Oligopoly

When a Few Firms Run the Show

Oligopoly describes a market where what your competitors do with their prices is more important than your own costs.

When just three or four companies control a market, competition doesn't work as you might think. Verizon, AT&T, and T-Mobile all charge roughly the same amount for unlimited data plans, month after month and year after year. Delta raises prices on flights from Atlanta to Chicago and United matches them before lunchtime. This is because of mutual interdependence, and this fundamentally alters how these companies act.

An oligopoly is when a small number of very large companies are in charge of the market. Think of cell phone companies, airlines, car makers, and streaming services. You have some power to set prices, but so do the other companies, and this conflict is at the heart of every decision they make about advertising, launching new products, lowering prices, or keeping them steady. This is very different from perfect competition (where one company is too small to affect the market price) or monopoly (where you are the market). Oligopoly is in the middle, and that middle ground is complicated.

The AP exam is most interested in this interdependence. A monopolist only thinks about what consumers want. A perfectly competitive company accepts the price and moves on. But an oligopolist must think several steps ahead, like in chess. If Coca-Cola cuts its prices by 15%, will Pepsi match that? Go lower? Or rely on people's loyalty to their brand? Whatever Pepsi does will cause Coca-Cola to respond.

It's hard for new companies to get into the market because of barriers to entry. Building a 5G network costs many billions of dollars (T-Mobile spent over $80 billion buying Sprint in 2020, largely to get the right frequencies). Pharmaceutical patents prevent competitors from selling for 20 years. And it would take a new company many years to build the brand recognition Nike or Apple have now. New companies would like to join an oligopoly and make its large profits, but the obstacles are huge.

The products can be the same (like steel or aluminum - this is a 'homogeneous' oligopoly) or different (like Samsung Galaxy and iPhone). The strategic interdependence is present in either case.

Game Theory and the Prisoner's Dilemma

Let's say you're in charge of pricing at American Airlines, looking at the Chicago to Miami route. Reducing prices by 20% would get passengers from United...but then United will probably lower their prices by 25%, Southwest will join in, and everyone's profits will suffer. Both airlines would have been better off if they hadn't changed the prices at all.

Economists use 'game theory' (the study of strategic decision making when your success depends on what someone else does) to describe situations like this. In an oligopoly, companies don't just respond to supply and demand. They predict what others will do, what strategies they'll use, and how they'll retaliate.

The 'prisoner's dilemma' is a typical example. Relating it to airline prices:

American and United each have to choose between keeping prices high or drastically reducing them. Both airlines making their fares high will earn each of them $10 million, but if they both lower fares, it will start a price war and each will only get $4 million. If one airline lowers fares while the other keeps them high, the airline with the lower fares gets a much larger share of the market and makes $12 million, while the one sticking to the high price only gets a meager $2 million.

Looking at American Airlines specifically, if United keeps prices high, American can make $12 million by lowering theirs, as opposed to $10 million by keeping theirs high. If United does lower prices, American will earn $4 million by also lowering, but only $2 million by holding firm. So, lowering prices is the better move for American no matter what United does, and this is true for United as well. However, when both lower prices, they both end up with $4 million, which is much worse than the $10 million they could have made by agreeing to keep prices high.

This difference between what makes sense for each company on its own, and what would be best for them as a group, is at the heart of how companies in a small number compete. They really want to agree to something, but the temptation to cheat on the agreement keeps them from doing so.

Nash Equilibrium and Dominant Strategies

John Nash, a mathematician at Princeton (and the subject of the 2001 movie A Beautiful Mind), gave us a way to understand this. A Nash equilibrium is a situation where neither player can improve their outcome by changing their own approach, given what the other player is doing. In the airline situation, both lowering fares is the Nash equilibrium. Once they're both doing it, neither would benefit from going back to high fares; they'd lose customers to the airline with the cheaper prices.

It's frustrating because this Nash equilibrium isn't the best outcome for both of them - $4 million each is clearly not as good as $10 million each. But it's a stable situation; no one has a reason to change.

A dominant strategy is one that's better than any other strategy, no matter what the other player does. In this "prisoner's dilemma" situation with the airlines, lowering fares is a dominant strategy for both. But not all games have a dominant strategy. When there are three or four options for each player, the best thing to do will often depend on what you think the competition will do, and there won't be a single option that's best in every case.

And it's worth remembering for the AP exam: A Nash equilibrium shows where rational companies acting in their own self-interest will end up, not where they'd like to be. This difference between the Nash outcome and what they could get by working together is what makes them try to work together secretly.

Cartels and Collusion

If both airlines lowering prices makes things worse for both of them, the obvious solution is to just agree not to lower them. This is called collusion, where companies competing with each other coordinate on prices, how much they produce, or areas where they operate to increase their combined profits.

OPEC is the classic example. Saudi Arabia, Iraq, the UAE, and the other members meet and decide how much oil each will produce. Less oil available means higher prices worldwide. When they all stick to the agreement (like during the 1973 oil embargo which caused prices to quadruple overnight) profits are huge. When they can't all be trusted to keep their promises, prices fall and the members begin to blame each other.

A cartel is collusion with a specific, formal structure: a clear agreement about prices or production levels. A successful cartel works like a monopoly - reducing the amount available, increasing prices, and causing losses for consumers. Most countries ban them for this reason. The Sherman Antitrust Act of 1890 made fixing prices a federal crime in the U.S., and the Department of Justice continues to prosecute these cases (like the lysine cartel in the 1990s, and the LCD price-fixing agreement between 2006 and 2010).

But every cartel has a weakness. If American and United agree to keep fares high at $10 million each, American knows it could secretly offer lower prices on some routes, get more customers, and make $12 million while United follows the agreement. Every member of a cartel faces this same temptation. This is why cartels are, by their nature, unstable.

OPEC consistently demonstrates this, with member countries routinely producing more than allowed, hoping to get extra money without being noticed.

It's easier for companies to work together when there are only a few of them (keeping an eye on three is far easier than on thirty), the product is all the same (making hidden discounts much harder to get away with as customers would quickly realize), demand is fairly stable, and companies are in competition with each other for a long time. This last point means the possibility of being punished later (economists call this the "grim trigger" approach) discourages them from cheating.

Companies can sometimes coordinate without explicitly speaking to each other. This is called tacit collusion. Think of one airline increasing prices, and all the others doing the same within hours. There's no secret meeting, no written proof, and while it's legally okay (prosecutors can't prove an agreement) the economic outcome is essentially the same as if they had formed a cartel.

The Kinked Demand Curve

Gas stations at the same intersection frequently charge the same price for weeks, and airlines on busy routes don't change their fares. Prices in an oligopoly are oddly fixed, and the kinked demand curve model explains this with one basic idea about how competitors will act.

If you raise your price, your rivals won't do the same; they'll happily let you lose customers to them. Therefore, demand at a price higher than the current one is very elastic - a small price increase will cause a large decrease in your sales.

If you lower your price, your competitors will immediately match it. They aren't going to let you take their customers. Demand at a price lower than the current one is relatively inelastic, and your price reduction won't gain you much, because your competitors will neutralize it almost instantly.

This difference in reaction creates a "kink" in the demand curve at the current price. The kink causes a break in the marginal revenue curve, and this is what's important for the AP exam: even if a company's marginal cost goes up or down within this break, the amount they produce and the price don't change. Prices remain where they are.

So companies don't raise prices (because you'd lose customers) and don't lower them (because rivals match, your profits on each item shrink, and your slice of the market doesn't get any bigger). Everyone ends up at the same price and it stays there until a significant change, like a big increase in costs or a shift in demand, moves the marginal cost outside of that break.

The model does have flaws. It explains why prices don't change, but not how they were originally set. George Stigler pointed this out in the 1940s and the criticism has remained. However, it does accurately describe how oligopolies work and is a common feature of AP exams.

Worked Example: 2-Firm Payoff Matrix

Let's look at an example: Samsung and Apple are deciding whether to spend a lot on advertising or keep their advertising budgets small.

Here's a table showing the potential profits (in millions of dollars) with Samsung listed first:

Apple: Big Ads Apple: Small Ads
Samsung: Big Ads (5, 5) (9, 2)
Samsung: Small Ads (2, 9) (7, 7)

Samsung's best strategy, no matter what:
- If Apple spends a lot on advertising, Samsung makes $5 million (from a big advertising spend) versus $2 million (from a small spend). A big spend is better.
- If Apple spends little on advertising, Samsung makes $9 million (from a big spend) versus $7 million (from a small spend). A big spend is still better.
- Therefore Samsung's best strategy is to spend a lot on advertising, whatever Apple does.

Apple's best strategy, no matter what:
- If Samsung spends a lot on advertising, Apple makes $5 million (from a big spend) versus $2 million (from a small spend). A big spend is better.
- If Samsung spends little on advertising, Apple makes $9 million (from a big spend) versus $7 million (from a small spend). A big spend is better.
- So Apple's best strategy is also to spend a lot on advertising.

Nash Equilibrium: Both spend a lot on advertising, earning $5 million each. Neither company could improve their profit by changing strategy alone. If Samsung switched to a small spend, while Apple continued with a big spend, Samsung would go from $5 million to $2 million. The same applies to Apple.

What could happen: If both agreed to spend little on advertising, they'd each make $7 million, two million more each. The agreement breaks down when it's tested. Samsung could be relying on Apple to not advertise too much, but Samsung could then decide to do a lot of advertising and increase their earnings from $7 million to $9 million. This temptation to not play fair is exactly the 'prisoner's dilemma' in action. Both companies are pushed by what they want for themselves towards the 'Nash equilibrium' of $5 million each, even though they'd both be better off with $7 million apiece if they both limited their advertising.