Oligopoly         (Chp 11.2)

This is a situation where there are a few firms in the industry – more than one (a monopoly) and not many (perfect competition). Oligopoly is more common than monopoly or very competitive markets – think about how many gas stations, grocery stores or telecommunications firms that there are in town and you can see that they are oligopolies.

The definition is somewhat vague but we can get a clearer idea about whether a market is an oligopoly or not by using the Concentration Ratio (CR).  This gives uses a measure of the market share of firms as an indicator of their market power. Usually we look at the share of the biggest four firms, known as CR4. So if the top four firms have a concentration ratio of:

·         0% - 50% it is a competitive market (Zero would be perfect competition and getting less competitive as their percentage market share increases).

·         51% to 80% the top four firms form an oligopoly.

·         81% to 100% is considered monopolistic.

CRm = s1 + s2 +.... + sm where si is the market share and m defines the ith firm. In this case m = 4.

CR1= 100%, is a pure monopoly.

What would we have if CR2 = 100%?

Note that it is not so clear cut as saying that 50% is competitive and 51% is oligopoly – it is a gradual transition.  The top four firms having 50% market share is not very competitive and could be described as oligopolistic. Similarly, four firms having 90% of the market share does not technically  make a monopoly but in practice that amount of market power is referred to as monopolistic (like a monopoly).

Example: Each firm has the following market shares: 5%, 23%, 9%, 14%, 12%, 2%, 11%. For CR4, we take the biggest four numbers and sum them (60%) which tells us that this market is an oligopoly.

For some real CR4 values see p584.

The analysis of oligopoly can be complex. Firstly, the large market share means that firms are not price takers.  Given that firms have some control over prices, any action that one firm takes will bring about a response from its competitor. A few years ago in Prince George, Costco reduces its gas prices significantly and in order to stay competitive, other gas stations quickly followed their lead. However, the low prices didn’t last long and we will see why later on. We need a clear way to analyse how firms act and react to each other which is where we will use game theory.

For simplicity we usually assume two firms in the oligopoly (which is called a duopoly).

They may exist because there are legal barriers or natural ones – e.g. if two firms can meet the demand and only make a normal profit this would be a natural oligopoly.  One firm alone would be making an economic profit.  Three firms might be making a loss.  A legal oligopoly exists when government regulation prevents more than a few firms providing a good or service.

The key point is that the actions of one firm affect the other firm significantly.  In perfect competition if one firm increased price, customers go to the other firms, but there are so many other firms that none of them see a significant increase in demand.  In duopoly, if one firm increases prices, customers will shift to the other firm, as it is the only competitor, it will see a significant increase in demand.

It appears that there will be an incentive for a firm to cut prices and get an increase in the market share.  However, the other firm will have the same plan.  The point is, when a firm decides what to do, it has to think about what the other firm will do in response (in this case there could be a price war – i.e. they both try to undercut the other’s price).