In economic theory, the oligopoly market structure basically covers cases that do not fit well with the perfect competition, monopolistic competition, or monopoly models.
Oligopoly covers many different types of situations, and economists have not developed one model that adequately explains behavior for all businesses in oligopoly. However, the oligopoly market structure itself covers more real world situations than the models for the other market structures.
Few firms, some if not all are relatively large compared to the overall market size; and difficult, but not impossible, entry into the market. The products may be differentiated or identical.
Firms have a large degree of control over the prices of their products, but the firms are highly interdependent. Since each firm has a large market share, the actions of each firm are dependent on the actions of competitors. If a firm does not react properly to a competitor's actions, it could lose market share, and profits.
The behavior of firms in oligopoly can be described as either competitive or cooperative.
Competitive behavior includes much more than just price competition. Most real world innovation and technological advances come from firms in oligopoly. Firms are continually trying to stay ahead of their competitors with improvements that consumers will want. Firms in oligopoly often spend large sums of money on research & development.
A large advertising budget is also typical.
There is no single economic model that explains all behavior in oligopoly. Two models that are used to explain competitive behavior are the kinked demand curve and prisoner's dilemma. Some behavior by firms in oligopoly can be described as cooperative rather than competitive.
Firms in oligopoly face a downward sloping demand curve. If they lower their price, the quantity demanded increases; and if they raise their price, the quantity demanded decreases.
Because the demand curve is downward sloping, firms will have to lower the price on all units sold in order to sell more units. This means that the marginal revenue (MR) curve lies below the demand curve.
If one firm decides to lower its price, other firms in the market are likely to match the lower price in order to prevent a loss of market share.
The result would be that the firms' market shares will stay roughly the same. The lower prices may induce some new customers into the market, but firms will not be able to “steal” customers away from their competitors if all firms match the lower price.
In this situation, the demand curve is inelastic.
If one firm decides to raise its price, the other firms in the market are not as likely to react with similarly raised prices. With a downward sloping demand curve, firms will see a chance to gain market share as customers choose the lower priced substitutes.
In this situation, the firm that raises its price will lose customers to the competition.
The demand curve is highly elastic for the firm that raises its price.
In effect, two demand curves exist: one that is inelastic and one that is highly elastic. Each demand curve has only one relevant segment. The inelastic segment is only relevant when the price decreases below the current price. The elastic segment is only relevant when the price increases above the current price.
The effective demand curve would be the combination of these two relevant segments. It would be a curve that is relatively flat at prices above the current price, and relatively steep at prices below the current price.
A kink forms at the current price.
This price - where the demand curve kinks - would have been determined by the demand at the profit maximizing quantity. The profit maximizing quantity is always determined by the quantity where marginal revenue is equal to marginal cost.
Because the demand curve has a kink, and the marginal revenue curve lies below the demand curve, the marginal revenue curve would have a gap where the two segments of the demand curve meet. That is, at the kink, or the profit maximizing price.
Profit is maximized at the same price and quantity combination as long as the marginal cost curve crosses the marginal revenue curve anywhere within this gap.
If variable costs change, a profit-maximizing oligopolist will not change price or quantity as long as the marginal cost curve crosses the marginal revenue curve within this gap.
The kinked demand curve model does not explain all behavior in oligopoly, but the gap in the marginal revenue curve helps to explain why firms in oligopoly change prices rather infrequently.
Game theory is a branch of mathematics often used in economics to explain strategic behavior. Prisoner's dilemma is a model in game theory that is used in economics to explain the behavior of firms in oligopoly.
Prisoner's dilemma explains why firms (without cooperating with competitors and without perfect knowledge of how their competitors will react, but knowing that their competitors will react in some fashion) will often find that the best strategy is the opposite strategy from what would be chosen if they could cooperate with the competition.
Why does this model have such a name? Why is it called prisoner's dilemma?
The answer lies in the similarity of firms in oligopoly to the prisoners in the following story. Understanding this story may help to understand the strategy choices in the model of prisoner's dilemma for oligopoly.
The story goes like this:
Two people have been arrested for the same crime. The police know that without a confession, not enough evidence exists to make a conviction. So the two prisoners are separated to prevent them from coordinating their stories. Each prisoner is then offered a deal, in an attempt to generate a confession.
The deal offered is that if the prisoner confesses and is willing to testify against the other, he will go free as long as the other prisoner does not confess. If he refuses to confess, but the other prisoner does confess, he will face the maximum sentence. If they both confess, they will not go free but will face a reduced sentence. However, because of the weak evidence against them, they will both go free if neither confesses.
This story emphasizes the different strategy that will be selected because of the lack of perfect knowledge, the lack of cooperation.
Because the prisoners are separated, each cannot know whether the other will confess or not. If they could collude, they would both choose not to confess, and both would be set free. But because they cannot collude, each would choose to confess in order to avoid the maximum sentence and retain the hope of being set free.
As a result, each would choose to confess; neither would be set free, but neither would face the maximum sentence.
When the prisoner's dilemma model is applied to oligopoly, the strategic choices of firms will be similar to those of the prisoners in the above story. Each firm would be better off if the firms could cooperate, but would choose the opposite strategy if they cannot cooperate.
Prisoner's dilemma is a simplified model of oligopoly that focuses on only two firms, and the options available to these two firms. It can be modified to focus on one firm's decisions against “all competitors” in order to take into consideration the fact that a typical market will have more than two firms.
Prisoner's dilemma is best understood with the use of an example in the form of a table. Often, economics textbooks will use as an example the choice of whether or not to raise prices, or whether or not to spend money to advertise.
This does not have to be a zero sum game: the amount that one firm gains from a choice does not have to be offset by an equal amount of loss for the other firm. This makes sense in the examples often used, because a change in price will change each firm's revenue and profit given a downward sloping demand curve. Also, advertising can draw new customers into the market.
Consider the following table, showing the payoff possibilities for two firms considering whether or not to advertise:
Notice that firm A's payoff is higher if it advertises regardless of the strategy used by firm B. If firm B chooses to advertise, firm A would be better off, by 70 to 40, if firm A advertises. If firm B chooses not to advertise, firm A would be better off, by 100 to 80, if firm A advertises. Either way, firm A would be better off if it chooses to advertise.
For firm A, the choice to advertise is called a dominant strategy. A dominant strategy is when the same strategy yields a better result regardless of what strategy the competition chooses.
In this example, firm B also has a dominant strategy to advertise.
If each firm in this example chooses its dominant strategy, each will choose to advertise. Firm A will earn a payoff of 70, and firm B will earn a payoff of 80.
But notice what would happen if cooperation were possible: each would be better off by choosing the opposite strategy, which is to not advertise. Firm A would earn a payoff of 80, and firm B would earn a payoff of 90.
One strategy based on competition. The opposite strategy based on cooperation. That is the prisoner's dilemma.
The prisoner's dilemma model illustrates that firms in oligopoly can be better off if they are able to cooperate rather than compete. If they cooperate in the form of a secret agreement, this is called collusion. The practice of collusion is illegal in the United States and many other nations, but it is not illegal in all nations.
Cooperation might make firms better off, but at the same time it is likely to make consumers worse off. Cooperation often means higher prices and lower quantities for consumers. Cooperation also reduces the incentive for firms to develop new and improved products. This could lead to domestic industries losing out to foreign competitors who are not a party to any cooperative agreements.
One method that firms in oligopoly may use to cooperate is called price leadership. In the price leadership method, one firm changes its price, and other firms automatically match the price change.
You can see an example of this in virtually every neighborhood in the United States. When one gas station changes its price, every other gas station in the same neighborhood will change to the exact same price on the same day.
Different strategies can be employed to determine which firm is the price leader. One is to have the largest firm set the price, and then other firms follow suit. This method appears to be useful in markets where one firm is a dominant firm.
Another strategy is to have the lowest-cost firm be the price leader.
Another strategy that is commonly used in real world situations is to have a barometric firm set the price for others to follow.
The barometric firm would be a firm that makes a public announcement, such as through a press release, of its intentions to change prices. In this public announcement, it will explain the reasons for a price change, such as trends in the costs of production. This would be a signal for other firms to match the price change.
Still another price leadership strategy would be for firms to hide their cooperation by using secret codes. They could agree to rotate the firm that is the price leader through a secret method in order to avoid having consumers and regulators know about this strategy. However, this strategy falls under the category of collusion and is therefore generally illegal.
Price leadership eliminates the kink in the demand curve, since both price increases and price decreases will be followed.
It also eliminates the prisoner's dilemma, since each firm will have knowledge of the strategy of the other firms.
A cartel is an organization of firms in an industry that agrees to restrict competition between its members in order to maximize the profits of the entire organization. All members of a cartel agree formally or informally to set prices and / or output levels as if the cartel were a monopoly.
An international cartel is a cartel composed of firms from different countries.
Since profits are maximized for the cartel as a unit, and not for individual firms in a cartel, an incentive to cheat exists. If one firm in a cartel can find a way to secretly break the agreement, such as by selling more output at a lower price, that firm will be able to increase its profits over what it could make within the agreement. This would decrease the profits of the cartel as a unit.
Such cheating can easily break up the cartel, especially if the cheating is detected; all firms would then be made worse off. Enforcement of agreements is the key to avoid cheating that will break up a cartel.
Because of the incentive to cheat, most cartels are not successful for very long. The conditions necessary for a successful cartel include:
Few firms in the industry
Significant barriers to entry
Few opportunities for secret actions
No legal barriers to sharing agreements
Cartels are generally illegal in the United States and many other countries. However, international cartels are not illegal. The most famous cartel, OPEC (the organization of petroleum exporting countries), is an international cartel whose enforcement mechanism is aided by the fact that its firms are actually the countries themselves rather than private organizations.
Even in the United States, where cartels are illegal, some cartel-like organizations are endorsed by the government. The NCAA (national collegiate athletic association) is a cartel of colleges and universities with a governing board that sets and enforces rules. Congress has granted Major League Baseball a special exemption to antitrust laws in order to allow it to function as a cartel.