OLIGOPOLY

 Definition: Oligopoly is a market structure in which there are

only a few firms in the industry selling either
homogeneous or differentiated products to many buyers;
so market supply will be concentrated in the hands of
relatively few producers.
 Where the few firms produce a homogenous product,
this is known as perfect oligopoly, and where, more
commonly, the products are differentiated, this is
referred to as imperfect oligopoly. The case
of duopoly, where there are only two firms in the
industry, is a special case of oligopoly.
Characteristics of oligopoly

 1. There are few firms in the industry

 2. The firms sell either homogeneous or differentiated

products
 3. There are high barriers to entry into the industry
 4. There is interdependence among firms in the industry.
The interdependence is responsible for the dilemma
faced by oligopolistic firms— whether to compete or to collude.
 5. Each firm is a price maker
 6. Each firm faces a downward sloping market kinked

demand curve (due to price rigidity).

Examples of oligopoly

 Telecommunications industry in Ghana e.g.

made up of MTN, Vodafone, AirtelTigo, Glo,
Espresso.
 Sportswear industry made up Nike and

Adddas (Duopoly)
 Soft drink industry made up of Coca-Cola,

Pepsi, and ?
Concentration Ratios
 Concentration ratios may be used to identify an oligopoly or any other
type of market structure.

 e.g. we have four-firm concentration ratio (C4), eight-firm

concentration ratio (C8), etc.

Generally,

Cn Ratio = S1 + S2 + S3 + S4 + S5 + …. + Sn
ST
Computation of Four-firm Concentration Ratio

C4 ratio is the ratio of the sum of the output, revenue or

market share of the first four largest firms to the total
industry output, revenue or market share, and it is
calculated as:

C4 = S1 + S2 + S3 + S4
ST
NB: 0< C4 <1 OR 0% < C4 < 100%
Using C4 to determine type of market structure
Game theory (the simple prisoner’s
Dilemma) to illustrate strategic
interdependence

Games theory involves the study of optimal

strategies to maximize payoffs, taking into
account the risks involved in estimating
reactions of rivals, and also the conditions
under which there is a unique solution, such
that an optimum strategy for two opponents
is feasible and not inconsistent.
Game Theory
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Dominant Strategy
 The Strategy (decision) of a firm that results
in the highest payoff to that firm regardless
of the strategy or decision of the rival firm.

 TASK: Determine the dominant strategy of

firms and A and B regarding the decision to
advertise or not to advertise.
Collusive versus non-collusive oligopoly
 Collusive Oligopoly : This type of oligopoly arises
where the firms in the industry to come together in
deciding the industry price and/or output each firm
must produce
 Non-collusive Oligopoly: The firms do not come

together to fix industry price or output for each firm to

produce.
Types of Collusive Oligopolies
 Formal/Open Collusion: The firms come together, rather
than compete and agree to set an industry price and output
which enables them to achieve a common objective.
 This results in the formation of a cartel with the aim to limit
competition between member firms and to maximize joint
profits as if the firms were collectively a monopoly.
 e.g. of cartel is OPEC, which set agreed output quotas for
each member in order to maintain the agreed price and
IATA, which has sought to set prices for international airline
routes.

 NB: Collusion of firms is illegal in most countries.

Formal collusive Oligopoly
 Such collusion may occur where firms
attempt to maximize their joint profits, by
reaching agreement on their price, output
and other policies, or where firms seek
to prevent the entry of new firms into the
industry so as to protect their longer run
profits.
Cartel as a Monopoly

Figure 1 Profit maximization for the cartel

Incentive of Cartel members to cheat
 This is where individual members may have an
incentive to renege on the agreement by secretly
undercutting the cartel price. The almost
inevitable necessity to limit output to keep price
high will tend to leave individual firms with spare
productive capacity, and provide the temptation
to increase profits by expanding output. Such an
expansion would not only generate profit on the
additional sales, but would also increase the
profits on existing sales, as average fixed costs
would fall as output expanded.
Conditions that make cartel structures difficult to maintain.

In practice, cartels may tend to be rather fragile

and may not last for very long. This is due to:
 Incentive to cheat
 Cost differences between firms
 Number of firms in the cartel agreement

 The market share enjoyed by the cartel

 The priority to survive during a recession
 Change in the objectives of the members

 Potential entry into the market

 Lack of a dominant firm
Tacit/informal collusion
 This occurs where one firm sets a price which
is subsequently accepted as the market price
by the other producers.
 There need be no formal or written

agreement for this to happen (thus tacit).

 It is sufficient that firms believe this to be the

best way of maintaining or increasing their

profits. Price leadership may take various
forms:
Dominant firm price leadership
 The dominant firm (by virtue of its
size) sets a price to suit its own needs
and the smaller firms then adjust their
planned output in line with the market
price that has been set for them.
 An example of such price leadership is

provided by Ford Motor Company, who

have often been the first to raise prices
in the car industry.
Barometric price leadership
 A barometric price leader need not necessarily
be the dominant firm in the industry; rather it
will be a firm, possibly small in size, which is
deemed by others in the industry as having an
informed insight into current market conditions,
perhaps because it employs the best team of
accountants and market analysts.
 The firm's reputation will therefore enable it to
act as a 'barometer' to others in the industry,
and its price movements will be closely followed.
Non-collusive or competitive
oligopoly
 In this case, each firm will embark upon a
particular strategy without colluding with its
rivals, although there will of course still exist
a state of interdependence, as possible
reactions of rivals will have to be considered.
Behaviour of firms in non-collusive
oligopoly
 Each firm will formulate a strategy and try to
anticipate how rivals are most likely to react,
and be prepared with suitable counter
measures.
 This is the basis of game theory in which

competition under oligopoly is seen as being

similar to a game of chess. The application of
the theory of games to economics was first
introduced in 1944 by J. von Neumann and O.
Morgenstern.
Price Rigidity in Non-collusive
Oligopoly
 In a non-collusive oligopoly, one expects
firms in the industry to charge different
prices as they compete to increase their
individual market shares, profits, etc.
 However, prices are likely to remain rigid

(unchanged) even though there no collusion

among them.
 This situation of price rigidity in non-

collusive oligopoly can be explained by the

kinked demand curve theory
The kinked demand curve theory

 This theory of kinked demand curve was

first developed in 1939 by Paul Sweezy in
the U.S.A to explain why oligopolistic
markets would be characterized by
relatively rigid prices, even when costs
increase.
The kinked demand curve theory

 The model makes the assumption of an

asymmetrical reaction to a change in price by
one firm:
 a decrease in price by one firm will cause a

similar reduction of price by other firms

eager to protect their market share
 whilst a price increase by one firm will not be

matched and its market share will be eroded.

 This is shown in Figure 1 below.

Kinked demand curve
The kinked demand curve theory
 Price is initially set at OP1 with an output of OQ1. If the firm tries to
reduce price to OP2 in order to sell more, other firms would match this
reduction so that sales would increase only slightly, or more
technically, by a less than proportionate amount, to OQ2.
 The demand curve would be inelastic and the reduction in price would
not represent a sound strategy as total sales revenue, and probably
profit levels, would both fall; clearly the area OP1 x OQ1, representing
initial revenue, is greater than OP2 x OQ2, the producer's revenue
after the reduction in price.

 The alternative ploy of raising price to OP3 would also be unsound as

none of the other firms would follow suit, and a large or more than
proportionate fall in demand would follow.

 Here, the demand curve would be elastic and the change in price
would again cause total revenue to fall - OP3 x OQ3 is smaller than OP
x OQ. The logical conclusion from this analysis would therefore be
that oligopolists would benefit from keeping prices stable so long as
all could enjoy reasonable profits at the established price.
The kinked demand curve theory

Figure 3: The oligopolist's absorption of a rise in costs

Why the non-collusive oligopolist’s price
remains rigid despite increase in costs.
The oligopolist's demand curve becomes less
elastic suddenly at the kink.
Mathematically, this causes the MR curve to
suddenly change to a different position, as can
be seen in Figure 3 above, so that a
discontinuity exists along the vertical line YZ
above output OQ1.
This implies that the MC curve can increase or
decrease between this discontiuity, without
necessitating a change in the profit maximising
output OQ1 or price OP1 - the oligopolist will
absorb the higher costs.
Why the non-collusive oligopolist’s price
remains rigid despite increase in costs.
 This implies that the MC curve can increase or
decrease between this discontinuity, without
necessitating a change in the profit maximising
output OQ1 or price OP1 - the oligopolistic firm will
absorb the higher costs.

 According to normal demand and supply analysis, an

increase in costs would cause a fall in output and an
increase in price.

 An example of cost absorption in practice is when the

price of crude oil rises and petrol companies wish to
increase price, but do not as no company wants to be
the first to do so.
The importance of non-price competition in oligopolistic markets

An important feature of oligopolistic markets,

i.e. ones dominated by a few large firms, is
the tendency towards relative price stability. 

However, this absence of price competition

does not necessarily mean an absence of
competition: oligopolistic firms are likely to
compete in a variety of non-price forms.
Non-price competition
 Non- price competition occurs where firms
attempt to win a competitive advantage over
their rivals by strategies other than reducing
prices.  Non-price competition inevitably
involves product differentiation.

 Here, the firms try to carve out separate

markets in which they can
command consumer loyalty through the
creation of actual or imagined differences in
the goods or services they offer, which are
essentially the same as their rivals.
Types of non-price
competition.
 Advertising (informative and persuasive)
 Branding
 Product innovation
 Packaging
 The provision of after sales services e.g.

product guarantees
 Free samples and gift offers.