Answer to Question #209666 in Macroeconomics for Boitumelo

Question

How can an oligopoly cause market failure

Answer 1

Oligopoly is a market structure dominated by a few firms. It is a market characterized by a small number of firms who realize they are interdependent in their pricing and output policies, when a market is shared between a few firms, it is said to be highly concentrated. For example pharmaceuticals, auto industry and supermarkets.

Oligopoly cause market failure in the following ways; interdependence, firms acting under oligopolistic conditions are said to be interdependent which means they cannot act independently of each other, therefore actors have to initiate strategies in decision making to either compete or collude(overt,covert,tacit ). They then decide whether to raise, lower or keep constant price,raising or lowering price could lead to beneficial pay_off, but both strategies can lead to losses, which could be potentially disastrous, its too risky to undertaker thus leads to market failure. Secondly, higher concentration reduces consumer choice due to predatory pricing,it usually occur when a firm tries to push prices low enough to force competitors out of the market.

On the hand, through adverts,the more that is spent by incumbent firms the greater the deterrent to new entrants, stronger brands locks in customers and deters entry into the market. Lastly,oligopoly cause barriers to entry into the market, it is difficult to enter an oligopoly industry and compete as a small start_up company due to factors such as exclusive contracts, patents and licenses. Cartel_like behavior reduces competition and can lead to higher prices and reduced output, thus there is a potential loss of economic welfare.