An Oligopoly is a type of market where there are a relatively small number of firms. The important thing to remember about an oligopolistic market is that each firm’s decision impacts another firm’s decision, so they are related or dependent on each other. For example, if one airline were to lower their ticket prices, all other airlines would lower their ticket prices as well to stay competitive; this dependence on rival firms is unique to the oligopoly market.
Imagine if you are in a perfectly competitive firm, you are a price taker, so the decisions of other firms do not impact you. If you are in a monopolistically competitive market you advertise, research, brand, change the quality of your product to make an economic profit, you do not interact directly with competitors. Finally, in a monopoly market you have no competition so rival firms do not impact your decisions.
Other factors necessary for an oligopolistic market are:
1. A small number of firms compete in an oligopolistic market
2. Barriers to entry (either natural or legal) are present
3. Firms consider other firm’s behavior in their decisions (game theory)
How does an oligopoly arise? It can either happen naturally due to economies of scale, or it can happen legally due to permits or laws enforced by the government. For the legal method, there simply needs to be a law in place that limits the number of firms that can enter a market. For example, some big cities in the US have 2 or 3 cable TV providers because the city government limits the amount of firms that can use the existing infrastructure. This same logic applies for trash collections companies or electricity providers. The natural way oligopolies can occur has to do with their long run average total cost curve, and how it is in the best interest of society to have only a few firms. Consider the following graph:
Here ATC1 is the long run average total cost curve for firm 1, and ATC2 and ATC3 represent the long run average total cost curves for firms 2 and 3 respectively. Not that the minimum of the ATC curve for each firm occurs at P*, and at this point each firm can make 3,000 units individually or 9,000 units in total. For this market, it makes sense to only have 3 firms, because with 3, each firm produces at its minimum ATC which results in the lowest price possible for consumers. This natural monopoly occurs because economies of scale are taken advantage of meaning only 3 big firms results in an efficient outcome.
Another big component of an oligopolistic market is that firms have the ability to collude. This means that the small number of firms can band together to form a cartel, and then operate as a monopoly. However, if firms do not collude, they may compete with each other by lowering their prices until both firms are producing at their marginal cost, which is identical to the perfectly competitive outcome.
Because of these characteristics of an oligopolistic market, the resulting equilibrium price and quantity can vary between the monopoly outcome at one extreme end, and the perfectly competitive outcome at the other extreme end. However, most of the time the final result will be somewhere in between depending on the behavior of the oligopolist.
Oligopolies also lead to into the study of game theory, which has been studied extensively by many economists.