Lesson preview · Oligopoly Intro
Strategic Interaction
~5 min · Free to read
Four airlines run almost every domestic US route. Cut your fare and you steal passengers from the others. Hold your fare high and they undercut you. There is no “just pick your own price” option — every fare is also a bet about how the rivals will respond.
This is an oligopoly: a market with a small number of large firms. The numbers are small enough that each firm’s choices visibly affect the others. Economists call this strategic interaction. Each firm’s optimal choice depends on what its rivals do.
Key Term
Four features of oligopoly
- Few firms — the market is concentrated (airlines, telecom, auto manufacturers).
- Barriers to entry — economies of scale, patents, brand loyalty, or strategic behaviour keep new firms out.
- Strategic interdependence — each firm considers rivals’ likely reactions before choosing price or quantity.
- Products may be homogeneous or differentiated — steel is homogeneous, smartphones are differentiated.
There is no single “oligopoly model” the way there is for perfect competition or monopoly. The outcome depends on the rules of the game. Do firms choose quantity or price? Do they move at the same time, or in sequence? Can they communicate and collude? Each set of assumptions gives a different model. To handle them, economists use game theory — the mathematical analysis of strategic interaction.
Worked Example
Two airlines (A and B) share a route. If both set high fares, each earns 10 million dollars. If both set low fares, each earns 4 million dollars. If one sets high and the other low, the low-fare airline earns 12 and the high-fare airline earns 2. Show why this is an oligopoly with strategic interaction.
Key Term
This game has a name: the Prisoner's Dilemma
The airline payoffs follow a structure famous enough that economists named it. In this analogy, high fare is cooperation (good for both airlines) and low fare is defection (good for whoever does it alone, bad for both when they all do it). Label the four payoffs:
- — temptation: payoff from defecting alone while the rival cooperates (12).
- — reward: mutual cooperation (10 each).
- — punishment: mutual defection (4).
- — sucker: cooperating alone while the rival defects (2).
A game is a Prisoner’s Dilemma whenever and . The same shape shows up in arms races, antibiotic overuse, climate negotiations, and advertising spending — cooperation is collectively better, defection is individually tempting.
Check yourself · no marks
Why is there no strategic interaction in a perfectly competitive market?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
The defining characteristic of oligopoly that distinguishes it from other market structures is:
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