What happens when markets do not work perfectly?
The third market structure — oligopoly — is similar to monopoly. It is another form of imperfect competition in which firms exercise considerable market power. However, unlike monopolies, oligopolies are quite common in the real economy. We do business with oligopolies whenever we take a domestic airline flight, buy a new car, or consume a can of soda.
An oligopoly is a market or an industry dominated by just a few firms that produce similar or identical products. Oligopoly is one of the less-competitive market structures. On our spectrum of structures, it lies closer to monopoly than to perfect competition.
Like monopolies, oligopolies often arise because of economies of scale, which give bigger producers an advantage over smaller ones. In an oligopoly, however, there is at least some competition. In addition, firms in an oligopoly do not have to be large. As an example, if two hardware stores control all the hardware business in a town, then together they make up an oligopoly. The modern American economy has many oligopolies. The airline, automobile, and soft drink industries are oligopolies, as are the industries that produce light bulbs, tennis balls, and large passenger jets.
If you go to a sporting goods store to buy tennis balls, for example, you will likely find just four brands: Wilson, Penn, Dunlop, and Spalding. In 2014, these four companies controlled the U.S. market for tennis balls. In aircraft manufacturing. just two companies, Boeing and Airbus, dominated the market for jetliners. Likewise, just three companies dominated the carbonated soft drink market: Coca-Cola, Pepsi, and Dr Pepper Snapple Group. Although other companies may be part of these industries, they have little impact on the market.
Oligopolies share four main characteristics.
Few producers. In an oligopoly, a small number of firms control the market. In general, an industry is considered an oligopoly if the four top producers together supply more than about 60 percent of total output. The proportion of the total market controlled by a set number of companies is called the concentration ratio. For example, the four-firm concentration ratio in the light bulb industry is 75 percent. Figure 7.4 shows concentration ratios for various oligopolies.
Similar products. Producers in oligopolies offer essentially the same product, with only minor variations. For example, light bulbs are all very similar. They may come in different shapes and sizes, but they are all close substitutes for one another. The same goes for kitchen appliances, soap, computer chips, and cola drinks. Though some consumers prefer Coca-Cola to Pepsi and vice versa, the two drinks are actually very nearly the same.
High barriers to entry. It is hard for new firms to break into an oligopoly and compete with existing businesses. One reason may be high start-up costs. Existing firms may already have made sizable investments and enjoy the advantage of economies of scale. For example, it would cost many millions of dollars to open a new computer chip factory and compete with industry leaders such as Intel. In addition, customers might be reluctant to give up their loyalty to the old brands and try something new.
Some control over-prices. Because there are few firms in an oligopoly, they may be able to exert some control over prices. Firms in an oligopoly are often influenced by the price decisions of other firms in the market. This interdependence between firms in setting prices is a key feature of oligopoly.
When firms in an oligopoly compete for customers, the result can be a fairly competitive market. often, however, oligopolies behave more like monopolies. Rather than lower their prices to try to win a larger share of the market, firms in an oligopoly may drive prices upward to levels above the market equilibrium price. They may do this in three ways: price leadership, collusion, and cartel formation.
Price leadership. In an oligopoly dominated by a single company, that firm may try to control prices through price leadership. The dominant firm sets a price, and the other, smaller firms follow suit. If the industry leader sets the price high, the other firms benefit. Sometimes, however, the dominant firm may cut prices to take business away from its competitors or even force them out of business. If the other firms also lower their prices, the market is said to be experiencing a price war. Price wars are hard on producers but beneficial for consumers.
Collusion. Firms in an oligopoly may also try to control the market through collusion. Collusion occurs when producers get together and make agreements on production levels and pricing.
Collusion is illegal because it unfairly limits competition. Nevertheless, firms sometimes try to get around the law. For example, Apple and five major book publishing companies were accused of collusion ai med at fixing the prices of electronic books, or e-books. In 2013, a federal judge ruled that these companies negotiated with one another to drive up prices.
Cartel formation. A cartel is an organization of producers established to set production and price levels for a product. Cartels are illegal in the United States, but they do sometimes operate on a global scale, most often in the commodities markets. For example, nations that produce coffee, sugar, and tin have all tried to form cartels in the past.
The Organization of the Petroleum Exporting Countries is the best-known modern cartel. OPEC consists of about a dozen countries that agree to set quotas on oil production and exports. By setting limits on the supply of oil, OPEC exerts a major influence on world oil prices.
The market power of a cartel like OPEC underscores the potentially harmful effects of oligopolies on consumers. When firms in an oligopoly work together to control the market, they act much like a monopoly. As such, they can use their market power to limit competition and raise prices.