What is an Oligopoly?

Oligopoly is a market structure with a small number of firms, none of which can keep the others from having significant influence. The concentration ratio measures the market share of the largest firms. A monopoly is one firm, duopoly is two firms and oligopoly is two or more firms. There is no precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the actions of one firm significantly influence the others.

Key Takeaways

  • Oligopoly is when a small number of firms collude, either explicitly or tacitly, to restrict output and/or fix prices, in order to achieve above normal market returns.
  • Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution, of oligopolies.
  • The major difficulty that oligopolies face is the prisoner's dilemma that each member faces, which encourages each member to cheat.
  • Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to limit competition.


Understanding Oligopoly

Oligopolies in history include steel manufacturers, oil companies, rail roads, tire manufacturing, grocery store chains, and wireless carriers. The economic and legal concern is that an oligopoly can block new entrants, slow innovation, and increase prices, all of which harm consumers. Firms in an oligopoly set prices, whether collectively – in a cartel – or under the leadership of one firm, rather than taking prices from the market. Profit margins are thus higher than they would be in a more competitive market. 

Conditions that Enable Oligopolies

The conditions that enable oligopolies to exist include high entry costs in capital expenditures, legal privilege (license to use wireless spectrum or land for railroads), and a platform that gains value with more customers (social media). The global tech and trade transformation has changed some of these conditions: offshore production and the rise of "mini-mills" have affected the steel industry, for example. In the office software application space, Microsoft was targeted by Google Docs, which Google funded using cash from its web search business.

Why Are Oligopolies Stable?

An interesting question is why such a group is stable. The firms need to see the benefits of collaboration over costs of economic competition, then agree to not compete and instead agree on the benefits of co-operation. Firms have sometimes found creative ways to avoid the appearance of price fixing, such as using phases of the moon. Another approach is to for firms to follow a recognized price leader; when the leader raises prices, the others will follow.

The principle problem that these firms face is that each firm has an incentive to cheat; if all firms in the oligopoly agree to jointly restrict supply and keep prices high, then each firm stands to capture substantial business from the others by breaking the agreement undercutting the others. Such competition can be waged through prices, or through simply expanding its own output brought to market. 

Game theorists have developed models for these scenarios, which form a sort of prisoner's dilemma. When costs and benefits are balanced so that no firm wants to break from the group, it is considered the Nash equilibrium state for oligopolies. This can be achieved by contractual or market conditions, legal restrictions, or strategic relationships between members of the oligopoly that enable the punishment of cheaters.

It is interesting to note that both the problem of maintaining an oligopoly, and the problem of coordinating action among buyers and sellers in general on market involve shaping the payoffs to various prisoner's dilemmas and related co-ordination games that repeat over time. As a result, many of the same institutional factors that facilitate the development of market economies by reducing prisoner's dilemma problems among market participants, such as secure enforcement of contracts, cultural conditions of high trust and reciprocity, and laissez-faire economic policy, might also potentially help encourage and sustain oligopolies.

Governments sometimes respond to oligopolies with laws against price fixing and collusion. Yet, if a cartel can price fix if they operate beyond the reach or with the blessing of governments. OPEC is one example, since it is a cartel of oil producing states with no overarching authority. Alternatively, in mixed economies, oligopolies often seek out and lobby for favorable government policy to operate under the regulation or even direct supervision of government agencies.