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Oligopoly

An industry where only a few firms operate

What is an Oligopoly?

The term “oligopoly” refers to an industry where there are only a small number of firms operating. In an oligopoly, no single firm has a large amount of market power. Thus, no single firm is able to raise its prices above the price that would exist under a perfect competition scenario. In an oligopoly, all firms have to collude in order to raise prices and realize a higher economic profit. Most oligopolies exist in industries where goods are relatively undifferentiated and broadly provide the same benefit to consumers.

 

Oligopoly

 

Why do oligopolies exist?

The biggest reason why oligopolies exist is collaboration. Firms see more economic benefits in collaborating on a specific price than in trying to compete with their competitors. By controlling prices, oligopolies are able to raise their barriers to entry and protect themselves from new potential entrants in the market. This is quite important, as new firms may have much lower prices and thus jeopardize the longevity of the colluding firms’ profits.

In most markets, antitrust laws exist that aim to prevent price collusion and protect consumers. Nonetheless, firms have devised ways to achieve price collusion without being detected by regulators. For example, firms might elect a price leader that is tasked with leading changes in prices before other firms follow suit in order to “react to competition.” Firms may also agree to change their prices on specific dates; in such case, the changes may be seen as reactionary to economic conditions such as fluctuations in inflation.

 

How do oligopolies work?

Below is a game theory example that models collusion in a two-firm oligopoly:

 

Oligopoly - Game Theory
Profits given as (Firm A, Firm B)

 

It is important to note that in real-life oligopolies, the games (instances of collusion) are sequential; meaning that one firm’s behavior in one game may influence the game’s outcome in future periods. In this scenario, we see that the optimal outcome that generates the most cumulative profits occurs if both firms collude. This situation would be the best long-run equilibrium situation that would provide the most benefit to all the firms.

Nonetheless, in this equilibrium, firms have an incentive to cheat and not collude. For example, if both firms agree to set a price of $10, but Firm A cheats and sets prices at $5, Firm A will essentially capture the entire market (assuming little to no differentiation). While this may result in high profits for Firm A in this game, Firm B now knows that Firm A is a cheater and thus will never collude again.

Therefore, the new equilibrium would be the one where neither firms collude and achieve profits that would occur under perfect competition (which is significantly less profitable than colluding). Thus, to realize the best long-run profits, firms in an oligopoly choose to collude.

 

How to protect consumers from oligopolies?

While some oligopolies do not significantly harm consumers, others do. In such cases, governments can take a range of actions to protect consumers, such as:

 

Lowering barriers to entry

By incentivizing new companies by providing tax relief, special grants or other financial aid. New firms that are not part of the collusion agreement will pull the industry closer to a perfect competition state, where prices are lower.

 

Antitrust laws

Imposing strict penalties for breaching antitrust laws can deter firms from excessive price manipulation. Periodic reviews of the state of competition and extensive market impact studies during M&As will also help keep price collusion in check.

 

Price ceilings

Price ceilings can be implemented to limit how high prices in an oligopoly are set.

 

Additional resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Macrofinance
  • Price Elasticity
  • Utility Theory
  • Supply and Demand

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