Oligopoly is a market that lies between perfect competition and monopoly.
In an oligopoly:
- Natural or legal barriers prevent other new firms from entering the market.
- Only a small number of firms will compete.
Recall from last section that economies of scale create natural barriers in monopoly.
This causes firms to produce more at a low cost and increase profit, which we call natural monopoly.
This also happens in oligopoly, so we call this natural oligopoly
We will look at two types of oligopoly:
- Natural duopoly
Suppose the market demand is 20 outputs. Firm produces at where economies of scale ends (efficient scale), which is at 10 outputs. Since there are 2 firms in duopoly, then there are 20 outputs in total, which meets demand.
- Natural oligopoly with 3 firms
Suppose the market demand is 30 outputs. Firm produces at where economies of scale ends (efficient scale), which is at 10 outputs. Since there are 3 firms in duopoly, then there are 30 outputs in total, which meets demand.
Note: Natural oligopoly is not limited to 2 or 3 firms.
Distinctive Features of Oligopoly
There are two distinctive features of oligopoly.
- Interdependence: Each firm is large enough so that one firm’s action can affect the market. Thus, the competing firms will be aware of each other’s action in the market and respond accordingly.
- Cooperation: Firms can increase their economic profit if they were to form a cartel and act like a monopoly.
Note: a cartel
is a group of firms working together by restricting output and increasing price to gain economic profit. This is what monopolies exactly do.