The term Oligopoly is derived from two Greek words: ‘oligi’ means few and ‘polein’ means to sell.

Oligopoly is a market structure in which there are only a few sellers (but more than two) of the
homogeneous or differentiated products.

Oligopoly refers to a market situation in which there are a few firms selling homogeneous or
differentiated products. Oligopoly is, sometimes, also known as ‘competition among the few’ as there
are few sellers in the market and every seller influences and is influenced by the behaviour of other
firms.

Example of Oligopoly:
In India, markets for automobiles, cement, steel, aluminium, etc, are the examples of oligopolistic
market. In all these markets, there are few firms for each particular product.

DUOPOLY is a special case of oligopoly, in which there are exactly two sellers. Under duopoly, it is
assumed that the product sold by the two firms is homogeneous and there is no substitute for it.
Examples where two companies control a large proportion of a market are: (i) Pepsi and Coca-Cola in
the soft drink market; (ii) Airbus and Boeing in the commercial large jet aircraft market; (iii) Intel and
AMD in the consumer desktop computer microprocessor market.

Types of Oligopoly:
1. Pure or Perfect Oligopoly:
If the firms produce homogeneous products, then it is called pure or perfect oligopoly. Though, it is
rare to find pure oligopoly situation, yet, cement, steel, aluminum and chemicals producing industries
approach pure oligopoly.

2. Imperfect or Differentiated Oligopoly:

If the firms produce differentiated products, then it is called differentiated or imperfect oligopoly. For
example, passenger cars, cigarettes or soft drinks. The goods produced by different firms have their
own distinguishing characteristics, yet all of them are close substitutes of each other.

3. Collusive Oligopoly:
If the firms cooperate with each other in determining price or output or both, it is called collusive
oligopoly or cooperative oligopoly. If firms in oligopoly collude and form a cartel, then they will try
and fix the price at the level which maximises profits for the industry. They will then set quotas to
keep output at the profit maximising level.
 Why are cartels illegal?

The Competition and Consumer Act not only prohibits cartels under civil law, but makes it a criminal
offence for businesses and individuals to participate in a cartel.

Cartels are immoral and illegal because they not only cheat consumers and other businesses, they also
restrict healthy economic growth by:

 increasing prices for consumers and businesses through artificially inflating input and capital costs
across the supply chain, including the cost of buildings and equipment rent, interest and decreased
opportunities over the life of an asset
 reducing innovation and choices by protecting their own inefficient members who no longer have to
compete so don’t bother to invest in research and development
 reducing investment by blocking new industry entrants that might invest in opportunities, economic
growth and jobs
 locking up resources because they interfere with normal supply and demand forces and can effectively
lock out other operators from access to resources and distribution channels
 destroying other businesses by controlling markets and restricting goods and services to the point
where honest and well-run companies cannot survive
 destroying consumer confidence in an entire industry sector, including creating negative consumer
sentiment towards law-abiding businesses that are not involved in cartel conduct.
 increasing taxes and reducing services by targeting the public sector and extracting extra costs paid for
by all consumers through rates and taxes
 decreasing infrastructure by rigging bids in public infrastructure projects which inflates costs and
ultimately reduces the public sector capacity to invest in beneficial projects.

Possible penalties for individuals involved in a cartel

Individuals found guilty of cartel conduct could face criminal or civil penalties, including:

 up to 10 years in jail and/or fines of up to $340 000 per criminal cartel offence
 a pecuniary penalty of up to $500 000 per civil contravention.
 It is illegal for a corporation to indemnify its officers against legal costs and any financial penalty.

Possible penalties for corporations involved in a cartel

For corporations, the maximum fine or pecuniary penalty for each criminal cartel offence or civil
contravention (whichever applies) will be the greater of:

 $10 000 000

 three times the total value of the benefits obtained by one or more persons and that are reasonably
attributable to the offence or contravention
 where benefits cannot be fully determined, 10 per cent of the annual turnover of the company
(including related corporate bodies) in the preceding 12 months.

Other penalties for cartel civil contraventions or criminal offences include:

 injunctions
 orders disqualifying a person from managing corporations
 community service orders.

4. Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it is called a non-collusive or non-
cooperative oligopoly.

Features of Oligopoly:
The main features of oligopoly are elaborated as follows:
1. Few firms:
Under oligopoly, there are few large firms. The exact number of firms is not defined. Each firm
produces a significant portion of the total output. There exists severe competition among different
firms and each firm try to manipulate both prices and volume of production to outsmart each other.
For example, the market for automobiles in India is an oligopolist structure as there are only few
producers of automobiles.

The number of the firms is so small that an action by any one firm is likely to affect the rival firms.
So, every firm keeps a close watch on the activities of rival firms.

2. Interdependence:
Firms under oligopoly are interdependent. Interdependence means that actions of one firm affect the
actions of other firms. A firm considers the action and reaction of the rival firms while determining its
price and output levels. A change in output or price by one firm evokes reaction from other firms
operating in the market.

For example, market for cars in India is dominated by few firms (Maruti, Tata, Hyundai, Ford, Honda,
etc.). A change by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce other firms
(say, Maruti, Hyundai, etc.) to make changes in their respective vehicles.

3. Non-Price Competition:
Under oligopoly, firms are in a position to influence the prices. However, they try to avoid price
competition for the fear of price war. They follow the policy of price rigidity. Price rigidity refers to a
situation in which price tends to stay fixed irrespective of changes in demand and supply conditions.
 Firms use other methods like advertising, better services to customers, etc. to compete with each
other.

If a firm tries to reduce the price, the rivals will also react by reducing their prices. However, if it tries
to raise the price, other firms might not do so. It will lead to loss of customers for the firm, which
intended to raise the price. So, firms prefer non- price competition instead of price competition.

4. Barriers to Entry of Firms:

The main reason for few firms under oligopoly is the barriers, which prevent entry of new firms into
the industry. Patents, requirement of large capital, control over crucial raw materials, etc, are some of
the reasons, which prevent new firms from entering into industry. Only those firms enter into the
industry which is able to cross these barriers. As a result, firms can earn abnormal profits in the long
run.

Kinked-Demand Theory

Consider a firm in an oligopoly that wants to change its price. How will the other firms react?
There are 2 possibilities: they can either match the price changes or ignore them. But what the
other firms will actually do will probably depend on the direction of the price change. If one firm
raises its price, the others probably will not follow, since that will allow them to take market
share from the price changer. This makes the demand curve more elastic, since as the firm raises
its price, then many of its customers will buy from the other firms, lowering the revenue of the
higher-priced firm.

If the firm lowers its price, then the other firms would surely follow, to prevent any loss of
market share. This part of the demand curve is much more inelastic, since all of the firms are
acting in concert. This creates a kink in the demand curve, where the change in demand goes
from very elastic at higher prices to inelastic at lower prices. Since the marginal revenue curve
depends on prices, the marginal revenue curve is also kinked. At lower prices, the marginal
revenue curve drops downward creating a gap.
 P1 = Product Price of the Oligopoly
 If a firm raises its price (D1), but the others do not match the increase, then revenue will decline
in spite of the price increase.
 If the firm lowers its price (D2), then the other firms will match the decrease to avoid losing
market share.
 Because there is a kink in the demand curve, there is a gap in the marginal revenue curve (MR1 -
MR2). Since firms maximize profit by producing that quantity where marginal cost equals
marginal revenue, the firms will not change the price of their product as long as the marginal cost
is betweenMC1 and MC2, which explains why oligopolistic firms change prices less frequently
than firms operating under other market models.

The kinked-demand curve explains why firms in an oligopoly resist changes to price. If one of
them raises the price, then it will lose market share to the others. If it lowers its price, then the
other firms will match the lower price, causing all of the firms to earn less profit.
Oligopoly & Game Theory

Author: Geoff Riley Last updated: Sunday 23 September, 2012

Game Theory

Game theory is mainly concerned with predicting the outcome of games of strategy in which the
participants (for example two or more businesses competing in a market) have incomplete
informationabout the others' intentions.

Game theory analysis has direct relevance to the study of the conduct and behaviour of firms in
oligopolistic markets – for example the decisions that firms must take over pricing and levels of
production, and also how much money to invest in research and development spending.

Costly research projects represent a risk for any business – but if one firm invests in R&D, can a rival
firm decide not to follow? They might lose the competitive edge in the market and suffer a long term
decline in market share and profitability.

The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and
the other firm does, then their profits fall and they lose market share. However, there are only a
limited number of patents available to be won and if all of the leading firms in a market spend heavily
on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.

The Prisoners’ Dilemma

 The classic example of Game theory is the Prisoners’ Dilemma, a situation where two
prisoners are being questioned over their guilt or innocence of a crime.
 They have a simple choice, either to confess to the crime (thereby implicating their
accomplice) and accept the consequences, or to deny all involvement and hope that their
partner does likewise.

Confess or keep quiet? The Prisoner’s Dilemma is a classic example of basic game theory in action!

 The “pay-off” is measured in terms of years in prison arising from their choices and this is
summarised in the table below.
 No communication is permitted between the two suspects – in other words, each must make an
independent decision, but clearly they will take into account the likely behaviour of the other
when under-interrogation.

Nash Equilibrium
A Nash Equilibrium is an idea in game theory – it describes any situation where all of the participants
in a game are pursuing their best possible strategy given the strategies of all of the other participants.
In a Nash Equilibrium, the outcome of a game that occurs is when player A takes the best possible
action given the action of player B, and player B takes the best possible action given the action of
player A.

Prisoner A

Two prisoners are held in a separate room and

cannot communicate
They are both suspected of a crime
They can either confess or they can deny the
crime
Payoffs shown in the matrix are years in prison
from their chosen course of action Confess Deny
Confess (3 years, 3 years) (1 year, 10 years)
Deny (10 years, 1 year) (2 years, 2 years)
Prisoner B

 What is the best strategy for each prisoner? Equilibrium happens when each player takes
decisions which maximise the outcome for them given the actions of the other player in the
game.
 In our example of the Prisoners’ Dilemma, the dominant strategy for each player is to
confess since this is a course of action likely to minimise the average number of years they
might expect to remain in prison.
 But if both prisoners choose to confess, their “pay-off” i.e. 3 years each in prison is higher
than if they both choose to deny any involvement in the crime.
 In following narrowly defined self-interest, both prisoners make themselves worse off
 That said, even if both prisoners chose to deny the crime (and indeed could communicate to
agree this course of action), then each prisoner has an incentive to cheat on any agreement
and confess, thereby reducing their own spell in custody.

The equilibrium in the Prisoners’ Dilemma occurs Prisoner A

when each player takes the best possible action for
themselves given the action of the other player.

The dominant strategy is each prisoners’ unique best

strategy regardless of the other players’ action
Best strategy? Confess?

A bad outcome! – Both prisoners could do better by

both denying – but once collusion sets in, each Confess Deny
prisoner has an incentive to cheat!
Confess (3 years, 3 years) (1 year, 10 years)
Deny (10 years, 1 year) (2 years, 2 years)
Prisoner B

Applying the Prisoner’s Dilemma to business decisions

Consider this example of a simple pricing game: The values in the table refer to the profits that flow
from making a particular decision.

Firm B’s output

High output Low output
High output £5m, £5m £12m, £4m
Firm A’s output
Low output £4m, £12m £10m, £10m
 Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B
opts for a low output, Firm A wins £12m and Firm B wins £4m.
 In this game the reward to both firms choosing to limit supply and thereby keep the price
relatively high is that they each earn £10m. But choosing to defect from this strategy and
increase output can cause a rise in market supply, lower prices and lower profits - £5m each if
both choose to do so.
 Example: Tesco fined for cartel pricing
Tesco plc has been fined £10m as part of a wider £50m penalty slapped on supermarkets and
milk companies by the Office of Fair Trading after it ruled there had been collusion over the
price of cheese and milk. The scam - dating back to 2002 and 2003 - was said to have cost
consumers around £270m. Tesco continues to deny it colluded with the other companies.
News reports, summer 2011

A dominant strategy is a strategy that is best irrespective of the other player’s choice. In this
case the dominant strategy is competition between the firms.

 The Prisoners’ Dilemma can help to explain the breakdown of price-fixing agreements
between producers which can lead to the out-break of price wars among suppliers, the break-
down of other joint ventures between producers and also the collapse of free-trade agreements
between countries when one or more countries decides that protectionist strategies are in their
own best interest.
 The key point is that game theory provides an insight into the interdependent decision-
making that lies at the heart of the interaction between businesses in a competitive market.