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Unit 12: Oligopoly

2. Price Retaliation: Firms may retaliate by reducing prices when entry actually occurs or if Notes
it appears imminent. When the danger has diminished, prices can be increased to
appropriate level. If a firm establishes a consistent pattern of reacting to entry by drastically
reducing prices, then potential rivals may become convinced that they will face the same
response and decide not to compete. Thus, by firmly establishing a reputation for dealing
harshly with all new entrants, the firm may create an effective barrier to entry.
3. Capacity Expansion: The threat of price retaliation may not be credible if existing firms
are unable to produce enough output to meet extra demand resulting from lower prices.
In a rapidly growing market, a new entrant may be able to survive by serving new
customers that the existing firms cannot supply with their present production capacity. A
strategic response by established firms to prevent this from occurring would be to invest
in additional capacity. Once this investment has been made, it becomes a sunk cost and
places existing firms in a position to expand their production at a relatively low cost. The
existence of excess capacity provides a strong signal that the established firms can reduce
prices as a strategic response to entry in their market.

Investment in excess capacity reduces the profits earned by an existing firm. Hence, this
investment will be undertaken only if management believes that the certain and immediate
loss of profit from making the investment is less than the expected future profit/loss
resulting from entry.
4. Market Saturation: The geographic location of the productive capacity can also cause
barriers to entry. When costs of transporting a good are high relative to its value, consumers
who are not close to a production facility may be required to pay substantially higher
prices to have the good delivered to their location. Thus, firms that locate closer to those
consumers will have a cost advantage and should be able to attract those customers.

12.6 Application of Oligopoly

An oligopoly market structure is characterized by a small number of large firms that dominate
the market, selling either identical or differentiated products, with significant barriers to entry
into the industry. This is one of four basic market structures. Oligopoly finds a major share in the
modern economic scene. Oligopolistic industries are quite diverse and widespread, covers almost
all production areas.

Oligopoly is a market structure characterized by a small number of relatively large firms that
dominate an industry. The market can be dominated by as few as two firms or as many as twenty,
and still be considered oligopoly. With fewer than two firms, the industry is monopoly. As the
number of firms increase (but with no exact number) oligopoly becomes monopolistic
competition.

Under oligopoly, firm is relatively large compared to the overall market, it has a substantial
degree of market control. It does not have the total control over the supply side as it happens in
the case of monopoly. There is an interdependence among firms in an industry, which is a key
feature of oligopoly. The actions of one firm depend on and influence the actions of another. The
interdependence of firms creates a number of economic issues. One is the tendency for competing
oligopolistic firms to turn into cooperating oligopolistic firms.
The cigarette industry was an example of this practice. Over time R.J. Reynolds emerged as the
price leader, and the other two major firms never changed prices until Reynolds did. There is not
as much evidence of such leadership today, but there was little price competition among cigarette
producers until 1993, when strong price competition from discount brands led to a period of
price cutting.
Oligopoly structure has both good and bad effects.

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