Oligopoly is a market structure in which a relatively small number of companies or organizations serve a large number of consumers. Along with monopoly, oligopoly as a structure exists in imperfect competition. Because the number of firms in oligopoly is usually extremely small, the profit of each participating company does not only depend on that company’s decisions. The decisions of other firms that exist in the oligopolistic industry have a significant impact on the firm’s profitability (Jeffrey R. Church, et al. 209). Game theory is often discussed in relation to oligopoly, because it studies strategic behaviors (Jeffrey R. Church, et al. 215). Strategic behavior of firms is their behavior in a situation where making a decision on further actions involves analyzing the possible response of other market actors. Since the number of firms in the oligopolistic market is small, each firm must develop its own strategy. Each firm understands that its profit depends not only on the volume of its production, but also on the output of other firms. This essay will discuss the features of oligopolistic markets, collusions, and the threat of entry in relation to game theory.
Oligopolies often emerge naturally as companies grow and begin to take over other companies, increasing their market share and gradually displacing or absorbing competitors. Over time, the number of companies that offer specific products and services reduces to a few large corporations. In turn, when choosing products, customers tend to trust brands that are more famous and reputable. When a small number of firms are present on the market, they are called oligopolies. In some cases, the largest firms in the industry can be called oligopolies as well. The products that the oligopoly supplies to the market are identical to its competitors’ products (for example, mobile communications), or have certain differentiation (for example, washing powders). At the same time, price competition is very rare in oligopoly markets. As a rule, it is very difficult for new firms to enter an oligopolistic market. The barriers are either legal restrictions or the need for large initial capital (Head and Spencer). Another feature characteristic for oligopolies is the fact that firms in the industry are aware of their interdependency, so price controls are limited.
Game theory, as applied to the analysis of market structures, was developed by the American economists John von Neumann and Oskar Morgenstern in their book Theory of Games and Economic Behavior. Another American scientist, a mathematician John Forbes Nash, was a pioneer of game theory who made a significant contribution to the development and application of game theory. The main idea of the theory can be expressed as follows: players strive to maximize their benefit; this benefit to the oligopoly is profit. In most cases, the best strategy for each player depends on the strategy chosen by the other players; equilibrium emerges when each player chooses a strategy that takes into account the other players’ best strategies (Alothman and Alqahtani 7). This equilibrium is called “Nash equilibrium” and implies that none of the participants can increase the benefit by changing their strategy if other participants do not change theirs. Sometimes, the player’s best strategy is developed independently of the strategies chosen by others. In this case, it is called the ‘dominant’ strategy, and the rest of the participants are forced for one reason or another to adapt their behaviors according to the dominant strategy.
Some firms favor collusion, which is an agreement concluded between oligopolies concerning price fixing, market division, and competition restrictions. The practice when competing companies make a formal agreement on collusion is called a cartel (Telser 23). Antitrust laws in most countries prohibit collusion; therefore, in practice, cartels are mostly either international, e.g. OPEC, or secret. The main barriers to collusion include differences in the demand for the product and differences in the costs of its production and circulation. When costs and demand differ, it is difficult to negotiate a price, so the fate of the collusion depends on the firms’ ability to reach a compromise. The more firms there are in the industry, the harder it is for them to collude. In addition, collusion is hindered by the decline in business activity and antitrust legislation. The goal of collusion is to maximize profits when firms act together as a monopoly; this is an equitable outcome for any number of firms.
A number of market factors can make it easier to maintain market collusion between several oligopolistic firms. These include frequent market interactions, market transparency, and the company’s contacts in different markets. Firms with an increased frequency of interactions in the market have more opportunities for collusion, since they can react more quickly to deviations of one of the companies from the agreement. It should be noted that companies will not collude if the alleged punishment for deviating from the strategy of maintaining the agreement either never occurs, or can only occur in the distant future (Telser 46). The same logic applies to the frequency of price adjustments. The more often prices are revised in the market, the shorter the period available for firms to profit from agreement deviation, and the faster the punishment for the deviation comes. Thus, spot markets with frequent price adjustments make it easier to maintain collusion.
The ability to maintain collusive agreements depends on the possibility of punishment for deviating from it, but for this, market participants need to detect the deviant company. Therefore, not only frequent price adjustments in the market are important, but also the observability of prices. Observability makes it easier to maintain collusive agreements, and uncertainty makes it difficult to do this in a market where prices cannot be unambiguously determined from available market signals (Jeffrey R. Church, et al. 601). Studies have noted that it is easier for firms to maintain collusion when they interact in multiple markets, as this increases the frequency of interactions between them and can smooth out asymmetries in individual markets (Telser 34). This allows collusion to be sustained where it would be otherwise impossible. Such contacts may include long-term contracts, which actually imply the emergence of another, forward market.
Entering an oligopolistic market is extremely difficult, and firms that conclude a collusive agreement can survive threats of entry because they have specific rules, or obstacles, which do not allow their rivals to enter the market. These restrictions and limitations are called barriers to entry and can be natural or artificial (Telser 14). Thus, natural entry barriers to the market include economies of large scale production, ownership or control of a scarce resource, high set-up costs and high research and development costs.
In turn, artificial barriers include companies pushing prices low enough “to force rivals out of the market” (predatory pricing). Another barrier occurs when firms set a low price with a high output, which makes it impossible for new entrants “to make a profit at that price” (“Oligopoly”, para. 23). Other artificial barriers include the firm’s superior knowledge of the market, purchasing sufficient shares of the firm’s rivals, creating a strong brand and loyalty schemes, advertising, and vertical integration (“Oligopoly”). Possessing a significant volume of production, oligopolistic firms provide themselves with cost savings; as a result, small firms simply cannot stay in the industry due to high costs. Another barrier to entry into the industry is the financial barrier, since a firm needs huge funds to enter the market.
The features of oligopoly include several large firms producing the bulk of the industry’s products and their control over prices, which is limited by general interdependence and the strategic behavior of firms. In addition, characteristics of oligopoly include the existence of high entry barriers into the industry and predominant use of methods of non-price competition. Nash equilibrium occurs when the best choice of the firm is optimal for the best optimal choices of other firms. Oligopoly markets are distinguished by whether their oligopolistic participants act completely independently, at their own risk, or, on the contrary, they conspire and conduct a collusive agreement, which can be open or secret. In the first case, this cooperation is referred to as an uncooperative oligopoly, and in the second, as a cooperative oligopoly, one of the forms of which is a cartel. Because of the entry barriers, it is not challenging for a collusion to survive the threat of entry. Game theory is often discussed in relation to oligopoly and firms in collusion because it examines strategic behaviors of firms in their decision-making process.
Works Cited
Alothman, Abdullah, and Ammar Alqahtani. “Analyzing Competitive Firms In An Oligopoly Market Structure Using Game Theory.” 2020 Industrial & Systems Engineering Conference (ISEC), 2020.
Jeffrey R. Church, et al. Industrial Organization: A Strategic Approach. Richard d Irwin, 2000.
Head, Keith, and Barbara J. Spencer. “Oligopoly in international trade: Rise, fall and resurgence.” Canadian Journal of Economics/Revue canadienne d’économique, vol. 50, no. 5, 2017, pp. 1414-1444.
“Oligopoly.” Economics Online, 2020.
Telser, Lester G. Competition, Collusion, and Game Theory. Routledge, 2017.