Section 3: Characteristics of an Oligopoly Industry

Oligopoly Characteristics

Four characteristics of an oligopoly industry are:

1. Few sellers.
There are just several sellers who control all or most of the sales in the industry.

2. Barriers to entry.
It is difficult to enter an oligopoly industry and compete as a small start-up company. Oligopoly firms are large and benefit from economies of scale. It takes considerable know-how and capital to compete in this industry.

3. Interdependence.
Oligopoly firms are large relative to the market in which they operate. If one oligopoly firm changes its price or its marketing strategy, it will significantly impact the rival firm(s). For instance, if Pepsi lowers its price by 20 cents per bottle, Coke will be affected. If Coke does not respond, it will lose significant market share. Therefore, Coke will most likely lower its price, too.

4. National advertising.
Oligopoly firms frequently advertise on a national scale. Many Super Bowl, World Series, Wimbledon finals, World Cup finals, NBA finals, and NCAA March Madness advertisements are sponsored by oligopoly firms.

Examples of Oligopoly Industries

Profit Maximization in an Oligopoly Industry

Firms in oligopoly industries maximize profits in the same way as firms in other industries. They maximize profits at the quantity where a rising marginal cost equals or approaches marginal revenue, as long as the price is greater than the average variable cost (otherwise, shut down).

The Kinked Demand Curve

Some economists claim that because of the interdependence between rival oligopoly firms, there are two demand curves to consider.

Let’s suppose that the current price of a product sold by oligopoly firm X is $8, and the firm sells 5 products at this price. What will happen to the firm’s quantity sold if it changes its price? The answer depends on what rival firm Y will do in response to the price change.

Let’s assume that firm Y does not copy the price change of firm X. Then if firm X lowers its price, it will have a significant competitive advantage over firm Y, and its quantity sold will increase considerably. If it raises its price, the opposite will occur. Thus, firm X’s price elasticity of demand is high, if firm Y does not copy its price change. This is shown in Table 1 below, and is illustrated by demand curve D1 in the graph below.

Let’s now assume that firm Y does copy the price change of firm X. Then if firm X lowers its price, it will not have a significant competitive advantage over firm Y, and its quantity sold will not increase considerably (there is no substitution effect, only an income effect). If it raises its price, and firm Y copies the price change, then firm X will not lose much market share. In other words, firm X’s price elasticity of demand is low, if firm Y does copy its price change. This is shown in Table 2 below, and is illustrated by demand curve D2 in the graph below.

Table 1 – Demand for firm X’s product, if the rival firm does not copy a price change

Table 2 – Demand for firm X’s product, if the rival firm does copy a price change

Some economists believe that rival firm Y will copy a price change of firm X, only if firm X lowers its price. However, they believe that rival firm Y will not copy a price change of firm X, if firm X raises its price. Thus, if firm X lowers its price below the current price of $8, demand D2 is relevant. This is illustrated by the green part of Table 2 and the green part of demand curve D2. If firm X raises its price above the current price of $8, demand curve D1 is relevant. This is illustrated by the green part of Table 1 and the green part of demand curve D1. We end up with two demand curves, depending on whether firm X lowers or raises its price. Therefore, the demand curve of firm X is kinked. This is illustrated by the green kinked demand curve in the graph below.

Because the demand curve is kinked, there is a gap in firm X’s marginal revenue curve. As you can see from the calculations in the tables above, marginal revenue at quantity 5 is different depending on whether you use demand 1 or demand 2. The relevant marginal revenue portions of the kinked demand curve are illustrated by the blue curve above.

Not every economist believes in the kinked demand curve theory. Some economists believe that oligopolies behave just like other firms. In that case, the demand and revenue curves look similar to the demand and revenue curves of the monopoly and monopolistically competitive firms discussed before.

Profits of Firms in an Oligopoly Industry

Regardless of the shape of the demand curve, we can conclude that for oligopoly firms, economic (above-normal) profits are possible in the long run because of the more difficult entry into the industry. However, in the long run, extremely high profits are unlikely. If the price of the product is too high, competitors will enter eventually, undercut the existing firms’ prices, and lower industry profits. Occasionally, gasoline prices increase, and people are concerned that oil companies are exploiting consumers. Not to say that this never happens, but the higher gasoline prices are usually a result of higher demand (for example, during the summer) or lower supply (because of deliberate cutbacks by OPEC, or a crisis in an oil-producing country). If oil prices are excessive for a considerable period of time, then, despite barriers, new technologies will be developed (as we have seen with fracking) and new competitors will enter the market. This will increase the supply and lower the price. If prices are high, consumers may also respond by reducing demand (purchasing more hybrid or fuel-efficient cars, turning to alternative sources of energy, living closer to work). These market forces will in the long run, make prices come down.
Video Explanation
For a video explanation of the Kinked Demand Curve Theory, please watch: