Imperfect Competition: Understanding Oligopoly Behavior with Strategic Thinking

Oligopoly

A market structure in which a small number of large firms dominate the market, so each firm’s actions can noticeably affect market outcomes and rivals’ profits.

Interdependence

The defining feature of oligopoly: each firm must consider how rivals will react to its pricing, output, and non-price decisions.

Barriers to Entry

Obstacles that make it difficult for new firms to enter an oligopoly (e.g., economies of scale, brand loyalty, patents, control of distribution, large capital requirements).

Economies of Scale

A situation where average cost falls as output rises; as a barrier to entry, it means low costs may require producing at very large scale.

Homogeneous Oligopoly

An oligopoly in which firms sell identical or very similar products.

Differentiated Oligopoly

An oligopoly in which firms sell similar but not identical products; branding and features matter.

Strategic Behavior

Decision-making in which a firm explicitly accounts for likely rival responses (a reason game theory is useful in oligopoly).

Price Competition

Competition based on changing prices; in oligopoly it can be risky because rivals may match price cuts, reducing profits for all firms.

Non-Price Competition

Competition using tools other than price (e.g., advertising, product improvements, service quality, warranties, bundling, loyalty programs, innovation).

Collusion

An agreement among firms to set prices, limit output, or divide markets in order to increase joint profits (i.e., act more like a monopoly).

Cartel

A formal collusive agreement among firms, typically aiming to set a higher common price and/or restrict output via coordination.

Output Quota

A production limit assigned to each firm in a cartel to help restrict total industry output and keep price high.

Cheating (Defection)

Secretly undercutting a collusive price or producing beyond a quota to raise an individual firm’s profit, often destabilizing collusion.

Price War

A downward spiral of price cuts when firms repeatedly match or respond to rivals’ price reductions, often shrinking profits for everyone.

Price Rigidity

The tendency for oligopoly prices to be “sticky” (slow to change) because firms anticipate rivals’ reactions to price increases or decreases.

Kinked Demand Curve Model

A model explaining price rigidity: demand is relatively elastic above the current price (rivals may not follow a price increase) and relatively inelastic below it (rivals may match a price cut).

Market Power

The ability of a firm (or group of firms) to influence price; oligopolies often have market power, so price may exceed marginal cost.

Deadweight Loss

The loss in total surplus that occurs when output is restricted below the efficient level (often associated with monopoly-like or collusive outcomes).

Allocative Efficiency

A condition where resources are allocated to their most valued use; in perfect competition P = MC, while oligopoly often has P > MC, implying allocative inefficiency.

Game Theory

A set of tools for analyzing strategic decision-making when outcomes depend on the choices of multiple interdependent players (common in oligopoly).

Payoff Matrix

A table showing the payoffs (often profits) each player receives for every combination of strategies chosen by the players.

Dominant Strategy

A strategy that gives a higher payoff than any alternative regardless of what the other player does.

Nash Equilibrium

A set of strategies where no player can improve their payoff by unilaterally changing their own strategy, given the other player’s choice.

Prisoner’s Dilemma

A situation where mutual cooperation would make both players better off, but each has an incentive to defect, leading to a Nash equilibrium that is worse for both than cooperation.

Repeated Game

A game played multiple times; repeated interaction can make cooperation more sustainable because cheating can be punished by future retaliation.