Microeconomics - Oligopolies

What is an Oligopoly?
Oligopoly refers to a market with "few sellers". Oligopolies interact among themselves. When an oligopolist changes a price, it must take into account how other firms in the industry will respond. Within an oligopoly, the products can be similar or differentiated. Oligopoly markets have high barriers to entry.

The Prisoner's Dilemma
The "prisoners' dilemma" was first described in the field of "game theory", which is a branch of applied mathematics and economics dealing with choices made under conflict and uncertainty. Suppose that the police believe Dave and Henry have committed a felony, but the evidence is weak. The police have placed Dave and Henry in jail, in separate cells. The police need the confession of at least one of the prisoners in order to get a felony conviction. If neither prisoner confesses, then the police can only convict them on a minor charge with a three-month prison term. Each prisoner is offered the following deal: if one testifies against the other while the other remains the silent, the one who testifies will not be convicted of anything, while the one who remains silent will go to jail for 20 years. If both confess, then each will receive a five-year jail term.

To sum up the situation:

The optimum result for the two together is to stay silent, in which Dave and Henry will each get only three months prison time. However, each prisoner does not have knowledge of what the other prisoner will do. The most rational response from the individual is to confess. If the other prisoner stays silent, then that person gets off free; if the other prisoner confesses, then the prison term will be less (five years vs. 20 years).

The prisoners' dilemma illustrates a situation in which individuals arrive at a non-optimal solution, due to a lack of cooperation and trust. A similar situation occurs with oligopolies. If firms within an oligopolistic industry have cooperation and trust with each other, then they can theoretically maximize industry profits by setting a monopolistic price. Firms would then have to figure out how to fairly divide up the profits.

If oligopolies collude successfully, they will set price and output such that MR = MC for the industry overall. In figure 3.17 on the following page, this is depicted as Pa and Qa. Without collusion, firms will lower prices to attract more customers. Gradually, the price and output will move to Pb and Qb, which is identical to what would be achieved with a competitive market.

Figure 3.16: Oligopolist Profit Maximization

Oligopolies have strong incentives to collude because while acting together, they can restrict output and set prices so that economic profits are earned. The individual oligopolist has an incentive to cheat because the firm's demand curve is more elastic than the overall market demand curve. By secretly lowering prices, the firm can sell to customers who would not buy at the higher price, as well as to customers who normally buy from the other firms.

Oligopolistic agreements tend to be unstable due to these conflicting tendencies.

Obstacles to collusion within oligopolies include:

Low Entry Barriers - Particularly as time goes on, more firms will be attracted to the potential economic profits, which will not be sustainable. For example, the OPEC's raising of oil prices during the 1970s and early 1980s enticed more non-OPEC producers to produce more. The market share of OPEC producers was drastically reduced and they had to reduce prices in order to gain market share. In the long run, cartels are not usually successful at raising prices.

Antitrust Laws - these laws prohibit collusion. Although firms may make secret agreements, those agreements will not be enforceable in a court of law.

Unstable Demand Conditions - These conditions will make collusion more difficult, as firms are more likely to have disagreements as to what is the best direction for the industry. Some may expect large increases in demand, while others may disagree and prefer that industry capacity remains the same.

Increasing Number of Firms - An increasing number of firms in an oligopolistic industry will make agreements harder to discuss, negotiate and enforce. Differences of opinion are more likely. As the number of firms in the industry increases, the industry will behave more like a competitive market.

Difficulties with Detecting and Stopping Price Cuts - These difficulties will undermine effective collusion. Sometimes oligopolistic firms will cheat by enacting quality improvements, easier credit terms and free shipping. If quality changes can be used to compete, collusive price agreements will not be effective.

Conclusion


Related Articles
  1. Fundamental Analysis

    The Business Model Of Private Prisons

    How does the business model of private prisons work?
  2. Economics

    Utilizing Prisoner’s Dilemma In Business And The Economy

    The Prisoner’s Dilemma, one of the most famous game theories, provides a framework for understanding how to strike a balance between cooperation and competition, and is a very useful tool for ...
  3. Term

    The Prevalence of Oligopolies

    An oligopoly occurs when a select few companies have the majority of market share.
  4. Economics

    Oligopoly

    Learn how a particular market can be controlled by a small group of firms.
  5. Economics

    Economics Basics: Monopolies, Oligopolies and Perfect Competition

    Investopedia explains the various degrees of competitiveness in the marketplace: monopolies, oligopolies and perfect competition.
  6. Economics

    Prisoner's Dilemma

    Learn more about this classic game theory scenario.
  7. Economics

    Understanding Game Theory

    Game theory is a model for making decisions that weighs the benefits of a choice along with the interaction between participants.
  8. Economics

    Advanced Game Theory Strategies For Decision-Making

    The importance of game theory to modern analysis and decision-making can be gauged by the fact that since 1970, as many as 12 leading economists and scientists have been awarded the Nobel Prize ...
  9. Economics

    Macroeconomics: Economic Systems

    By Stephen Simpson Within the study of macroeconomics, there are certain basic goals for economic systems. Generally speaking, desirable goals include economic growth, full employment, economic ...
  10. Professionals

    Effects on Equilibrium in the Short and Long Run

    Effects on Equilibrium in the Short and Long Run. Examines how various short and long term changes affects equilibrium.
RELATED TERMS
  1. Oligopoly

    A market structure in which a small number of firms has the large ...
  2. Iterated Prisoner's Dilemma

    A normal prisoner's dilemma played repeatedly by the same participants. ...
  3. Collusion

    A non-competitive agreement between rivals that attempts to disrupt ...
  4. Prisoner's Dilemma

    A paradox in decision analysis in which two individuals acting ...
  5. Tit For Tat

    A game-theory mechanism which is subject to a payoff matrix similar ...
  6. Monopolistic Competition

    Characterizes an industry in which many firms market products ...
RELATED FAQS
  1. What are the major differences between a monopoly and an oligopoly?

    The major differences between a monopoly and an oligopoly include the number of firms in the market, type of barriers to ... Read Answer >>
  2. What are some current examples of oligopolies?

    Learn what oligopolies are and examples of markets where they are prevalent. Read Answer >>
  3. Why are oligopolies legal while monopolies are not?

    Learn about oligopolies and monopolies. Explore situations where anti-competitive practices have led to intervention by the ... Read Answer >>
  4. What are the most famous cases of oligopolies?

    Learn about famous examples of oligopolies currently in place in the United States, Canada and worldwide. Explore imperfect ... Read Answer >>
  5. What is the difference between perfect and imperfect competition?

    Learn the differences between perfect competition and imperfect competition and what types of markets are considered imperfectly ... Read Answer >>
  6. Is the airline industry in an oligopoly state?

    Learn about oligopolies and the current state of the U.S. airline industry. Explore how the Airline Deregulation Act changed ... Read Answer >>
Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  3. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  4. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  5. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  6. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
Trading Center