Oligopoly

An oligopoly is an industry where a small number of firms produce the bulk of the industry’s output. Each firm competes with the others in an interdependent manner; every firm’s sales depends not only on the price it charges, but also on the prices charged by its competitors. Because there are few firms and because there are real or imagined differences between them, the demand curve faced by each firm is downward sloping. However, many of the goods and services produced by oligopolists are essentially homogeneous. Barriers to entry in oligopolies are largely the same as for monopolies: Economies of scale, patents, or the sheer size and complexity of the firms involved.

Unlike perfect competition, when an oligopolist changes their price, the other producers are likely to react. If one firm raises its price, most of its customers will switch to other firms (assuming they do not raise prices to match). So above the going price, the demand curve is highly elastic. If one firm lowers its price, the other firms will lower theirs to match, so the quntity sold will not change much. So below the going price, the demand curve is relatively inelastic. This results in a “kinked” demand curve. Since the demand curve (=average revenue curve) is downward sloping, the marginal revenue curve is also downward sloping and below the demand curve. At the point where the kink appears in the demand curve, the marginal revenue curve is vertical over some price range. As a result, there is a range of marginal costs over which the profit maximizing price is the same.

The long term profit maximizing strategy for an oligopolist is not simple because it depends on what the competitors will do. This is what has led to the compexity of airline pricing. The easiest solution is for the oligopolists to to form a cartel, establish the industry-wide profit maximizing price, and earn monopoly profits. Fortunately this is illegal. What oligopolists can do legally is to implicitly elect one firm as the “price leader” and have all other firms match any price changes. This is legal so long as the firms act only on publically available data and do not collude.