Chapter 17: Oligopoly

A few firms, a lot of strategy — and why cooperation is so hard to hold together

Section 1

What Is an Oligopoly?

An oligopoly is a market with only a few sellers of a similar product. Tennis balls (Penn, Wilson, Prince), commercial aircraft (Boeing, Airbus), and oil (OPEC) are classic examples.

Because each firm is large, what one firm does noticeably changes the others' profits. That's strategic interdependence — the one feature that separates oligopoly from everything else. Perfect competitors ignore rivals. Monopolists have none. Oligopolists must ask: "What will the others do, and how should that change what I do?"

Which of these is an oligopoly?

Section 2

The Prisoners' Dilemma

Two suspects, Bonnie and Clyde, are caught for a small crime but suspected of a bigger one. Each is offered the same deal separately: confess and rat out your partner — you go free, partner gets 20 years. Both confess? Both get 8. Both stay silent? 1 year each.

Clyde stays silent. Click Bonnie's best response.
Bonnie's decision
Confess Stay silent
Clyde
confesses		 (8, 8) yrs Nash eq. (0, 20) yrs
Clyde
stays silent		 (20, 0) yrs (1, 1) yrs
Confess is Bonnie's dominant strategy (her best move no matter what Clyde does) — and Clyde's too. So (Confess, Confess) is the Nash equilibrium: neither wants to change. Yet (Silent, Silent) would give both only 1 year — self-interest delivers a worse outcome.
This is the oligopoly story. Replace "confess" with "produce more" and "stay silent" with "honor the cartel." Each firm's dominant strategy is to cheat. Both cheat. Both end up worse off.

Section 3

Duopoly: Jack, Jill, and the Nash Equilibrium

Jack and Jill each own a water well. Pumping is free — MC = $0. Town demand: P = 120 − Q.

Since each gallon costs nothing to make, joint profit = Q × P.

Try it: calculate the duopoly's joint profit in the table below.

Market structure Q P Joint profit
Perfect competition (P = MC) 120 × $0

Why $0 in perfect competition?

When many firms compete and pumping costs nothing (MC = $0), each firm undercuts the others until price = MC. The price gets driven all the way down to $0 — huge quantity, no profit per gallon.
 		= $0
Duopoly Nash eq. 80 × $40 =
Monopoly / cartel (MR = MC) 60 × $60 = $3,600

Oligopoly lands between competition and monopoly.

So which strategy will Jack and Jill actually pick?

Each firm chooses High (40 gallons) or Low (30). To decide, we look for each firm's best response — the highest-profit move, knowing what the other firm picked.

If Jill plays High, click Jack's best response cell.
Jack's choice
High: 40 Low: 30
Jill
High: 40		 ($1,600, $1,600) Nash eq. ($2,000, $1,500)
Jill
Low: 30		 ($1,500, $2,000) ($1,800, $1,800)
(High, High) is the Nash equilibrium: given what the other is doing, neither would change their move. Each earns $1,600 — worse than the $1,800 each at (Low, Low).

Dominant strategy — describes one player's best move, no matter what the other does.

Nash equilibrium — describes an outcome (a combination of both players' moves) where neither would change, knowing what the other picked.

When both players have a dominant strategy, both playing it is automatically a Nash equilibrium.

Section 4

Cartels: Jointly Rational, Individually Unstable

Cooperating, oligopolists act as a single monopolist: small Q, high P, big joint profit. Like any monopolist, the cartel adds units while extra revenue (MR) exceeds extra cost (MC), and stops where MR = MC:

A cartel acts like a monopolist: choose Q where MR = MC.

Read the graph: what does the cartel choose?
Cartel choice: Q = 2, P = $8, $2 profit each. Same setup as Pac MC 1–2.
1. Q where MR = MC → Q = 2.
2. P from demand at Q = 2 → P = $8.
3. Profit per firm = (P − MC) × Q ÷ 2 = ($8 − $6) × 2 ÷ 2 = $2.
Three reasons cartels break down:
  • Each firm's dominant strategy is to cheat (the prisoners' dilemma).
  • Antitrust laws make explicit price-fixing illegal.
  • Even with the threat of retaliation, the short-term gain from cheating usually wins — OPEC member countries regularly cheat on their oil quotas.

Section 5

Takeaways

Tap each to expand.

  • That's why oligopoly needs game theory — competition and monopoly don't.
  • Jack & Jill example: monopoly Q = 60, duopoly Q = 80, perfect competition Q = 120. When oligopolies collude, they produce less — just like a monopoly.
  • Dominant strategy = your best move no matter what. Nash equilibrium = the outcome where, knowing what the other picked, neither would change. When both players have a dominant strategy, them both playing it is automatically Nash.
  • Both players defect because defection is dominant — leaving both worse off than if they had cooperated. Same logic applies to cartels.
  • A cartel produces where MR = MC, just like a monopoly — that's the highest joint profit. But each firm wants to cheat, so cartels usually break down.