Characteristics of Oligopoly
#1 A few large producers
- Few large firms control the majority of the market
#2 Differentiated or standardized products
- The product sold can be homogeneous in the case of pure oligopoly.
- In imperfect oligopoly, the product may be slightly differentiated.
#3 Entry Barriers
- Relatively high entry barriers.
#4 Mutual Interdependence
- Each firm is influenced by the decisions of other firms in the industry. i.e. decision of one firm will affect others and vice versa.
#5 Others: Price rigidity and non-price competition
- Prices do not change much over time.
- Firms tend to compete in other areas – e.g. advertising, quality, packaging, branding
Understanding the demand curve of a firm under oligopoly
An individual firm under oligopoly faces a demand curve which is kinked at the current market price.
Reasons for the kinked demand curve:
- If the firm increases its price above P1, the other firms will not change their prices for they will gain more market share by having lower prices. Hence for the firm, for a price increase (say $1), the total revenue will fall due to a large drop in quantity sold. Therefore, this firm will have demand that is elastic.
- If the firm cuts its price below P1, it will face strong retaliation from its rivals who will act to cut prices too. Hence, for some amount of price drop (say $1), the gain in quantity sold is only little. Therefore, this firm will have demand that is inelastic.
Oligopoly's supernormal profit
- An oligopolist will produce their goods at quantity Q1 and that is based on the profit-maximisation condition given by MR=MC.
- At that level of optimal output, the oligopolist is able to price their product at P1, although its actual cost is only C1.
- This means that it is able to enjoy supernormal profit given by the shaded green area.
There are inefficiencies under oligopoly
- The oligopolist is not producing its goods at the lowest ATC. Since its price (P1) > minimum ATC, hence it does not have productive efficiency.
- The oligopolist does not have allocative efficiency either as its price is above the marginal costs i.e. (P1) > MC. This means that there is society values more of this good than alternative goods in the market, but the oligopolist is producing less than what is actually needed. Hence, they are able to price it above its MC.
- Another way to analyse the allocative inefficiency is to look at the deadweight loss (DWL), as illustrated in the oligopoly market supply and demand, as shown the the diagram.
- The pricing of the oligopolists (P0) is the same as that determined if it is a monopoly scenario (Pm).
- The only difference between the monopoly and a oligopoly scenario is that the additional producer surplus abcd is shared between the oligopolists in the market (here, they are Firm A and Firm B) .