In oligopolies, a firm's best actions and profit depend on how its rivals behave. To analyze such situations, economists use game theory.
In a Nash equilibrium of an oligoploy market, each firm is choosing a best response to the choices of its rivals.
A fundamental problem facing oligopolists is that each cares only about its own profit and ignores the effects of its actions on rivals' profits. Because each has an incentive to lower its price or increase its quantity to expand its sales, joint profits in the Nash equilibrium are lower than they would be if the firms colluded and acted like a monopolist.
The Bertrand model: price competition with homogeneous goods
In the Bertrand model of oligopoly, firms produce homogeneous goods and set their prices simultaneously.
At the equilibrium point in a Bertrand oligopoly, all sales occur at a price equal to marginal cost.
The Bertrand model's assumptions are often unrealistic.
Cournot quantity competition
In the Cournot model of oligopoly, firms produce homogeneous goods and choose their quantities simultaneously.
In a Cournot market, the equilibrium price is lower than the monopoly price but higher than the marginal cost. The deadweight loss is therefore positive but smaller than in a monopoly.
As the number of firms in a Cournot market grows larger the price falls, approaching marginal cost as the number of firms grows very large.
In a Cournot market with N identical firms, the markup equals negative one divided by the product of the number of firms and the elasticity of market demand:(P - MC)/P = -1/(N × Ed).
Price competition with differentiated products
When a firm's products are differentiated, the firm won't lose all its customers if it raises the price a little above marginal cost. As a result, the equilibrium price exceeds marginal cost in a market for differentiated goods.
The more willing consumers are to switch between different firms' differentiated products in response to a price difference, the lower the equilibrium price.
Collusion
When firms compete repeatedly with no definite end, the noncooperative outcome is the repetition in each period of the outcome when they compete just once. In the repeated Bertrand model, this means that the firms charge a price equal to marginal cost in every period.
Sometimes other outcomes are possible, including in some cases the monopoly outcome. Firms manage to sustain a collusive price by adopting strategies that call for future competition to become more intense (a price war) if anyone deviates from the collusive price.
The more important future profits are, the more likely that firms will be able to sustain collusive pricing. Firms compare the current gain from undercutting the collusive price to the loss of future profits. When the future losses (discounted to their present value) exceed the current gains, firms will refrain from undercutting the collusive price.
Several factors can make collusion difficult to achieve, including a large number of firms, imperfectly observable prices, a large number of products, and differing marginal costs.
Firms engage in explicit collusion when they communicate about the prices or strategies they plan to adopt. Firms engage in tacit collusion when they manage to collude without communicating with one another. Explicit collusion is illegal but is more likely to be successful (barring discovery by antitrust authorities) than tacit collusion.
Market entry and monopolistic competition
Firms respond to profit opportunities in deciding whether to enter an oligopolistic market. They will enter only if the profits they anticipate more than compensate for the fixed costs of entry.
When the fixed cost associated with participating in a market falls, more firms will enter the market. As the fixed cost approaches zero, the number of firms grows very large, and the price falls close to the level of marginal cost.
When the size of the market increases, holding fixed costs constant, more firms will enter the market. As the size of the market grows very large, holding fixed costs constant, the number of firms grows large, and the price approaches marginal cost.
Economists say that competition is more intense in one market than in another if, given any fixed number of firms, the equilibrium price is lower in the first market than in the second. A market with more intense price competition will have fewer firms than a market with less intense price competition. It may even end up with a higher price, once the difference in the number of entering firms is taken into account.
The number of firms that choose to enter an oligopoly market may differ from the socially optimal number. The first entrant into a market has too little incentive to enter, because that firm does not capture the entire consumer surplus that its entry generates. Additional entrants often have too much incentive to enter, because part of their profit comes from stealing business from existing firms.
Monopolistic competition occurs in a market with free entry when there is a large number of firms, each of which produces a unique product, prices above marginal cost, and earns (close to) zero profit net of its fixed costs.
Strategic behavior that shapes future competition
Among a firm's most important strategic decisions are those that shape its future competition with rivals.
One way for a firm to raise its future competitive profit is to cause rivals to become less aggressive in their pricing by raising those rivals' marginal costs.
Another way for a firm to raise its future competitive profit is to commit to certain actions before rivals can commit to theirs.
In some cases, the first entrant into a market can commit to an output level before its rivals, forcing them to reduce their production or to forgo entering the market.
Through strategic precommitments, firms sometimes commit themselves to "play tough" and at other times commit themselves to "play soft" in order to reduce rivals' aggressiveness.
The downside of strategic precommitments is that they limit a firm's flexibility in responding to changing market conditions.
Antitrust policy
Antitrust law is a form of regulation that applies quite broadly. The goal is to maintain certain basic rules of competition that enable markets to achieve good outcomes.
Antitrust concerns can be divided into two categories: those that apply to collaboration among competitors and those that apply to exclusion of rivals.
Agreements by competitors about the prices they will charge or quantities they will produce—called price fixing—are illegal.
Horizontal mergers can both increase market power and reduce costs. In deciding whether to allow a merger, antitrust authorities must weigh those two opposing effects on social welfare.
Dominant firms can engage in tactics such as predatory pricing, exclusive contracting, and bundling to disadvantage rivals and monopolize markets. However, distinguishing between anticompetitive exclusionary behavior and efficiency-enhancing behavior can be difficult.
