Oligopoly describes a market where a few large producers dominate. Unlike competitive and monopolistically competitive markets, oligopolistic firms have more pricing power. In addition, oligopoly is characterized by considerable barriers to entry because of the sheer scale of the firms. Oligopoly is often the result of once-competitive markets maturing. As monopolistically competitive firms grow and merge with other firms, fewer firms result. Oligopolies are of concern to government regulators attempting to preserve and enforce competition in industries. As competition decreases, prices become higher, and productive and allocative efficiency, which benefit society, are lost.
When firms in the same stage of the production process join to form a single firm, it is called a horizontal merger. Chevrolet, Buick, Cadillac, and GMC form the horizontal merger better known as General Motors. Vertical mergers occur when firms in different stages of the production process merge. Andrew Carnegie employed this strategy in making Carnegie Steel the industrial titan of its day. He bought up firms in every step of the production process, from raw iron ore to the finished steel.
To determine whether a market meets the condition of oligopoly, economists calculate the Herfindahl-Hirschman index (HHI) for the market. A relatively low index number identifies a market as competitive, and a relatively high index number indicates oligopoly. The Federal Trade Commission (FTC) and the Justice Department can use the index numbers as a way to determine whether or not to approve mergers between companies in an industry. If the merger would significantly increase the HHI, then the merger would most likely be blocked because it would reduce competition.
Regulators and economists also use concentration ratios to determine if a market is oligopolistic. The more market share is dominated by a few firms, the higher the concentration ratio. For example, if the four-firm concentration ratio is 80%, then the four largest firms have 80% of the market share. According to the 2002 census, the four-firm concentration ratio for the vacuum cleaner industry was 78%, and the eight-firm concentration ratio was 96.1%. It is safe to say that the vacuum cleaner industry is an example of oligopoly. By way of comparison, a perfectly competitive industry would have a four-firm concentration ratio of about 0%, and an industry dominated by a monopoly would have a one-firm concentration ratio of 100%.
What defines an industry for the purpose of determining concentration ratios?
It depends. Today the definition of industry is becoming blurred. In the past, the newspaper industry was an industry. Today it is part of a larger industry known as the media. Even though the local paper may have 100% of the local newspaper market share, other forms of media reduce its effective share in the overall industry.
The large market share that oligopolists enjoy shapes the way they view the market. Unlike firms in more competitive market structures that behave independently of each other, the oligopolists have an interdependent relationship with each other. Because the oligopolists control so much market share, their individual decisions have considerable impacts on market prices. Knowing this to be the case, the oligopolist tends to be more aware of the competition and takes this into account when making production and pricing decisions.