A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each have its own drug for reducing high blood pressure, those three firms may become an oligopoly.
Similarly, a natural oligopoly will arise when the quantity demanded in a market is only large enough for very few firms to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only two or three firms, because no smaller firm can operate at a low enough average cost to compete, and no single large firm could sell what it produced given the quantity demanded in the market.
Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms. Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role in creating an oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.
This brings us to understanding the Characteristics of an Oligopoly Market:
Therefore, Oligopoly is a market structure where a few interdependent firms compete, each firm pays close attention to what the other firm does and this is possible because a relatively small number of firms compete in the market. Barriers to entry result in less competition by preventing the entry of new firms in the market.
Because oligopoly models are complex due to this interdependence among firms, we do not use the traditional economic models to study Oligopoly, rather we use a different kind of model to understand firms’ behaviour in Oligopolistic set up. Such models are called Game Theory Models. We will discuss these in the consequent sections.
“10.2 Oligopoly” in Principles of Economics 2e by OpenStax is licensed under Creative Commons Attribution 4.0 International License.