Oligopoly: Markets with Few Sellers and Strategic Behavior

Oligopoly

Definition and Characteristics

An oligopoly is a market structure characterized by a small number of firms that offer similar or identical products. Because there are few sellers, each firm's decisions affect the market outcomes and the profits of other firms.

• Few Sellers: Each firm must consider the potential reactions of its rivals when making decisions about prices and output.

• Interdependence: Firms are mutually interdependent; the actions of one firm influence the actions of others.

• Barriers to Entry: High barriers to entry help maintain the small number of firms.

• Product Differentiation: Products may be homogeneous (identical) or differentiated.

Game theory is the study of how people behave in strategic situations, which is essential for understanding oligopoly.

Duopoly: A Special Case of Oligopoly

Duopoly Example

A duopoly is an oligopoly with only two members. For example, Jack and Jill own wells that produce water. The marginal cost of water is zero, so total revenue equals total profit.

• Perfect Competition: Price equals marginal cost, and the equilibrium quantity is efficient.

• Monopoly: Price exceeds marginal cost, quantity is lower than efficient, and profit is maximized at a lower quantity and higher price.

Table: Demand Schedule for Water (Inferred)

Quantity (gallons)	Price per Gallon ($)
0	120
60	60
120	0
Other values	Inferred as linear between points

Additional info: Table values inferred from context; actual table may have more detail.

Collusion and Cartels

Definitions

• Collusion: An agreement among firms in a market about quantities to produce or prices to charge.

• Cartel: A group of firms acting in unison to maximize total profit, typically by producing the monopoly quantity and charging the monopoly price.

For example, if Jack and Jill form a cartel, each produces 30 gallons, the price is $60 per gallon, and each earns a profit of $1,800.

Incentives to Cheat

• Each member of a cartel has an incentive to cheat by increasing output, which can increase individual profit but reduce total cartel profit.

• If all members cheat, the market outcome moves away from the monopoly outcome toward competition.

Example: Gas Stations in Smallville

• If both stick to the agreement: Each earns $13,200.

• If one cheats (sells more): Cheater earns $15,000, other earns less.

• If both cheat: Each earns $12,000.

Oligopoly Equilibrium

Barriers to Cartel Formation

• Disagreements over profit division make collusion difficult.

• Antitrust laws prohibit explicit agreements among oligopolists.

Outcomes Without Collusion

• Firms act in self-interest, producing more than the monopoly quantity but less than the competitive quantity.

• Price is lower than the monopoly price but higher than marginal cost.

• Total profit is less than monopoly profit.

Nash Equilibrium

Nash equilibrium is a situation in which each economic actor chooses their best strategy given the strategies of others. In oligopoly, this often means each firm produces more than the monopoly quantity, leading to lower prices and profits.

• Example: Jack and Jill each produce 40 gallons, price is $40, each earns $1,600.

Effect of Number of Firms

• As the number of firms increases, the market outcome approaches perfect competition: price approaches marginal cost, and quantity approaches the efficient level.

• Output effect: Selling one more unit increases profit.

• Price effect: Increasing output lowers the price and reduces profit on all units sold.

The Economics of Cooperation

The Prisoners’ Dilemma

The prisoners’ dilemma is a game that shows why cooperation is difficult even when it is mutually beneficial. Each player has a dominant strategy—the best strategy regardless of the other’s choice.

• Cooperation is individually irrational, as each has an incentive to defect.

• Oligopolists face a similar dilemma: the monopoly outcome is best collectively, but each has an incentive to cheat.

Examples of the Prisoners’ Dilemma

• Arms races: Each country’s dominant strategy is to arm, even though both would be better off not arming.

• Common resources: Each firm’s dominant strategy is to overuse the resource, leading to lower profits.

Cooperation in Repeated Games

• In repeated interactions, cooperation may be sustained as firms can punish defectors in future rounds.

Public Policy Toward Oligopolies

Antitrust Laws

• Sherman Antitrust Act (1890): Made agreements among oligopolists a criminal conspiracy.

• Clayton Act (1914): Strengthened antitrust laws, used to prevent mergers and collusion.

• Policymakers aim to induce competition and move resource allocation closer to the social optimum.

Controversial Business Practices

• Resale Price Maintenance: Manufacturers require retailers to charge a set price. May seem anticompetitive but can have legitimate business purposes (e.g., ensuring service quality).

• Predatory Pricing: Firms set prices below cost to drive out competitors. Often not profitable in the long run.

• Bundling: Selling two goods together at a single price. Can be a form of price discrimination and may increase profit, but does not always increase market power.

Example: Airline Fare Wars Game

	Braniff: Cut Fares	Braniff: No Cut
American: Cut Fares	$400M, $400M	$800M, $200M
American: No Cut	$200M, $800M	$600M, $600M

Additional info: Table inferred from context; Nash equilibrium is both cut fares ($400M, $400M).

Conclusion

Oligopolies would prefer to act like monopolies, but self-interest often leads to more competitive outcomes. The final market outcome depends on the number of firms and the degree of cooperation. Policymakers use antitrust laws to regulate oligopolists, but the application of these laws can be controversial, as some practices that appear anticompetitive may have legitimate business purposes.