Answer to Question #262946 in Management for Mareeye

Question

Briefly explain how firms compete/set price under the Oligopoly market structure.

Answer 1

Discussion

An oligopoly is defined as a type of market structure where two or more firms have market control. Combined, they are able to dictate prices and supply. Yet, they are unable to influence the market on their own. Firms in an oligopoly can have varying degrees of market share. This could be as significant as 50 percent, or, as little as 5 percent. The point is that the oligopoly is characterized by a few firms no matter their size as long as a handful of them have enough power to dictate supply and demand.

Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable. Oligopoly is a market structure in which there are a few firms producing a product. When there are few firms in the market, they may collude to set a price or output level for the market in order to maximize industry profits. As a result, price will be higher than the market-clearing price, and output is likely to be lower. At the extreme, the colluding firms may act as a monopoly, reducing their individual output so that their collective output would equal that of a monopolist, allowing them to earn higher profits. If oligopolists individually pursued their own self-interest, then they would produce a total quantity greater than the monopoly quantity, and charge a lower price than the monopoly price, thus earning a smaller profit. The promise of bigger profits gives oligopolists an incentive to cooperate. However, collusive oligopoly is inherently unstable, because the most efficient firms will be tempted to break ranks by cutting prices in order to increase market share.

Game theory provides a framework for understanding how firms behave in an oligopoly. In an oligopoly, firms are interdependent; they are affected not only by their own decisions regarding how much to produce, but by the decisions of other firms in the market as well. Game theory offers a useful framework for thinking about how firms may act in the context of this interdependence. More specifically, game theory can be used to model situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action. For instance, game theory can explain why oligopolies have trouble maintaining collusive arrangements to generate monopoly profits. While firms would be better off collectively if they cooperate, each individual firm has a strong incentive to cheat and undercut their competitors in order to increase market share. Because the incentive to defect is strong, firms may not even enter into a collusive agreement if they don’t perceive there to be a way to effectively punish defectors.

Reference

Mazzeo, M. J. (2002). Product choice and oligopoly market structure. RAND Journal of Economics, 221-242.