters are price fixing, total industry output, market share, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits. Each member of a cartel would be able to make a higher profit, at least in the short-run, by breaking the agreement producing a greater quantity or selling at a lower price than it would make by abiding by it.
However, if the cartel collapses because of defections, the firms would revert to competing, profits would drop, and all would be worse off. Whether members of a cartel choose to cheat on the agreement depends on whether the short-term returns to cheating outweigh the long-term losses from the possible breakdown of the cartel.
It also partly depends on how difficult it is for firms to monitor whether the agreement is being adhered to by other firms. If monitoring is difficult, a member is likely to get away with cheating for longer; members would then be more likely to cheat, and the cartel will be more unstable.
In members of OPEC reduced their production of oil. In the mid s, however, OPEC started to weaken. Around the same time OPEC members also started cheating to try to increase individual profits. Privacy Policy. Skip to main content. Search for:. Oligopoly in Practice. Collusion and Competition Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable.
Key Takeaways Key Points Firms in an oligopoly may collude to set a price or output level for a market in order to maximize industry profits. At an extreme, the colluding firms can act as a monopoly. Oligopolists pursuing their individual self-interest would produce a greater quantity than a monopolist, and charge a lower price.
Collusive arrangements are generally illegal. Moreover, it is difficult for firms to coordinate actions, and there is a threat that firms may defect and undermine the others in the arrangement. Price leadership, which occurs when a dominant competitor sets the industry price and others follow suit, is an informal type of collusion which is generally legal.
Key Terms Price leadership : Occurs when one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. Game Theory Applications to Oligopoly Game theory provides a framework for understanding how firms behave in an oligopoly.
Learning Objectives Explain how game theory applies to oligopolies. Key Takeaways Key Points In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well.
Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action. In this game, the dominant strategy of each actor is to defect. However, acting in self-interest leads to a sub-optimal collective outcome.
Game theory is generally not needed to understand competitive or monopolized markets. Key Takeaways Key Points In the game, two criminals are arrested and imprisoned. Each criminal must decide whether he will cooperate with or betray his partner. The criminals cannot communicate to coordinate their actions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.
A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly.
When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly. Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve.
In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market. Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms and they need not produce differentiated products.
Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name.
The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task. When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide up the profit among themselves.
When firms act together in this way to reduce output and keep prices high, it is called collusion. A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel. See the following Clear It Up feature for a more in-depth analysis of the difference between the two. In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law.
The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.
The desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits has been well understood by economists. Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high.
If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. Indeed, a small handful of oligopoly firms may end up competing so fiercely that they all end up earning zero economic profits—as if they were perfect competitors. Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures.
Instead, economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy. It applies well to oligopoly. The game theory situation facing the two prisoners is shown in Table 3.
If A believes that B will confess, then A ought to confess, too, so as to not get stuck with the eight years in prison. But if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes!
B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up doing a total of 10 years of jail time between them. The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have had to serve a total of four years of jail time between them.
If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer jail terms.
If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits.
Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions. The following Clear It Up feature discusses one cartel scandal in particular. The primary U. The U. Federal Bureau of Investigation FBI , however, had learned of the cartel and placed wire taps on a number of their phone calls and meetings.
From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a meeting in Mona, Hawaii:.
The price of lysine doubled while the cartel was in effect. Our customers are the enemy. Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high.
If a group of U. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries OPEC , have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports.
Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop. Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself. Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging.
Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.
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