Four Market Model Summary: Oligopoly - Online Tutor, Practice Problems & Exam Prep

Oligopolies are characterized by a few firms, such as Coke and Pepsi, and high barriers to entry, making it difficult for new competitors to enter the market. Firms in an oligopoly engage in strategic pricing influenced by competitors, leading to long-run profitability due to their market power. The demand curve is downward sloping, resulting in marginal revenue being less than price. Understanding game theory is crucial for analyzing firm behavior in this market structure, highlighting the interdependence among firms and the potential for collusion.

Four Market Model Summary: Oligopoly

Alright, guys. You did it. You've reached the end of the oligopoly unit. So we saw how the oligopoly is actually quite different from other market structures, right? We had to use game theory and we had that idea of interdependence between the firms, alright? So let's go ahead and fill out that column for the oligopoly in our model summary, okay? Remember when we first started perfect competition, we had this page with the four market models, right? We're going to go ahead and fill in on that page the column for oligopolies, all right?

So what did we see so far? Oligopolies, the number of firms in an oligopoly were few, right? We mostly dealt with a situation where there were two firms and well that's the minimum amount for an oligopoly, right? Because if it was just one firm, we would have a monopoly. So we're going to have few firms in an oligopoly. Examples: We talked about some good examples. We talked about Coke and Pepsi, right? Coke and Pepsi, that's a great oligopoly over the soft drink industry. We also talked about aluminum. Aluminum is an identical good that exists in an oligopoly. There are only a few suppliers of aluminum, so that's also an oligopoly.

Alright, barriers to entry in an oligopoly market. Barriers to entry, that’s keeping people, keeping other firms from entering this business, right? And that's what we saw: there were high barriers to entry, right? It's difficult to join a market where there's an oligopoly already, right? So barriers to entry are high, just like with a monopoly.

Alright, so let's go on here to the profit-maximizing quantity. Well, the profit-maximizing quantity in this case, we can't really just say there's a profit-maximizing quantity like we did before with marginal revenue equals marginal cost, right? That's how we were always finding profit maximizing. Well, here it's more strategic, right? They have to do strategic pricing based on what their competitors are doing. So unfortunately, there's not just a profit-maximizing quantity.

How about long-run profitability? Well yes, it's still profitable in the long run in an oligopoly, right? Because there are so few firms, it's possible to have long-run profits. Okay? And that's because of the market power. There are few firms in the market. They have market power and they're able to influence the output and the price so that there's actually profits to be made in the long run.

Okay, how about the relationship between price and marginal revenue? Well, we saw that oligopolies face a downward-sloping demand curve, right? The only time we had that special case with the firm facing a flat demand curve was in perfect competition. Well everywhere else, we see that the price, which is our demand curve—that average revenue curve—is going to be greater than marginal revenue, right? And that's any situation where we have a downward-sloping demand curve; the marginal revenue is always going to be below it, okay? And we also saw a situation where the price was greater than marginal cost as well, right? When the price equals the marginal cost, we're being efficient. We're in perfect competition in that case. Well, here the price is going to exceed the marginal cost, alright?

This is not everything we covered, right? We don't really have much information about the game theory that we went over in this chapter, but this is some high-level stuff that you can compare between the different market structures, alright? So let's go ahead and move on to our next chapter.

Here’s what students ask on this topic:

What are the key characteristics of an oligopoly market structure?

An oligopoly market structure is characterized by a few dominant firms, high barriers to entry, and interdependent decision-making. Examples include industries like soft drinks (Coke and Pepsi) and aluminum. The high barriers to entry prevent new competitors from easily entering the market. Firms in an oligopoly engage in strategic pricing, often influenced by the actions of their competitors. This interdependence can lead to collusion, where firms may agree to set prices or output levels to maximize collective profits. The demand curve in an oligopoly is downward sloping, meaning that marginal revenue is less than the price. Long-run profitability is possible due to the market power held by the few firms in the industry.

How does game theory apply to oligopoly markets?

Game theory is crucial for understanding firm behavior in oligopoly markets because it highlights the strategic interdependence among firms. In an oligopoly, each firm's decisions regarding pricing, output, and other strategic factors depend on the anticipated reactions of their competitors. Common game theory concepts used in oligopoly analysis include the Nash Equilibrium, where firms choose their best strategy given the strategies of others, and the Prisoner's Dilemma, which illustrates why firms might not cooperate even when it is in their best interest. Game theory helps explain phenomena like price rigidity and the potential for collusion in oligopolistic markets.

Why are barriers to entry high in oligopoly markets?

Barriers to entry are high in oligopoly markets due to several factors. First, existing firms often have significant economies of scale, making it difficult for new entrants to compete on cost. Second, established firms may have strong brand loyalty and customer bases, which new entrants find hard to break. Third, there may be substantial capital requirements for entering the market, such as the need for expensive technology or infrastructure. Additionally, existing firms might engage in strategic behaviors like predatory pricing to deter new competitors. These high barriers help maintain the market power and long-run profitability of the few firms in the oligopoly.

What is the relationship between price and marginal revenue in an oligopoly?

In an oligopoly, the relationship between price and marginal revenue is such that the marginal revenue (MR) is always less than the price (P). This is because the demand curve in an oligopoly is downward sloping. When a firm lowers its price to sell more units, it must reduce the price on all units sold, not just the additional ones. This causes the marginal revenue to fall below the price. Mathematically, this can be represented as:

$P>\mathrm{MR}$

This relationship contrasts with perfect competition, where the price equals marginal revenue.

Can firms in an oligopoly achieve long-run profitability?

Yes, firms in an oligopoly can achieve long-run profitability. This is primarily due to the high barriers to entry that prevent new competitors from entering the market and eroding profits. The few firms in the market have significant market power, allowing them to influence prices and output levels. This market power enables them to maintain prices above marginal cost, leading to sustained profits over the long run. Additionally, the strategic interdependence among firms often results in stable pricing and output decisions, further supporting long-term profitability.