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Summary

Oligopoly

• 1. Many industries are oligopolies, characterized by a small number of sellers. The smallest type of oligopoly, 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.
• 2. Predicting the behavior 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 the agreed upon quantity of output—to engage in noncooperative behavior. Informal collusion is likely to be easier to achieve in industries in which firms face capacity constraints.

Game Theory

• 3. 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 on both its own actions and on the actions of the other; this interdependence can be shown in 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.
• 4. Some duopolists face a particular type of game known as a prisoners’ dilemma; if each acts independently in its own interest, the resulting Nash equilibrium or noncooperative equilibrium will be bad for both. However, firms that expect to play a game repeatedly tend to engage in strategic behavior, trying to influence each other’s future actions. A particular strategy that seems to work well in such situations is tit for tat, which often leads to tacit collusion.

Oligopoly in Practice

• 5. In order to limit the ability of oligopolists to collude and act like monopolists, most governments pursue antitrust policy designed to make collusion more difficult. In practice, however, tacit collusion is widespread.
• 6. A variety of factors make tacit collusion difficult: a large numbers of firms, complex products and pricing, differences in interests, and buyers with bargaining power. When tacit collusion breaks down, there can be 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 approach is nonprice competition, such as advertising.

Monopolistic Competition

• 7. Monopolistic competition is a market structure in which there are many competing producers, each producing a differentiated product, and there is free entry and exit in the long run.
• 8. Short-run profits will attract the entry of new firms in the long run. This reduces the quantity each existing producer sells at any given price and shifts its demand curve to the left. Short-run losses will induce exit by some firms in the long run. This shifts the demand curve of each remaining firm to the right.
• 9. In the long run, a monopolistically competitive industry is in zero-profit equilibrium: at its profit-maximizing quantity, the demand curve for each existing firm is tangent to its average total cost curve. There are zero profits in the industry and no entry or exit.
• 10. In long-run equilibrium, firms in a monopolistically competitive industry sell at a price greater than marginal cost. They also have excess capacity because they produce less than the minimum-cost output; as a result, they have higher costs than firms in a perfectly competitive industry. Whether or not monopolistic competition is inefficient is ambiguous because consumers value the product diversity that it creates.

Product Differentiation and Advertising

• 11. Product differentiation takes three main forms: style or type, location, and quality. Firms will engage in advertising to increase demand for their products and enhance their market power. Advertising and brand names that provide useful information to consumers are valuable to society. Advertisements can be wasteful from a societal standpoint when their only purpose is to create market power.