On one hand we have perfect competition, in which the allocation of resources is the most efficient it can possibly be. On the other hand we have monopolies, in which resources are allocated in an inefficient manner. The majority of markets however, aren’t either of these and are better described as oligopolies.
This structure is a go-between of monopolies and perfect competition (though slightly leaning towards the former). Oligopolies usually entail the following:
Dominated by a small group of large firms. (“Oli” comes from the Greek word for “few” and “poly” comes from the Greek word for “sellers.” This applies to other terms as well; “mono” means single, and hence “mono” + “poly” means “single seller”)
Similar to monopolies, these oligopolistic firms are protected by large barriers to entry and are price setters as opposed to price takers
The goods being sold can be either homogeneous (raw materials) or differentiated (smartphones)
Interdependence. This is what makes oligopolies unique. Because these markets are composed of only a few firms, the actions of just one of them will affect the entire market and consequently, those other firms. The reason this doesn’t occur under perfect competition is because there is no firm large enough to affect the market’s price - remember, perfectly competitive firms are price takers
In the first point, you’ll notice it says “a small group of large firms.” But what exactly does a “small” group mean? There’s no objectively small group; it depends on the market. Throwing around vague phrases such as “a small group” fosters ambiguity, so economists Orris C. Herfindahl and Albert O. Hirschman developed the Herfindahl-Hirschman Index (HHI). What this does is quantitatively measure a market’s concentration ratio, which tells us the percentage of output created by the largest firms in an industry. A lower concentration ratio means more competition among the competitors, whereas a high concentration ratio means just that, a higher market concentration.
There’s actually 2 ways to calculate market concentration, both of which should theoretically give us the same or similar results. Say we have these 4 companies in the steel industry:
Metal Corp: 18% market share
Standard Metal: 35% market share
Robinson & Co: 24% market share
JPOC Iron: 10% market share
The quicker way to calculate this would be simply adding up the market shares of the largest 4, 8, 20, or 50 firms in that industry (these are the parameters the US Census Bureau uses). In our example, the market concentration ratio would be 87%, indicating the steel industry is very oligopolistic.
The HHI method, however, calculates market concentration via the following formula:
Let’s break this down. The “s” in “Si” refers to the market share of firm “i”. So, the market share of a given firm is squared - that’s what the “2” at the top right of the “Si” means. The “N” represents the number of firms in the given market. For those of you who don’t know, the funny-looking “E” in the center means “the sum of.” In plain English, this equation squares the market share of each competing firm in the industry and then adds them up. An easier way to look at it would be like so:
So if we look at our steel industry example:
Metal Corp: [181]^2 = 324
Standard Metal: [351]^2 = 1225
Robinson & Co: [241]^2 = 576
JPOC Iron: [101]^2 = 100
HHI = 2225
What does this number mean? Well, the HHI can go up to 10,000, which is a full monopoly. Our steel industry has an H of 2225, indicating that it’s somewhat concentrated. Generally speaking:
A H below 100 indicates a highly competitive industry
A H below 1500 indicates an unconcentrated industry
A H ranging from 1500 - 2500 indicates a moderately concentrated industry. Markets in this range tend to raise antitrust concerns and may result in extra government oversight
A H above 2500 indicates a very concentrated industry and are almost always a product of anti-competitive behaviour
The major benefit of the HHI, aside from how simple it is to calculate, is that it gives a greater weighting to larger firms, thus giving you a more detailed picture as to who exactly has control of the market.
Of the characteristics of oligopolies mentioned earlier, let’s turn on to the last point, interdependence. Imagine you’re a coffee shop owner (as you have been for the last several articles) and you have 2 other competitors of similar size to you. If any one of you 3 suddenly cuts their prices, the entire market is going to be affected. What does this mean for you? 2 things. Firstly, you need to pay close attention to your competitors’ decisions and respond appropriately. Secondly, you must, on top of that, anticipate what your competitors are going to do. If you don’t, chances are you won’t always be making the best decision for your business.
Now, your competitors can do any number of things that steal your customers. Slashing their prices, launching an ad campaign, buying higher-quality ingredients, etc. And keep in mind that these actions can occur regardless if you take action or not, so you’re not necessarily going to make the first move. What emerges in this sort of scenario is something similar to a game of chess.
You not only need to consider the consequences (which take place in the form of competitors) responding to your own market moves, but you must also consider what your competitors might do without waiting for you to “start the game” so to speak. The study of how this would play out and more importantly, what you ought to do under these sorts of scenarios is called game theory. It’s often introduced alongside the concept of oligopolies, given how oligopolistic markets are perfect for studying game theory.
We’re not going to get into the nuances of it at the moment, but we promise to soon. Getting back to our 3 competing coffee shops, you and the other business owners may be tempted to simply cooperate. Being at each other’s throats is pretty exhausting and just imagine how better the world would be if we toned down the ruthlessness demonstrated in market competition. Wouldn’t that be nice? And since there’s only 3 of you, how hard can the coordination be? Eventually you and the other 2 owners agree to restrict your output of coffees, thus raising the price of each cup which in turn maximises the collective profit. This is what’s known as collusion, when rival companies, in a deceitful manner, cooperate with one another for their mutual benefit.
This means cartels - a group of companies who collude with each other - colluding is banned in most countries on the basis that it can turn once competitive markets into functionally indistinguishable monopolies. Asides from it being banned, cartels may not be the best option even for the firms involved. The real danger for each participant is someone else suddenly breaking the cartel agreement and undercutting them. As such, firms must invest in expensive administration to maintain the cartel, that is to continually check up on everyone and make sure they’re keeping their word.
Due to both the legal and practical problems with colluding, oligopolies tend towards competition, which is just where we’d like them to be, thank you very much. If you think about various oligopolistic markets in real life, they’re often the arenas of history’s greatest business rivalries.