What is Oligopoly?
Oligopoly is an economic term that describes a market structure wherein only a select few market participants compete with each other. The competitive dynamics within an oligopoly are distorted to favor a limited number of influential sellers.
How Does an Oligopoly Work in Economics?
An oligopoly is defined as a market in which the industry is dominated by a few companies that are each influential participants in the market.
There is no precise number of companies that qualifies a market as an oligopoly. But as a rough guideline, the number of sellers must exceed two yet be fewer than about five.
The oligopoly market structure forms from a limited number of companies possessing a substantial portion of the market, coupled with stiff competition and high barriers to entry.
Over time, the competition within the market reduces, resulting in only a handful of competitors controlling the market.
Since a market characterized as an oligopoly consists of just a few competitors, the decisions of each company directly influences the decisions of the rest of the market participants.
Given those market conditions, it should be intuitive as to why the formation of an oligopoly can easily become corrupt (and the participants are prone to collusion).
What Factors Cause an Oligopoly to Form?
An oligopoly is characterized by only a handful of influential companies competing in a given market, which can either occur by chance or deliberately.
Because the number of market participants is low enough that the actions of one competitor is noticed by the rest, one company diverging from cooperating with other competitors can swiftly set off a chain reaction.
In a sense, the companies are trapped in a prisoner’s dilemma scenario, where all the companies are in a state of mutual interdependence, i.e. the strategy of the participating companies are reactive with attempts to anticipate the moves of their rivals.
Each company has the resources to actively influence the market, such as raising prices or intentionally restricting output to create an artificial shortage.
Yet the companies involved rarely want to make the first move, as they want to minimize unnecessary regulatory oversight and avoid accusations of unethical practices such as “price fixing” (when the prices are not set by the free market but by the efforts of those in influential positions).
- Collusion: In a worst-case scenario, the companies involved in an oligopoly decide to cooperate and agree to collude, so their partnership effectively creates a monopoly.
- Passive Cooperation: If one company acts in their self-interest, there is a tendency for others to follow suit shortly – i.e. causing herd-like behavior despite a formal lack of uniformity – reflecting how the behavior of the market participants tends to be predictable (or at least their reactions to each other’s actions). In this case, the rivals are not actually cooperating, but are instead moving sequentially in a form of passive cooperation, whereby the dominant leader makes the first move and the others follow.
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Enroll TodayWhat are the Characteristics of a Non-Cooperative Oligopoly?
In non-cooperative oligopolies, the competition can become intense because the companies – each being very influential – are essentially set off into a price war with one another.
In contrast, the concept of Nash equilibrium in game theory states that each participant in a non-cooperative market can optimize their outcome by maintaining their current strategy.
The state of Nash equilibrium is reached when the participants realize that nothing can be gained from changing their strategy, so it is in the best interests of all parties to avoid any strategy changes at all.
What are the Different Types of Oligopoly Markets?
In an oligopoly, competition is among only a few companies, and there are two distinct forms of competition:
- Homogenous Oligopoly (or Pure) → No to Minimal Product Differentiation in Market
- Differentiated Oligopoly → Product Differentiation in Market
Regardless, important similarities include the absence of free market forces and a limited number of sellers in the market, where a few sellers dominate the market and dictate the prices of the good(s) in question.
What is the Difference Between Monopoly vs. Oligopoly?
In an oligopoly, while there are only a handful of companies in possession of significant market share in the market, no individual company exerts far more influence relative to the others.
The lack of a single company in control of the market is the differentiation between an oligopoly and a monopoly, wherein there is only one seller with outsized control over the entire market.
Compared to markets with perfect competition, oligopolistic markets are clearly more concentrated, but still not as much as in a monopoly.
What is an Example of Oligopoly?
An example of a modern oligopoly is the U.S. airline industry, where four carriers hold in excess of 2/3 of total market share.
The four airline carriers are as follows:
- American Airlines (AAL)
- Delta Air Lines (DAL)
- Southwest Airlines (LUV)
- United Airlines (UAL)
Because each of these airlines’ market shares is relatively similar, they form an oligopoly rather than a monopoly.
Domestic Airline Market Share (Source: JetBlue)
The reason for these market conditions is in part attributable to the capital-intensive nature of the airline industry, where the required amounts of capital expenditures to even enter the market are substantial.
These spending needs effectively function as a barrier to entry for other airlines that struggle to compete.
Further, the unit economics in the airline industry is well-known for being unfavorable – i.e. significant fuel and personnel costs coupled with seasonality and cyclicality result in unpredictable performance and razor-thin profit margins.
The U.S. government is well-aware of the oligopoly, as confirmed by the Department of Justice’s lawsuit to block a potential partnership agreement between American Airlines and JetBlue Airlines on the basis of antitrust laws.
American Airlines and JetBlue vs DOJ: How Big Can Airlines Get? (Source: Economics Review At NYU)
