Question

What are the causes of oligopoly? Discuss.

Short answer

Answer: The main causes of oligopoly are high barriers to entry, economies of scale, mergers and acquisitions, control over a unique or scarce resource, and strong brand loyalty. These factors contribute to a market structure where only a few large companies control the bulk of the market, leading to the strategic interdependence of firms and potential for non-competitive behavior.

Step-by-step solution

Definition of Oligopoly

An oligopoly is a market structure characterized by a small number of large firms that dominate the market, producing similar goods or services, thus having significant control over prices. In this situation, these firms are interdependent and can often engage in non-competitive behavior, such as price-setting or collusion.

Barriers to Entry

One of the primary causes of oligopoly is the presence of high barriers to entry in the industry. These barriers could be in the form of high initial capital investment, strict government regulations, high research and development costs, or control over essential resources. As a result, new firms find it difficult to enter the market and compete, leading to a smaller number of dominant firms.

Economies of Scale

Another cause of oligopoly is the existence of economies of scale. In certain industries, the cost per unit of a product or service decreases as the level of production increases. Consequently, larger firms, which can produce more significant quantities at lower average costs, are more likely to dominate the market. Smaller firms, unable to achieve similar economies of scale, struggle to compete with these larger firms.

Mergers and Acquisitions

Oligopolies can also be a result of mergers and acquisitions (M&A). As firms consolidate through M&A, there will be an increased market concentration, leaving a smaller number of powerful firms dominating the market. M&A can happen due to strategic reasons, market conditions, or regulatory approvals and can lead to oligopolistic market structures.

Control Over a Unique or Scarce Resource

In some instances, a few companies control a unique or scarce resource essential to a particular industry. This control allows them to effectively restrict access to the resource and limit the number of competitors that can enter the market. As a result, the market will become concentrated, leading to an oligopoly.

Brand Loyalty

Strong brand allegiance can also contribute to the formation of an oligopoly. If consumers are fiercely loyal to certain brands, it can be challenging for new firms to enter the market and convince customers to switch products. In such cases, the market will continue to be dominated by a few well-established firms.

Conclusion

In summary, the main causes of oligopoly are high barriers to entry, economies of scale, mergers and acquisitions, control over a unique or scarce resource, and strong brand loyalty. These factors contribute to a market structure where only a few large companies control the bulk of the market, leading to the strategic interdependence of firms and potential for non-competitive behavior.

Key concepts

Barriers to Entry

Barriers to entry are obstacles that make it difficult for new firms to enter a market. In an oligopoly, these barriers play a crucial role in maintaining the dominance of a few large firms. There are various forms of barriers to entry that you might encounter:

• Initial Capital Investment: Many industries require a substantial financial outlay to start operations. This high cost can be prohibitive for new firms, deterring them from entering the market.
• Government Regulations: Strict rules and certifications can make it challenging for new businesses to comply, creating a hurdle for new entrants.
• Research and Development Costs: In technology-intensive industries, substantial R&D funding is required to stay competitive, creating a barrier for smaller companies.
• Control Over Essential Resources: If existing firms control crucial resources, new firms cannot easily access what they need to produce their goods or services.

These barriers ensure that established firms face little competition, allowing them to maintain their market power.

Economies of Scale

Economies of scale refer to the cost advantage that enterprises obtain due to their scale of operation, with cost per unit of output generally decreasing with increasing scale. In an oligopoly, large firms benefit immensely from economies of scale which enhances their competitive position. Here's how it works:

• Large Production Output: By producing in larger quantities, firms can lower their average costs, which in turn allows them to reduce prices or increase profits.
• Buying Power:**
• Technical Efficiency:** Strong financial resources allow larger firms to invest in better technologies, increasing production efficiency.

Smaller firms struggle to match these cost benefits, thus finding it difficult to compete with giants who dominate the market.

Mergers and Acquisitions

Mergers and acquisitions (M&A) are strategies used by companies to consolidate their position in a market, often leading to an oligopoly. M&A is where two or more companies combine to form a single entity, either through acquisition or through a merger. Here's why they matter:

• Market Power: By merging, companies can increase their market share, reduce competition, and enjoy greater pricing power.
• Economies of Scope: Combining resources can lead to synergies, allowing consolidated firms to offer a variety of products efficiently.
• Strategic Positioning: Companies might merge to access new markets, expand their product lines, or acquire new technologies, strengthening their strategic stance.

Through M&A, market concentration increases, creating a few dominant players capable of controlling the market.

Brand Loyalty

Brand loyalty plays a significant role in forming an oligopoly by influencing consumer choices and market dynamics. It is when consumers prefer certain brands over others, even when alternatives are available.

• Customer Retention: Strong brand loyalty means customers are less likely to switch to new entrants in the market, sustaining the market share of established firms.
• Brand Value: Firms with high brand loyalty can command higher prices, knowing their loyal customer base will likely absorb these costs.
• Marketing Advantage: Firms with strong brands benefit from word-of-mouth and customer referrals, reducing their new customer acquisition costs.

For newer firms, competing with this entrenched loyalty can be challenging, often keeping the market power in the hands of a few large firms.