16.1 Oligopoly
Oligopoly is characterized by having a small number of firms competing and natural or legal barriers preventing the entry of new firms.
A. Small Number of Firms
1. Interdependence
With only a small number o f firms in a market, each firm’s actions influence the profits of the other firms.
2. Temptation to Collude
To maximize profit, firms in an oligopoly might choose to form a cartel. A cartel is a group of firms acting together to limit output, raise price, and increase economic profit. Cartels are illegal in the United States.
B. Barriers to Entry
A duopoly is a market with only two firms. A natural oligopoly occurs when a few firms can supply the market more cheaply than many firms. A legal oligopoly exists when a legal barrier to entry protects the small number of firms in a market.
C. Identifying Oligopoly
The key feature that determines whether a market is an oligopoly is whether the firms are interdependent. As a practical matter, a market in which the HHI exceeds 1,800 is usually an example of oligopoly.
16.2 The Range of Oligopoly Outcomes
A. Duopoly in Airplanes
1. Competitive Outcome
A competitive outcome occurs when the firms produce the level of output determined by the intersection of the industry supply curve (the marginal cost curve) and the market demand curve.
2. Monopoly Outcome
A monopoly outcome occurs when the firms produce the same level of output as a single-price monopoly at the intersection of the marginal cost and marginal revenue curves.
3. Possible Oligopoly Outcomes
An oligopoly will produce the quantity of output ranging from the quantity produced by a perfectly competitive market and to that produced by a single-price monopoly.
B. Collusion Versus Competition
Boeing and Airbus can collude so each produces 3 airplanes a week and together they produce the monopoly output of 6 airplanes a week.
1. Boeing Increases Output to 4 Airplanes a Week
Boeing can increase its profit if it increases its output to 4 airplanes a week. In this case,
Air bus’s profit decreases and it decreases by more than the increase in Boeing’s profit.
2. Airbus Increases Output to 4 Airplanes a Week
Once Boeing has increased its output to 4 airplanes a week, Airbus can increase its profit if it increases its o utput to 4 airplanes a week. In this case, Boeing’s profit decreases and it de creases by more than the increase in Airbus’s profit.
3. Boeing Increases Output to 5 Airplanes a Week
Once Airbus has increased its output to 4 airplanes a week, neither Boeing nor Airbus can increase its profit by further increasing its production.
16.3 Game Theory
Game theory is the tool economists use to analyze strategic behavior —behavior that recognizes mutual interdependence and takes account of the expected behavior of others.
A. What Is a Game?
A game is defined by its rules, strategies, and payoffs.
B. The Prisoners’ Dilemma
The prisoners’ dilemma is a game between two prisoners that shows why it is hard to cooperate even when it would be beneficial to both players to do so. Two prisoners are caught committing a crime for which they must serve a 2-year sentence. The district attorney suspects they are the

same criminals who committed an earlier crime. To get the criminals to confess to the earlier crime, the district attorney makes them play a game. The game is defined by the following:
1. Rules
If both prisoners confess, each will receive a 3-year sentence. If one prisoner confesses and his accomplice does not, the confessor receives a 1 –year sentence while the accomplice receives a 10-year sentence. If neither confess, each gets a 2-year sentence.
2. Strategies
Strategies are all the possible actions of each player in a game. In the prisoners’ dilemma, the strategies are that the prisoners can confess to the earlier crime or deny committing the crime.
3. Payoffs
A payoff matrix is a table that shows the payoffs for each player for every possible combina tion of actions by the players. There are four possible payoffs in the prisoners’ dilemma. If one prisoner (Art) confesses and the other prisoner (Bob) does not, Art serves 1 year and Bob serves 10 years. If Bob confesses and Art does not, Bob serves 1 year and Art serves 10 years. If both Art and Bob confess, each serves 3 years. If neither confesses, they only serve the 2 years for the crime for which they were caught red-handed.
4. Equilibrium
The game’s equilibrium occurs when each player chooses the best possible action given the action of the other player. This equilibrium concept is called Nash Equilibrium, named after
John Nash who proposed it. In the prisoner’s dilemma, each prisoner chooses to confess.
5. Not the Best Outcome
The equilibrium outcome is not the best for each prisoner. Without the ability to communicate and cooperate, the prisoners choose to confess. This choice produces a more severe sentence for each prisoner.
C. The Duopolists’ Dilemma
Airbus and Boeing play a game where each firm must choose how many airplanes to produce.
They can produce 3 or 4 airplanes each week.
1. The Payoff Matrix
If they want to maximize the industry’s profits ($72 million), each will collude and produce 3 planes a week. If Airbus cheats on the agreement to reduce output and produces 4 planes
(while Boeing produces only 3 planes), Airbus makes $40 million and Boeing makes $30 million. If Boeing cheats on the agreement to reduce output and produces 4 planes (while
Airbus produces only 3 planes), Boeing makes $40 million and Airbus makes $30 million. If both firms cheat on the agreement and make 4 planes, each firm makes $32 million.
2. Equilibrium of the Duopolists’ Dilemma
The firms each decide that it is best off if it produces 4 airplanes per week.
3. Collusion is Profitable but Difficult to Achieve
Collusion is difficult to achieve because it is in each firm’s individual interest to increase its production beyond the restricted limit assigned to it.
D. Other Oligopoly Games
Other interactions between firms in oligopoly, such as the amount of R&D to conduct, can be analyzed using game theory.
E. Repeated Games
By repeating a game, firms in a duopoly are more likely to cooperate and earn a monopoly profit.
If a firm knows that it can be punished in subsequent games by its competitors, it has an incentive not to cheat. This “tit for tat” strategy is likely to produce a monopoly outcome.
F. Is Oligopoly Efficient?
If the oligopoly can restrict its output, it is inefficient.