How do oligopolies affect the market?

An industry where only a few firms operate

What is an Oligopoly?

The term “oligopoly” refers to an industry where there are only a small number of firms operating. In an oligopoly, no single firm enjoys a large amount of market power. Thus, no single firm is able to raise its prices above the price that would exist under a perfect competition scenario. In an oligopoly, all firms would need to collude in order to raise prices and realize a higher economic profit. Most oligopolies exist in industries where goods are relatively undifferentiated and broadly provide the same benefit to consumers.

Why do oligopolies exist?

The biggest reason why oligopolies exist is collaboration. Firms see more economic benefits in collaborating on a specific price than in trying to compete with their competitors. By controlling prices, oligopolies are able to raise their barriers to entry and protect themselves from new potential entrants into the market. This is quite important, as new firms may offer much lower prices and thus jeopardize the longevity of the colluding firms’ profits.

In most markets, antitrust laws exist that aim to prevent price collusion and protect consumers. Nonetheless, firms have devised ways to achieve price collusion without being detected by regulators. For example, firms might elect a price leader that is tasked with leading changes in prices before other firms follow suit in order to “react to competition.” Firms may also agree to change their prices on specific dates; in such cases, the changes may be seen as merely a reaction to economic conditions such as fluctuations in inflation.

How do oligopolies work?

Below is a game theory example that models collusion in a two-firm oligopoly:

It is important to note that in real-life oligopolies, the games (instances of collusion) are sequential; meaning that one firm’s behavior in one game may influence the game’s outcome in future periods. In this scenario, we see that the optimal outcome that generates the most cumulative profits occurs if both firms collude. This situation would be the best long-run equilibrium situation that would provide the most benefit to all the firms.

Nonetheless, in this equilibrium, firms have an incentive to cheat and not collude. For example, if both firms agree to set a price of $10, but Firm A cheats and sets prices at $5, Firm A will essentially capture the entire market (assuming little to no differentiation). While this may result in high profits for Firm A in this game, Firm B now knows that Firm A is a cheater and thus will never collude again.

Therefore, the new equilibrium would be the one where neither firms collude and achieve profits that would occur under perfect competition (which is significantly less profitable than colluding). Thus, to realize the best long-run profits, firms in an oligopoly choose to collude.

How to protect consumers from oligopolies?

While some oligopolies do not significantly harm consumers, others do. In such cases, governments can take a range of actions to protect consumers, such as:

Lowering barriers to entry

By incentivizing new companies by providing tax relief, special grants, or other financial aid. New firms that are not part of the collusion agreement will pull the industry closer to a perfect competition state, where prices are lower.

Antitrust laws

Imposing strict penalties for breaching antitrust laws can deter firms from excessive price manipulation. Periodic reviews of the state of competition and extensive market impact studies during M&As will also help keep price collusion in check.

Price ceilings

Price ceilings can be implemented to limit how high prices in an oligopoly are set.

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following CFI resources:

• Macrofinance
• Price Elasticity
• Utility Theory
• Supply and Demand

An economic setup in which a few companies rule over many in a particular market or industry

What is an Oligopolistic Market or Oligopoly?

The primary idea behind an oligopolistic market (an oligopoly) is that a few companies rule over many in a particular market or industry, offering similar goods and services. Because of a limited number of players in an oligopolistic market, competition is limited, allowing every firm to operate successfully. The situation typically breeds regular partnerships between firms and fosters a spirit of cooperation.

An oligopoly is a term used to explain the structure of a specific market, industry, or company. A market is deemed oligopolistic or extremely concentrated when it is shared between a few common companies. The firms comprise an oligopolistic market, making it possible for already-existing smaller businesses to operate in a market dominated by a few.

For example, major airlines like American Airlines and United Airlines dominate the flight industry; however, smaller airlines also operate within the space, offering special flights in the holiday niche or offering unique services as Southwest does, providing special guest singers and entertainment on certain flights.

Breaking Down Oligopolistic Markets and Firms

When thinking about oligopolistic companies, it’s important to note that these are the firms that operate in an oligopolistic market. The businesses are generally the trend and price setters, seeking out and forming partnerships and deals that establish prices that are higher than the ruling companies’ marginal costs. It means that oligopoly firms set prices to maximize their own profit. Ultimately, it leads to partnerships and collaborations that foster success for themselves and other firms, specifically smaller companies operating within the same market or industry.

If one firm in a market lowers its prices on goods and services, attaining optimal sales growth, firms in direct competition usually follow suit, often creating a price war. Oligopoly companies generally do not enter such price wars and, instead, tend to funnel more money into research to improve their goods and services and into advertising that highlights the superiority of what they offer over other companies with similar products.

Entering Oligopolistic Markets

Because of the structure of oligopolies, new firms typically find it difficult – if not impossible – to penetrate into oligopolistic markets. It is primarily due to two significant factors: strong competition from well-established and successful large firms that dominate the space and their competitive and wide-ranging product and service offerings, including premium and mass market.

For new companies with similar offerings, breaking into an oligopoly is a challenge. The only firms that typically manage to do so are those with significant funding; an oligopolistic market requires large amounts of capital to operate in because the inherent economies of scale built by oligopolies generally ensure that they have a production cost advantage.

Oligopolies form when several dominant companies rule over a particular market or industry, making collaboration and partnerships possible between the firms that exist within them. While an oligopolistic setup can be incredibly beneficial for companies already existing in the marketplace, they are equally as hard to break into for new companies without substantial funds.

Additional Resources

We hope you enjoyed reading CFI’s explanation of oligopolistic markets, industries, and companies. The following CFI resources will be helpful in furthering your financial education:

• Free Economics for Capital Markets Course
• Barriers to Entry
• Market Positioning
• Natural Monopoly
• Syndicate