4.5 Oligopoly and Game Theory

Oligopoly basics

Oligopoly is a market with a small number of large, interdependent firms producing identical or differentiated products. High barriers to entry limit competition. Because there are so few firms, each firm's decisions (price, output) directly affect rivals — this mutual interdependence is the defining feature and sets up strategic decision-making.

Game theory & payoff matrices

Game theory models strategic interactions using a payoff matrix showing outcomes for each firm's choices. A dominant strategy is best regardless of what the rival does. A Nash equilibrium occurs when neither firm wants to change its strategy given the other's choice. Oligopolists often face a prisoner's dilemma: individually rational choices (like cheating on a cartel) lead to a worse joint outcome than cooperation.

Collusion and cartels

Firms may form a cartel, colluding to set price/output like a monopoly and maximize joint profits. This is unstable because each firm has an incentive to cheat (produce more than agreed) to boost its own profit, breaking the agreement. Cartels are also illegal in the U.S. under antitrust law, and are undermined without binding, enforceable contracts.

Key terms

Oligopoly

A market with a few large, interdependent firms and high barriers to entry.

Game theory

The study of strategic decision-making among interdependent firms, often shown via payoff matrices.

Dominant strategy

A strategy that yields the best outcome for a firm regardless of what its rival does.

Nash equilibrium

An outcome where neither firm wants to change its strategy given the other's choice.

Cartel

A group of firms that collude to set price/output jointly like a monopoly, though unstable due to incentives to cheat.

Try an AP-style question

What is Firm A's dominant strategy?

1. Depends on B
2. Low price
3. High price
4. No dominant strategy