16

MARKET STRUCTURES III: OLIGOPOLY

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Oligopoly Is A Form Of Imperfect Competition
Imperfect competition refers to those market structures that fall
between perfect competition and pure monopoly.

Types of Imperfectly Competitive Markets

◦ Oligopoly
◦ Only a few sellers, each offering a similar or identical product to the others.
◦ Monopolistic Competition (see chapter 15)
◦ Many firms selling products that are similar but not identical.

Concentration ratio measure the proportion of the total market

share of a particular number of firms.

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Characteristics Of A Monopoly
The typical firm has some market power, but its market power is
not as great as that described by monopoly.
◦ Top five firms usually have high concentration ratio.
◦ Examples include crude oil, supermarkets and mobile phone networks.

Oligopolies sell similar products

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 Differentiation
• Differentiation helps capture market share of others.
• Differentiation is often not through price.
• May target specific groups of customers
• The market segment is the breaking down of customers into groups with
similar buying habits or characteristics Similar or identical products but

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Interdependence
Oligopolistic markets are dominated by a few large firms that are
interdependent.
There is a tension between cooperation and self-interest.
◦ A group of oligopolists is better off cooperating and acting like a
monopoly and charging above MC.
◦ Profit provides an incentive to go alone which limits the group to act as
a monopoly.

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A Duopoly Example
A duopoly is an oligopoly with only two members. It is the simplest
type of oligopoly.

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Table 1 The Demand Schedule for Water

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A Duopoly Example
Price and Quantity Supplied
◦ The price of water in a perfectly competitive market would be
driven to where the marginal cost is zero:
◦ P = MC = €0
◦ Q = 120 litres
◦ The price and quantity in a monopoly market would be where
total profit is maximized:
◦ P = €60
◦ Q = 60 litres

Price and Quantity Supplied

◦ The socially efficient quantity of water is 120 litres, but a monopolist
would produce only 60 litres of water.
◦ So what outcome then could be expected from duopolists?
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Competition, Monopolies, and Cartels
The duopolists may agree on a monopoly outcome.
◦ Collusion
◦ An agreement among firms in a market about quantities to produce or prices
to charge.
◦ Cartel
◦ A group of firms acting in unison.

Competition laws prohibit explicit agreements among oligopolists

as a matter of public policy.

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The Equilibrium for an Oligopoly
A Nash equilibrium is a situation in which economic actors interacting with
one another each choose their best strategy, given the strategies that all
the others have chosen.

When firms in an oligopoly individually choose production to maximize

profit, they produce a quantity of output greater than the level produced
by monopoly, and less than the level produced by competition.
◦ In Table 1 monopoly output = 60litres and under competition = 120
litres, oligopoly output = 80 litres
The oligopoly price is less than the monopoly price but greater than the
competitive price (which equals marginal cost).
◦ In Table 1 oligopoly price= €40, monopoly price = €60 and competition
price = €0

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Game Theory And The Economics Of Cooperation
Game theory is the study of how people behave in strategic
situations.
Strategic decisions are those in which each person, in deciding
what actions to take, must consider how others might respond to
that action.
Payoff matrix is a table showing the possible combination of
outcomes (payoffs) depending on the strategy chosen by each
player.

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Figure 2 The Payoff Matrix

Mr Blue gets 8 years

Mr Green goes free Mr Green gets 1 year

Mr Blue gets 20 years Mr Blue gets 1 year

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Game Theory And The Economics Of Cooperation
Because the number of firms in an oligopolistic market is small,
each firm must act strategically.
Each firm knows that its profit depends not only on how much it
produces but also on how much the other firms produce.

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The Prisoners’ Dilemma
The prisoners’ dilemma provides insight into the difficulty in
maintaining cooperation.
Often people (firms) fail to cooperate with one another even when
cooperation would make them better off.
The prisoners’ dilemma is a particular “game” between two
captured prisoners that illustrates why cooperation is difficult to
maintain even when it is mutually beneficial.

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 Figure 3 The Prisoners’ Dilemma

Mr Green’s Decision
Confess Remain Silent

Mr Green gets 8 years Mr Green gets 20 years

Confess

Mr Blue’s Mr Blue gets 8 years Mr Blue goes free

Decision Mr Green goes free Mr Green gets 1 year

Remain
Silent

Mr Blue gets 20 years Mr Blue gets 1 year

The Prisoners’ Dilemma
The dominant strategy is the best strategy for a player to follow
regardless of the strategies chosen by the other players.
Cooperation is difficult to maintain, because cooperation is not in
the best interest of the individual player.

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 Figure 4 An Oligopoly Game

Saudi Arabia’s Decision

High Production Low Production

Saudi Arabia gets Saudi Arabia gets
€40 billion €30 billion
High
Production

Iran’s Iran gets €40 billion Iran gets €60 billion

Decision Saudi Arabia gets Saudi Arabia gets
€60 billion €50 billion
Low
Production

Iran gets €30 billion Iran gets €50 billion

The Prisoners' Dilemma and the Welfare of
Society
In some cases, the non-cooperative equilibrium is bad from
society's standpoint.
◦ In the common resources game, the extra wells dug are wasteful.

However, in the case of a cartel trying to maintain monopoly

profits, the non-cooperative solution is an improvement from the
standpoint of society.

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Why People Sometimes Cooperate
While cooperation is difficult to maintain, it is not impossible.
Cooperation is easier to enforce if the game is repeated.
◦ Any short term gain from a one off achievement will be more than
offset by future losses.

A tacit collusion occurs when firm behaviour results in a market

outcome that appears to be anti-competitive but has arisen
because firms acknowledge that they are interdependent.

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 Figure 8 Jacques and Joelle Oligopoly Game

Jacques’s Decision

Sell 40 litres Sell 30 litres

Jacques gets Jacques gets

€1,600 profit €1,500 profit
Sell 40
litres
Joelle gets Joelle gets
Joelle’s €1,600 profit €2,000 profit
Decision Jacques gets Jacques gets
€2,000 profit €1,800 profit
Sell 30
litres
Joelle gets Joelle gets
€1,500 profit €1,800 profit
Summary
① Oligopolists maximize their total profits by forming a cartel and acting
like a monopolist.
② If oligopolists make decisions about production levels individually, the
result is a greater quantity and a lower price than under the monopoly
outcome.
③ The prisoners’ dilemma shows that self-interest can prevent people
from maintaining cooperation, even when cooperation is in their mutual
self-interest.
④ The logic of the prisoners’ dilemma applies in many situations,
including oligopolies.
⑤ Oligopolies can play both cooperative and non cooperative games.
⑥ In the long-term it pays to cooperate.
⑦ Oligopolies van compete on price or on the quantity they supply.
⑧ Policy makers use competition laws to prevent oligopolies from
engaging in behaviour that reduces competition.

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