Oligopoly

Sample Question

Oligopoly and Monopolistic Competition: A Comparative Analysis

Oligopoly vs. Monopolistic Competition

Oligopoly:

• Definition: A market structure characterized by a few dominant firms.  
• Key Characteristics:
  • High barriers to entry  
  • Interdependence among firms  
  • Product differentiation (may or may not be present)
  • Price rigidity (due to interdependence)  
• Real-World Example: The automobile industry, dominated by a few major players like Toyota, Ford, and General Motors. These firms compete on factors such as brand image, product differentiation, and advertising.  

Monopolistic Competition:

• Definition: A market structure characterized by many firms selling differentiated products.  
• Key Characteristics:
  • Low barriers to entry  
  • Product differentiation
  • Price-setting power
• Real-World Example: The restaurant industry, where numerous restaurants compete by offering unique menus, ambiance, and services.

Unique Decision-Making in Oligopolies

In an oligopoly, firms are interdependent, meaning that the actions of one firm can significantly impact the decisions of others. This interdependence leads to strategic behavior, where firms carefully consider the potential reactions of rivals before making pricing or output decisions. This can result in price rigidity, as firms may be reluctant to engage in price wars that could harm all players.  

Economic Profit in Oligopolies

Yes, firms in oligopolies can earn economic profits in the long run, especially if they can differentiate their products or collude. However, the extent of these profits depends on factors such as the degree of product differentiation, the intensity of competition, and the effectiveness of collusion.  

Cartels: A Double-Edged Sword

A cartel is a group of firms that collude to fix prices or output levels. Cartels can be stable in the long run if:  

• Strong Barriers to Entry: High barriers to entry can deter new firms from entering the market and challenging the cartel.  
• Effective Monitoring and Enforcement: The cartel must have a mechanism to monitor members' behavior and punish those who deviate from the agreed-upon strategy.
• Limited Demand Elasticity: If demand for the product is relatively inelastic, firms can raise prices without significantly reducing demand.  

However, cartels are inherently unstable due to the incentive for individual firms to cheat. If a firm can increase its profits by secretly lowering its price or increasing its output, it may be tempted to do so. This can lead to a breakdown of the cartel and a return to more competitive behavior.  

Impact of Cartel Breakup on Market Price and Quantity

If a cartel breaks down and firms engage in price competition, the market price will likely decrease, and the quantity produced will increase. This is because firms will attempt to undercut each other's prices to gain market share. The market outcome will approach that of a perfectly competitive market, with lower prices and higher output.