Many industries are oligopolies: there are only a few sellers. In particular, a duopoly has only two sellers. Oligopolies exist for more or less the same reasons that monopolies exist, but in weaker form. They are characterized by imperfect competition: firms compete but possess market power.
Predicting the behaviour of oligopolists poses something of a puzzle. The firms in an oligopoly could maximize their combined profits by acting as a cartel, setting output levels for each firm as if they were a single monopolist; to the extent that firms manage to do this, they engage in collusion. But each individual firm has an incentive to produce more than it would in such an arrangement—
The situation of interdependence, in which each firm’s profit depends noticeably on what other firms do, is the subject of game theory. In the case of a game with two players, the payoff of each player depends both on its own actions and on the actions of the other; this interdependence can be represented as a payoff matrix. Depending on the structure of payoffs in the payoff matrix, a player may have a dominant strategy—an action that is always the best regardless of the other player’s actions.
Duopolists face a particular type of game known as a prisoners’ dilemma; if each acts independently in its own interest, the resulting Nash equilibrium will be bad for both. However, firms that expect to play a game repeatedly tend to engage in strategic behaviour, trying to influence each other’s future actions. A particular strategy that seems to work well in maintaining tacit collusion is tit for tat.
In order to limit the ability of oligopolists to collude and act like monopolists, most governments pursue a competition or an antitrust policy designed to make collusion more difficult. In practice, however, tacit collusion is widespread.
A variety of factors make tacit collusion difficult: large numbers of firms, complex products and pricing, differences in interests, and bargaining power of buyers. When tacit collusion breaks down, there is a price war. Oligopolists try to avoid price wars in various ways, such as through product differentiation and through price leadership, in which one firm sets prices for the industry. Another is through nonprice competition, like advertising.