Oligopoly
What is Oligopoly?
An oligopoly is a market structure dominated by a small number of large interdependent firms.
Firms in an oligopoly are mutually aware of each other’s actions and often engage in strategic behavior, such as price leadership or collusion. High barriers to entry limit competition and can lead to sustained economic profits.
Oligopoly: a worked example
Two airlines are the only carriers on a route and each must choose a high or a low fare. If both keep fares high they earn $50 million each; if both cut fares they earn $30 million each; if one cuts while the other holds high, the cutter takes the traffic and earns $70 million while the rival earns $10 million. Cutting is each airline's better move whichever fare the rival picks, since $70 million beats $50 million and $30 million beats $10 million, so both cut and the Nash equilibrium pays $30 million each. Both firms end up worse off than the $50 million they could have shared by cooperating, which is the strategic trap at the heart of oligopoly.
The mistake students make with oligopoly
Students assume that because colluding raises the industry's combined profit, oligopolists will simply agree on a high price and stick to it. Each member's individually best move is to break the agreement and sell more while the others hold output back, so the cartel price is not a stable equilibrium and cartels tend to fall apart or need enforcement to survive. The stable outcome of the game is usually the one where firms compete, which pays each of them less than cooperation would.
Oligopoly questions
How many firms are in an oligopoly?
An oligopoly is a market where a small number of firms, typically from two to about ten, account for most of the sales, and the real test is whether each firm has to consider how rivals will react before changing its price or output. A market with exactly two firms is a duopoly, which is a special case of oligopoly.
What is the difference between an oligopoly and a monopoly?
An oligopoly has several interdependent firms whose profits depend on each other's pricing and output decisions, while a monopoly has one seller facing the entire market demand curve with no strategic rival to anticipate. Both are protected by high barriers to entry and both can sustain economic profit in the long run.
Why is game theory used to analyze oligopoly?
Game theory is used to analyze oligopoly because each firm's best price or output depends on what its rivals choose, so the outcome cannot be read off one firm's own cost and demand curves the way it can in monopoly or perfect competition. Payoff matrices, dominant strategies and Nash equilibrium are the tools that predict which combination of choices is stable.
Related terms
Common comparisons
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