Oligopoly
Oligopoly
• Oligopoly is a market structure in which
• Natural or legal barriers prevent the entry of new firms.
• A small number of firms compete.
Barriers to Entry
Small Number of Firms
Because barriers to entry exist, oligopoly consists of a small number of firms,
each of which has a large share of the market. Such firms are interdependent,
and they face a temptation to cooperate to increase their joint economic profit.
• Interdependence: With a small number of firms in a market, each firm’s
actions influence the profits of all the other firms.
• Temptation to Cooperate: When a small number of firms share a market,
they can increase their profits by forming a cartel and acting like a monopoly.
A cartel is a group of firms acting together—colluding— to limit output, raise
price, and increase economic profit.
Oligopoly Games
• Economists think about oligopoly as a game between two or a few players,
and to study oligopoly markets they use game theory.
• Game theory is a set of tools for studying strategic behavior—behavior that
takes into account the expected behavior of others and the recognition of
mutual interdependence.
• Game theory was invented by John von Neumann in 1937 and extended by
von Neumann and Oskar Morgenstern in 1944 (p. 367).
• All games share four common
• features:
1. Rules
2. Strategies
3. Payoffs
4. Outcome
Payoff Matrix
Nash Equilibrium
• The choices of both players determine the outcome of the game. To predict
that outcome, we use an equilibrium idea proposed by John Nash of
Princeton University.
• In Nash equilibrium, player A takes the best possible action given the action
of player B and player B takes the best possible action given the action of
player A.
An Oligopoly Price-Fixing Game
• We can use game theory and a game like the prisoners’ dilemma to understand price
fixing, price wars, and other aspects of the behavior of firms in oligopoly.
• A collusive agreement is an agreement between two (or more) producers to form a
cartel to restrict output, raise the price, and increase profits. The strategies that
firms in a cartel can pursue are to
• Comply
• Cheat
• A firm that complies carries out the agreement. A firm that cheats breaks the
agreement to its own benefit and to the cost of the other firm.
• Because each firm has two strategies, there are four possible combinations of
actions for the firms:
1. Both firms comply.
2. Both firms cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.
Primary Scenario
Colluding to Maximize Profits
One Firm Cheats on a Collusive Agreement
Both Firms Cheat
Duopoly Payoff Matrix
