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The nature of oligopoly / assumptions of the model

Oligopoly is a market form in which there are only a few firms in the industry with many buyers; so market supply will be concentrated in the hands of relatively few producers, although an industry might still be said to be oligopolistic where several smaller firms existed alongside the few large firms that dominate; the wholesale petrol market provides a suitable example of the latter. The markets for cigarettes, records, confectionery, motor vehicles, fizzy drinks, high street banks, airline carriers, domestic appliances, soap powders and supermarket chains all provide good examples of oligopoly in the UK and elsewhere.

Where the few firms produce an identical product, this is known as perfect oligopoly, and where, more commonly, the products are differentiated, this is referred to as imperfect oligopoly. The case of duopoly, where there are only two firms in the industry, is a special case of oligopoly.

However, the absolute number of firms in the market is less significant than the way in which they behave and the relationship between the firms that comprise the industry. In the case of the monopolist, for example, independent price and output decisions can be made, with the only consideration being the customer's reaction to the change in price. However, in oligopoly, where there is competition amongst the relatively few, each firm has to also try to assess the reaction of its rivals to a change in price, as each firm will occupy a sufficiently important position within the industry for its particular price and output decisions to have a significant impact on its competitors. Thus if an oligopolist is thinking of raising the price of its product, it has to assess whether its rivals will do likewise or keep price down in order to gain more custom. Oligopoly is therefore characterised by interdependence between the firms that comprise the industry, and by reactive market behaviour.

Oligopoly has emerged as the most prevalent market form in the industrialised world. This can partly be explained by the existence of economies of scale, especially in manufacturing, encouraging the growth of large scale production; inevitably, as firms grow in size, the number of firms supplying the market falls, and hence the tendency towards oligopoly power. Moreover, once established, this power may be sustained by various barriers to entry, similar to those that exist under monopoly.

The importance of non-price competition

As we shall see from our forthcoming discussion of oligopoly, an important feature of oligopolistic markets, i.e. ones dominated by a few large firms, is the tendency towards relative price stability. Lack of price movement will occur most obviously where firms collude with each other to collectively fix their prices, but it may also occur in a situation of, what is known as, non-collusive oligopoly, where no such price agreements exist; inderdependent firms may well come to the conclusion that there is no point in 'cutting each others throats' by engaging in price warfare in the longer term as this could be disastrous for all the combatants, although there may be a tendency towards occasional short bursts of price cutting. However, this absence of price competition does not necessarily mean an absence of competition: oligopolistic firms are likely to compete in a variety of non-price forms.

Non- price competition occurs where firms attempt to win a competitive advantage over their rivals by strategies other than reducing prices. Non-price competition inevitably involves product differentiation. Here, oligopolistic competitors try to carve out separate markets in which they can command consumer loyalty through the creation of actual or imagined differences in the goods or services they offer, which are essentially the same as their rivals. This is in contrast to perfect competition where the good on offer, perhaps an agricultural one, is homogeneous, and product differentiation is difficult e.g. one carrot is pretty much the same as another.

Product differentiation is extremely widespread amongst the whole variety of consumer goods and services that we buy e.g. washing machines, television sets, home computers, motor cars, washing powders, soft drinks, packaged holidays and financial services, to name but a few. These are all differentiated one from another in a variety of ways, including shape, size, quality and image.

Non-price competition may take a variety of forms, including:

  • Advertising
  • Branding
  • Product innovation
  • Packaging
  • The provision of after sales services e.g. product guarantees
  • Free samples and gift offers.

We shall examine the first three of the above i.e. advertising, branding and product innovation in greater detail.