Oligopoly: Structure, Behaviour, and Welfare Implications

Oligopoly

Definition and Market Structure

An oligopoly is a market structure characterized by a small number of large firms that dominate the market. At the most extreme, an oligopoly with only two firms is called a duopoly. Because there are only a few firms, each has significant market power, meaning they can influence prices and output levels.

• Homogenous oligopoly: Firms produce undifferentiated goods and compete mainly on price.

• Differentiated oligopoly: Firms produce differentiated goods and compete on both price and quality.

Barriers to entry prevent new firms from entering the market, allowing existing firms to maintain market power and earn long-run economic profits.

Barriers to Entry

Barriers to entry are factors that prevent or hinder new competitors from entering an industry. In perfectly competitive and monopolistically competitive markets, economic profits attract new entrants, increasing competition. In oligopoly, barriers to entry prevent this process.

• Economies of Scale: Large firms can produce at lower average costs due to high fixed costs spread over more units, making it difficult for small entrants to compete.

• Government Regulations: Licenses, patents, and copyrights can restrict entry. For example, a license may be required to operate, and the government can limit the number of licenses. Patents grant exclusive production rights for 20 years; copyrights protect creative works for the creator's life plus 70 years.

• Limited Ownership of a Resource: Control over essential resources (natural, human, or knowledge-based) can block entry.

• Operating History and Brand Recognition: Established firms with strong brands and reputations deter new entrants.

Example: Car manufacturing, telecommunications, and airlines are industries with high capital costs and regulatory barriers, leading to oligopolistic structures.

Economies of Scale

Economies of scale occur when increasing production lowers average total cost (ATC). If the minimum efficient scale is large relative to market demand, only a few firms can operate efficiently, resulting in an oligopoly.

• Small firm: Small quantity, higher average cost.

• Large firm: Large quantity, lower average cost.

Formula:

$\text{Markup} = P - MC$

where $P$ is price and $MC$ is marginal cost.

Profit Maximization in Oligopoly

Profit and Loss Conditions

• Firms maximize profit where marginal revenue equals marginal cost ($MR = MC$).

• If $MR > MC$, increasing output raises profit.

• If $MR < MC$, reducing output raises profit.

• For an oligopoly firm, price exceeds marginal cost ($P > MC$), resulting in a price markup.

Profit per unit:

$\text{Profit per Unit} = \frac{\pi}{q} = P - ATC$

• If $P > ATC$, the firm earns profit per unit.

• If $P < ATC$, the firm incurs a loss per unit.

• In oligopoly, profits can be sustained in the long run due to barriers to entry.

Example: If a firm’s price is $10, ATC is $8, profit per unit is $2.

Oligopoly Behaviour

Oligopolists must consider the actions of their competitors due to mutual interdependence. Strategic behaviour is more pronounced than in monopolistic competition.

Strategic Behaviour and Game Theory

Game Theory Basics

Game theory is a tool used to analyze strategic interactions where the outcome for each participant depends on the actions of all.

• Conjecture: An assumption about a competitor’s behaviour.

• Strategy: A plan of action from available choices.

• Best response: The action that maximizes profit given the competitor’s choice.

• Dominant strategy: The best action regardless of what competitors do.

Game Theory Outcomes

• Nash Equilibrium: Each player chooses their best response given the other’s choice; no player has an incentive to deviate unilaterally.

• Dominant Strategy Equilibrium: Both players choose dominant strategies (if they exist).

Decision Matrices

Payoff matrices are used to map out possible decisions and profits for each firm.

Firm B	Low Budget	High Budget
Firm A: Low Budget	A: $10m B: $10m	A: $5m B: $12m
Firm A: High Budget	A: $12m B: $7m	A: $7m B: $7m

Example: In the advertising game, both firms choosing a high budget is a Nash Equilibrium and a Dominant Strategy Equilibrium for Firm B.

Social Welfare and Oligopoly

• Oligopolies can result in higher prices and lower output compared to competitive markets, leading to deadweight loss.

• Barriers to entry allow for sustained economic profits and can increase income and wealth inequality.

Collusion and Cartels

Definition and Legality

Collusion occurs when firms coordinate actions to increase prices or reduce costs, forming a cartel or trust. Collusion is illegal in most developed countries due to its negative effects on consumers and workers. Anti-trust laws are enforced to prevent such behaviour.

Why Collusion Fails

• Firms have incentives to cheat on collusive agreements to increase individual profits.

• If firms believe the agreement will not last, they may defect early.

• Whistleblower protections encourage reporting of anti-competitive behaviour.

Games Without Dominant Strategies

Some games have multiple Nash equilibria or none with dominant strategies. In repeated games, firms can learn and adapt strategies over time, possibly sustaining cooperation.

Welfare Effects of Oligopoly

Price Elasticity and Deadweight Loss

• Oligopolies typically have fewer substitutes, making demand less elastic.

• Price markups and deadweight loss are larger in oligopoly than in monopolistic competition.

Oligopoly and Inequality

• Oligopoly profits can lead to greater income and wealth inequality as firm owners accumulate more wealth.

Oligopolies and Innovation

• Oligopolies may foster innovation due to excess profits available for research and development (R&D).

• Competition among oligopolists can drive continuous innovation, a process known as creative destruction.

• Product innovation: Creation of new goods and markets, increasing social welfare.

• Process innovation: Improved production methods, increasing efficiency.

• Both types of innovation can be protected by patents.

Are Oligopolies Always Bad?

Oligopolies have both disadvantages (higher prices, deadweight loss, inequality) and advantages (potential for innovation). The benefits are realized only when competition is maintained and collusion is prevented through active government policy.