Oligopoly is a market structure in which a few sellers supply all or most of the total market output. Now, let us examine why does oligopolistic tendency arise in the market? There are various reasons for the emergence of oligopoly.
1. Huge Capital Investment:
Industries like cement, steel, chemicals, petroleum, aircrafts, ship building, etc., are highly capital intensive and require huge capital investment as well as recurring expenses.
The cost and time that new firm will have to face make the entry unviable and unattractive.
Consequently, only a few big firms continue to operate in the market, who also enjoy the economies of large scale. Few big firms produce enough to meet the entire demand at a lower cost than a large number of firms dividing this total output. Further, firms engaged in research and development of their new products guard the technology of their innovations through patent laws, copy rights, etc. Consequently, only a few firms are able to come out with similar products.
2. Absolute Cost Advantage:
A small number of firms may secure absolute advantage in cost over all others, which permits them to operate profitably even at a low price at which the others cannot survive. The existing firms may acquire a cost advantage over the new entrants through control of low cost raw materials, natural resources, economic production technique, operating experience, patent rights, etc.
They also develop distribution and marketing net work. If some firms try to enter the market, the existing firms compete them out through various marketing strategies. According to a study by Jee S. Bain, in the United States, for three industries, namely steel, copper and gypsum, potential entrants were at absolute disadvantage.
3. Product Differentiation:
A few firms in some cases obtain an advantage of product differentiation. Buyers develop brand loyalties and they prefer these products to other varieties of the same product. Sometimes, these products come to be commonly referred to by their original brand names, such as ‘snowcem’ for cement coating. Buyers stick to their use and avoid trial of non-tested goods. Thus, a few firms are able to secure a major share of the market demand against all competition. In this way, it acts as a barrier to entry.
Modern business firms are now learning to eliminate competition through mergers and amalgamations. As a result, the number of firms decline, profits rise and oligopolies are established. Mergers will be successful in producing profits over time, if there are effective barriers to entry.
5. Informal Collusion:
Merger is one way to combine firms to expand the size of the firms. However, mergers come under scrutiny of anti-trust laws and restrictive trade practices legislations. To avoid this situation, firms engage in informal agreements among themselves to restrict output and charge higher prices above the marginal cost of production to enhance their position against potential entry of new firms. The firms create unreasonable restraint on competition by setting prices and even their market shares. Since, these agreements are implicit in nature; these are less likely to be noticed by law enforcing authorities.