Oligopolies are markets dominated by a few large firms with significant market power. These firms engage in strategic decision-making, considering competitors' reactions when setting prices and output. This interdependence leads to unique market behaviors and outcomes.

Oligopolies can exhibit competitive or collusive behaviors, impacting prices and consumer welfare. Strategic interactions, often modeled using game theory, influence market outcomes. While oligopolies may drive innovation, they can also lead to higher prices and reduced consumer surplus compared to perfect competition.

Oligopoly Characteristics and Market Behavior

Characteristics of oligopolies

• Few sellers dominate the market
  • High concentration ratio indicates a small number of firms control a large share of total market sales
  • High Herfindahl-Hirschman Index (HHI) measures market concentration by summing the squared market shares of all firms in the industry
• High barriers to entry prevent new firms from easily entering the market
  • Economies of scale allow existing firms to produce at lower average costs due to their large size
  • High startup costs (capital investments) deter potential entrants
  • Legal barriers such as patents and licenses protect existing firms from competition
• Interdependence among firms leads to strategic decision-making
  • Firms consider competitors' likely reactions when making pricing, output, and advertising decisions
• Product differentiation through branding and advertising helps firms distinguish their products from competitors
• Examples of oligopolistic markets include automobiles (Toyota, Ford), telecommunications (Verizon, AT&T), and airlines (Delta, American)

Competitive vs collusive oligopoly behaviors

• Competitive behavior occurs when firms act independently to maximize their own profits
  • Price competition leads to lower prices and profits as firms undercut each other
  • Examples include price wars and aggressive advertising campaigns
• Collusive behavior involves firms cooperating to maximize joint profits
  • Explicit collusion (cartels) with formal agreements is illegal in most countries
  • Tacit collusion occurs without formal agreements through price leadership or conscious parallelism
    • Firms follow a dominant firm's pricing decisions to avoid price wars
• Factors influencing behavior include the number of firms, degree of product differentiation, barriers to entry, and legal environment
• Non-price competition strategies, such as product quality improvements or enhanced customer service, are often employed to avoid direct price wars

Strategic Interactions and Market Outcomes

Prisoner's dilemma in oligopolies

• Prisoner's dilemma is a game theory model illustrating the difficulty of cooperation
  • Each player has two strategies: cooperate or defect
  • Payoff matrix shows outcomes for each combination of strategies
• In oligopoly pricing, firms can choose to set high (cooperative) or low (competitive) prices
  • If both firms set high prices, they maximize joint profits
  • If one firm sets a low price, it can increase its market share at the expense of the other firm
  • The dominant strategy for each firm is to set low prices, leading to a suboptimal outcome for both
• In repeated interactions, firms may develop trust and collude to avoid price wars
  • The threat of future punishment can sustain collusion over time
• Nash equilibrium occurs when each firm's strategy is optimal given the strategies of its competitors

Economic impacts of oligopolies

• Higher prices compared to perfect competition lead to allocative inefficiency and deadweight loss
  • Oligopolies have market power and can set prices above marginal cost
• Reduced consumer surplus as higher prices transfer surplus from consumers to producers
• Potential for innovation and product variety as oligopolies invest in R&D to differentiate products and maintain market share
  • Product differentiation can increase consumer choice
• Potential for predatory behavior such as predatory pricing to drive out competitors or limit pricing to deter entry
• Regulatory challenges involve balancing the benefits of scale economies with the costs of market power
  • Antitrust laws aim to prevent collusion and maintain competition in oligopolistic markets

Strategic behavior and market power

• Firms in oligopolies engage in strategic behavior to maintain or increase their market power
• The kinked demand curve model explains why oligopolistic firms may be reluctant to change prices
• Market power allows oligopolies to influence prices and quantities in the market, leading to potential inefficiencies