Oligopoly Highlighted Sections Oligopoly Equilibrium Game Theory Public Policy Towards Oligopolies Oligopoly Equilibrium - (Back to Top) Oligopoly is different from the other types of market structures you will study (perfect competition, monopolistic competition and monopoly). An oligopoly market is dominated by a few large producers, who are price makers. The best possible outcome for these oligopolists is always to band together and collectively act like a monopolist. When economic agents act in unison, this is called collusion. A group of oligopolists who are colluding are referred to as a cartel. The nations of OPEC have, during the last 25 years, been one of the most powerful cartels ever.   Q: What are the basic types of oligopoly equilibrium? A: Collusive and non-collusive.   In the first paragraph, you reviewed the equilibrium that oligopoly firms will choose if they decide to (or are allowed too) collude - they will imitate a monopoly. Suppose, however, that oligopolists are not able to collude (for example, in the US, collusion is illegal by law).   Q: What is a non-collusive equilibrium like? A: Each oligopolist does what is best for its firm, given what they think the other firms in the market will choose to do.   The answer to the previous question points up what is perhaps the most interesting characteristic of oligopoly - the interdependence of firms. In oligopoly markets, a firm's choices clearly affect that firm, but the firm's choices ALSO affect the firm's competitors. Economists have a term for the situation where each firm does what is best for them, given the strategies chosen by their opponents - this is called a Nash equilibrium.   Q: What do oligopoly firms consider when choosing a level of output? A: The output effect and the price effect.   The output effect works because (with Price > MC) increasing output increases profits. This relates back to the profit maximizing rule you learned in the chapter on competitive markets - any time price is greater than marginal cost, a firm can increase its profit by increasing its output.   The price effect works because oligopoly firms are price makers. If oligopolists increase their output, this will lower the price of the product in the marketplace (think of normal demand and supply, and what occurs when supply shifts to the right.). Therefore, if oligopolists increase their output, they lower the price and lower their profits at the same time.   Oligopoly equilibrium occurs where the oligopoly firm is able to balance the output effect and the price effect. Anytime the output effect exceeds the price effect, the oligopolist should increase output - anytime the price effect exceeds the output effect, the oligopolist should reduce output.   The last important topic for you to consider is the effects of the number of firms on oligopoly equilibrium. By now, you should understand that the larger is the number of firms competing in a market, the less market power each firm has. Looking at oligopolists, this means that as the number of firms increases, the size of the price effect must diminish. Remember that the price effect occurs because the firm is a price maker in the first place. The result is that oligopoly markets become more and more like competitive markets as the number of firms continues to rise. Finally, when all firms are price takers, each firm is selling where P=MC, and BOTH the price effect and the output effect are equal to zero. Oligopoly will eventually become a competitive market if the number of firms gets large enough. Game Theory - (Back to Top) Game Theory is a tool that economists use to study strategic decision making. The prisoner's dilemma game from your textbook is reproduced here to point out a few key aspects of analyzing games and their relation to oligopoly behavior. Notice that in ALL the games presented in this chapter, there are two players. The players should represent the oligopoly firms operating in the market place. Each player has a set of choices (or strategies), and they MUST pick ONE from this set. This is like the oligopolists output or price decision that was discussed in the last section. The payoff each player in the game receives is dependent NOT ONLY on the players choice, BUT ALSO on the opponents choice. In this sense, game theory is very good at modelling the interdependence of oligopoly competitors. As shown in your textbook, both players in this game will decide to confess, and BOTH will spend 8 years in jail. This is the Nash equilibrium solution to the game, because both players are playing their dominant strategies. When both players confess, NEITHER player would UNILATERALLY like to change their decision. Most people look at this game and immediately think that Bonnie and Clyde should jointly decide to remain silent, and they'll each get 1 year in prison. This LOOKS like the best overall outcome. In fact, if Bonnie and Clyde are allowed to collude, this will be the outcome of the game. When Bonnie and Clyde collude and BOTH choose to remain silent, this outcome of the game is NOT a Nash equilibrium. In fact, what is interesting about the collusive outcome to this game is that BOTH players will WISH that they had cheated. Look closely at the game - if either player would UNILATERALLY deviate from the collusive outcome (in other words, if ONE of the players suddenly confesses), that player will go free and be better off. The last point about the incentive to cheat is common to real cartels. In fact, the incentive to cheat slightly from collusive agreement has been a problem that has plagued OPEC in recent years. Public Policy Towards Oligopolies - (Back to Top) Within the US, collusion and other cooperative practices among oligopoly firms are illegal. Two pieces of legislation in particular protect people from oligopolies (and monopolies). The Sherman Antitrust Act (1890) - This act makes all attempts to monopolize trade within the US a criminal act. The Clayton Act (1914) - This act allowed private agents to sue a monopolist or oligopolist for triple damages in the event that collusive or monopoly activity has somehow damaged them. The result of this legislation is that competitors in the US may NOT talk about pricing strategies or discuss ways to promote their common interests in the market place. This guarantees that oligopolies in the US will have to find a Nash equilibrium (as discussed in the first two sections of this study guide, rather than a collusive equilibrium that may be better for both firms, but worse for other firms and consumers. (Back to top)