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Study markets dominated by a few large firms and use basic game theory to understand their strategic behavior.
Why do gas stations on opposite corners usually have the exact same price? If one lowered their price by just a penny, they might steal every customer—so why don't they?
An Oligopoly is a market structure dominated by a small number of large firms. Unlike perfect competition, where firms are 'price takers,' firms in an oligopoly have significant market power. The defining feature is mutual interdependence: the actions of one firm (like Apple) directly affect the profits and decisions of another (like Samsung). Because there are high barriers to entry, such as massive startup costs or patents, these few giants don't have to worry about new competitors appearing overnight. Instead, they focus entirely on outmaneuvering each other.
Quick Check
What is the term for the situation where one firm's profit depends not just on its own pricing, but also on the pricing of its rivals?
Answer
Mutual interdependence
To understand how these firms behave, we use Game Theory. The most famous model is the Prisoner's Dilemma. Imagine two firms can either Collude (keep prices high together) or Cheat (lower prices to steal customers). If both collude, they make high profits. However, each firm has an incentive to cheat to capture the whole market. If both cheat, they end up in a 'price war' where profits are low for everyone. This explains why cartels (groups of firms acting together) are so difficult to maintain—the temptation to cheat is always present.
Consider two airlines, SkyHigh and CloudNine. They are deciding whether to charge a High Price () or a Low Price ().
1. If both choose , they each earn LH150 million and CloudNine earns only L40 million.
Even though is better for both, SkyHigh thinks: 'If CloudNine goes High, I should go Low to get 40 instead of $20.' Going Low is the dominant strategy.
Quick Check
In the example above, if both firms act in their own self-interest, what is the total combined profit of the industry?
Answer
40m + $40m)
A Nash Equilibrium occurs when each player chooses the best possible strategy given the strategy chosen by the other player. At this point, no player has an incentive to deviate unilaterally. In our airline example, the Nash Equilibrium is . Even though both firms would be richer at , neither can trust the other to stay there. If one firm switched from Low to High while the other stayed Low, their profit would drop from 20 million. Thus, they are 'stuck' in a sub-optimal equilibrium.
Let the profit function for Firm A be and Firm B be .
Matrix: - Both High: - A Low, B High: - A High, B Low: - Both Low:
To find the Nash Equilibrium: 1. Underline Firm A's best responses to B's moves. If B is High, A wants 12 (Low). If B is Low, A wants 6 (Low). 2. Underline Firm B's best responses to A's moves. If A is High, B wants 12 (Low). If A is Low, B wants 6 (Low). 3. The cell where both profits are underlined is the Nash Equilibrium: with payoffs .
Which of the following is a characteristic of an oligopoly?
In a Nash Equilibrium, which of the following is true?
Collusion is easy to maintain because firms always prefer the highest possible shared profit.
Review Tomorrow
In 24 hours, try to sketch a 2x2 payoff matrix from memory and identify the Nash Equilibrium.
Practice Activity
Look up the 'OPEC' oil cartel. Research how they try to control oil prices and why individual member countries sometimes 'cheat' by producing more oil than agreed.