College of Business Management

Institute of Business Management

ECO 101 - Principles of Microeconomics

Faculty Name: Ms. SABEEN ANWAR

Chapter 16: Oligopoly

The market structures discussed so far are the two extremes: only one supplier (monopoly) or
a very large number of suppliers (perfect competition).

In reality quite a number of markets are characterized by imperfect competition.

There are two important forms of imperfection (in the sense that these forms deviate from the
idealized case):

- oligopoly: a market structure in which only a few sellers offer similar or identical
products or services.
- Monopolistic competition: a market structure in which many firms sell products
that are similar but not identical.

We can distinguish four types market structures:

Number of firms?
One firm Few firms Type of product?
Differentiated product Identical products
Monopoly Oligopoly Monopolistic competition Perfect competition
Tap water Crude oil Novels, movies Wheat, milk

Markets with only a few sellers

Because there are only a few sellers, a oligopoly is characterized by tension between
cooperation and self-interest.

The group of oligopolists make the highest profit if they manage to behave as if they were a
monopolist, i.e. selling a limited number of goods or services and charging a relatively high
price.

A Duopoly Example
A oligopoly with just two producers is called duopoly. For the example given we can look at
the optimum strategy for perfect competition (price equals marginal cost) or a monopoly
(marginal revenue equals marginal cost). The oligopolists would be able to get the highest
joint profit if they agree to cooperate. In this case the oligopolists together would produce
the same quantity as the monopolist, and charge the same price. The oligopolist, however,
have to agree on how to share the quantity produced and hence how to share the profit: An
agreement among firms in a market about quantities to produce or prices to charge is
called collusion. The group of firms cooperating is called cartel.

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 The equilibrium for an oligopoly
“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. The oligopoly price is less than the monopoly price but greater
than the competitive price (which equals marginal cost).”

A situation in which economic actors interacting with one another each choose their best
strategy given the strategies that all the other actors have chosen is called Nash equilibrium.

In the example given, the best solution for the oligopolist is to cooperate and each firm
producing half. If producer A expands production, based on the assumption that producer B
keeps producing the smaller quantity, the profit for A would increase, the profit for B would
decrease. If A and B are equal, it is possible that B would expand production as well. Now
both earn less than when jointly producing the optimum quantity. This process of expanding
production would eventually end at the Nash equilibrium.

The example given is quite similar to the real situation in the world oil market. Members of
OPEC try to control the total market volume. However, in some periods they did not succeed:
individual members did not stick to the agreed upon share and expanded unilaterally leading
others to follow.

How the size of an oligopoly affects the market outcome

The larger the number of firms in the market, the less likely it is that firms will consider the
impact of their own action on the market. With a considerable number of sellers in an
oligopoly, the oligopolistic market looks more like a competitive market. The price
approaches marginal cost.

This consideration can show as well that international trade is able to bring the market result
to the optimum level. While oligopolists might be able to cooperate in national markets, they
are much less likely to cooperate internationally, and the price would be close than to
marginal cost.

Game Theory and the Economics of Cooperation

Game theory is the study of how people behave in strategic situations. By strategic a situation
is described when someone has to consider the action of others when deciding on his or her
own action.

The prisoner’s dilemma is a particular game between two captured prisoners that illustrates
why cooperation is difficult to maintain even when it is mutually beneficial.

If the number of producers is small, the situation in an oligopoly resembles that of the
prisoner dilemma.

The prisoner dilemma can be found in other fields as well: arms race, using common
resources, advertising. If the strategic situation reoccurs again and again, the strategic players
can gain experience and cooperation is more likely to prevail.

Public Policy Toward Oligopolies

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For society it is best when oligopolists compete rather than cooperate.

While freedom of contract is a basic principle for any market economy, it has usually been
forbidden to agree among competitors to reduce quantities and raise prices.

The Sherman Antitrust Act of 1890 or in Germany the German Law against restricting
competition (1957) are directed at outlawing collusion. Most economists agree that price
fixing should not be allowed.

There is disagreement, however, whether certain strategies oligopolists employ can be

considered unfair and detrimental to society. Examples mentioned are resale price
maintenance, predatory pricing and tying.