4.5 Oligopoly and Game Theory

An oligopoly has a few large firms protected by high barriers to entry, and its defining trait is interdependence: each firm's best choice depends on what rivals do. Game theory models this with a payoff matrix showing each player's outcome for every combination of strategies.

A dominant strategy is a choice that gives a player a higher payoff no matter what the rival picks — test it by holding the rival's choice fixed and comparing your own payoffs, one row or column at a time. A Nash equilibrium is an outcome where neither player can do better by changing strategy alone; it's where the game settles even if a better joint outcome exists.

In the classic prisoners' dilemma, both firms have a dominant strategy (cheat, or price low) that leaves them worse off than if they had cooperated. That logic explains why cartels and collusion are unstable: every member's individual incentive is to break the agreement, even though all members profit more if everyone keeps it.