What will happen to one firm operating in an oligopoly when it raises its price and the other firms do not?

What Is an Oligopoly?

An 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 a market with only one producer, a duopoly has two firms, and an oligopoly consists of 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

• The term "oligopoly" refers to a small number of producers working, 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.

Oligopoly

Understanding Oligopolies

Oligopolies in history include steel manufacturers, oil companies, railroads, 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 (such as 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 the costs of economic competition, then agree to not compete and instead agree on the benefits of co-operation. The firms have sometimes found creative ways to avoid the appearance of price-fixing, such as using phases of the moon. Price-fixing is the act of setting prices, rather than letting them be determined by the free-market forces. Another approach is for firms to follow a recognized price leader; when the leader raises prices, the others will follow.

The Prisoner's Dilemma

The main 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 the individual company 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.

Companies in an oligopoly benefit from price-fixing, setting prices collectively, or under the direction of one firm in the bunch, rather than relying on free-market forces to do so.

Special Considerations

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 the market involve shaping the payoffs to various prisoner's dilemmas and related coordination 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, a cartel can price fix if they operate beyond the reach or with the blessing of governments. OPEC is one example of this 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.

What Are Some Negative Effects of an Oligopoly?

An oligopoly is when a few companies exert significant control over a given market. Together, these companies may control prices by colluding with each other, ultimately providing uncompetitive prices in the market. Among other detrimental effects of an oligopoly include limiting new entrants in the market and decreased innovation. Oligopolies have been found in the oil industry, railroad companies, wireless carriers, and big tech.

What Is an Example of a Current Oligopoly?

One measure that shows if an oligopoly is present is the concentration ratio, which calculates the size of companies in comparison to their industry. Instances where a high concentration ratio is present include mass media. In the U.S., for example, the sector is dominated by just five companies: NBC Universal; Walt Disney; Time Warner; Viacom CBS; and News Corporation—even as streaming services like Netflix and Amazon Prime begin to encroach on this market. Meanwhile, within big tech, two companies control smartphone operating systems: Google Android and Apple iOS.

Is the U.S. Airline Industry an Oligopoly?

With just four companies controlling nearly two-thirds of all domestic flights in the U.S. as of 2021, it has been purported that the airline industry is an oligopoly. These four companies are Delta Airlines, United Airlines Holdings, Southwest Airlines, and American Airlines. According to a report compiled by the White House, "reduced competition contributes to increasing fees like baggage and cancellation fees. These fees are often raised in lockstep, demonstrating a lack of meaningful competitive pressure, and are often hidden from consumers at the point of purchase." Interestingly, in 1978, The Airline Deregulation Act was imposed, which stripped away the Civil Aeronautics Board the ability to regulate the industry. Prior to this time, the airline industry operated much like a public utility, while fare prices had declined 20 years before the deregulation was introduced. 

What happens when an oligopoly increase its price?

Why the oligopolist will not compete on price to increase his/her market share?

What happens to price in an oligopoly when one firm reduces its price?

What happens if oligopolists compete hard against each other?