For example, if an oligopolist firm raises its prices, it could risk loosing market share if its competitors do not follow which would lead to lower profits for that firm. If the firm was to reduce prices, it could risk starting a price war. This is because, other firms are likely to follow, in order to stay competitive. Therefore, all firms in the industry would suffer from a sharp fall in profits as they continuously cut prices to compete with each other. Eventually, prices will have to rise again to restore profitability and the firm that started the price war could have lost market share.
Therefore firms want to avoid price competition as all firms will lose out in the long term due to reduced profits. So there is an incentive for firms to form a price agreement in order to reduce uncertainty. There is a greater incentive to form price agreements in markets where the demand for the product is inelastic e.g. sugar, petrol and oil. This is because, increases in prices will lead to increased revenue and in turn higher profits.
There is also a greater incentive for firms to avoid price competition if the product produced has a high cross elasticity of demand. This is a measure of the responsiveness of the quantity demanded of product A when the price of product B is changed. This means that, consumers can easily find substitutes if a firm raises its prices.
If the firms have similar costs then firms are also less likely to want to initiate a price war because it would be unprofitable for firms to simultaneously cut prices as eventually prices would fall bellow total costs.
If there are very high entry barriers new firms will not be attracted to enter the market which allows incumbents to set high prices and earn high profits without new entrants entering the market, increasing supply and reducing prices.
However, some oligopoly markets do have price competition and face price wars. This can be a result of various reasons. Firstly, it is possible that the firms in the industry all have different total cost. Therefore, those firms with lower costs are able to pass on lower costs as lower prices to consumers yet still make substantial profits. This may lead to a price war with other firms or it would cause them to leave the market if they are unable to cuts costs.
Price wars may also be a result of different objectives that the firms of the same industry have. For example, a profit maximising firm will want to charge as higher prices as possible unlike a revenue maximising firm who may charge lower prices. A firm that may want to increase market share may use predatory pricing in order to force existing firms out of the market. This can be achieved by reducing prices bellow average costs, and experience short term loses therefore rivals are forced to leave the market which then allows the remaining firm to increase its prices again, to as much as they want.
An oligopoly market can be analysed by using The Game Theory, in which uncertainty and interdependency can be illustrated. The Game Theory demonstrates how firms try to identify different strategies and then estimate how rivals reactions will affect them.
