Introduction to Oligopoly | Economics Explained

In 1951, several college basketball players from different teams were accused of working together to alter the final score of their game, known as point shaving, and affect betting markets.

This is illegal and several players served time in jail.

And one person took them down. Junius Kellogg, a star player for Manhattan College, was offered a bribe if he would participate in the point-shaving scheme. He declined and reported it to authorities. This led to the downfall of the collusion scheme. 

A collusion is an illegal agreement between people or businesses to limit competition in some way, and it’s very hard to pull off.

Whether it’s related to point shaving in a sporting match or price fixing in a market—such as setting an artificially high price in the market for a good like soda.

Because all it takes is one person to dissolve the collusion.

And as you can guess, as the number of people involved in a scheme increases, it’s harder to collude on anything.

Most of the time, you get caught or the effort unravels because someone refuses to cooperate.

And while it doesn’t happen very often, collusion is more likely to happen in an industry where a few businesses dominate, known as an oligopoly.

An oligopoly is a specific type of imperfect competition where a few large businesses dominate a market, and usually there is a reason for this industry structure.

For example, the costs to start a business are really high which lends itself to a few large businesses.

Some examples of industries that lend themselves to just a few large firms are the airline, or gaming console, or automobile industry.

There are barriers to entry that keep most competitors out of the market—all but a few. This means businesses have more power in the market because they face few competitors.

Products in an oligopoly market can be similar or differentiated. 

But since businesses have some degree of market power, they have some control over the prices they charge. But when they do that, they have to consider other businesses’ decisions at the same time.

Let’s take a look at how this works in the airline industry. Imagine you run a large business like an airline company and have just a few competitors that sell a nearly identical product.

When you’re making the price/quantity combination decision with just a few other businesses, any one of the businesses in the market is big enough that its decisions will affect the market price and therefore affect you!

Say one of your competitors suddenly decides to lower its prices and sell at marginal cost. If you don’t lower your prices, you’ll probably lose a lot of business.

Or what if an additional business enters the market, adding extra competition to your small oligopoly. Should you lower your prices, slow production, or increase advertising?

Usually, a business has to make its pricing and production decisions without knowing what their competitors are doing.

So to make better decisions, oligopolistic businesses rely on game theory—the study of how people behave when other people’s behaviors will affect their outcome and behavior.

So let’s look at an example of how game theory helps explain business behavior.

Technically in an industry with, say, just three companies it would be in these businesses’ best interest to collude, or price fix, and cooperatively set the price and level of output.

Essentially, they’d collectively become a monopoly—charge the same high price that a monopolist would charge and divide the output sold evenly among the three businesses. In this case, competition among the businesses is just an illusion.

But think about it: There is no incentive for any of the businesses to keep up their end of the bargain.

Say, if two of the three businesses kept their prices high and one business dropped its price by just a little, it would capture the whole market and make a higher profit.

Businesses would quickly realize that it’s in their best interest to drop their prices regardless of what the other businesses do, which means that all of the businesses drop their prices and the illegal collusive agreement unravels just like the basketball point-shaving scandal did.

So game theory predicts that oligopoly businesses usually do not end up colluding so that they can price like a monopolist. But they still have to take their competitors’ actions into account when making decisions.

And when they do, the prices they charge they charge will be higher and the quantity sold will be lower than they would be in a perfectly competitive or even a monopolistically competitive market, but the prices will be lower and the quantities higher than in a monopoly market.

To recap, oligopolies are markets made up of a few large businesses, usually because of barriers to enter the market. Therefore, these firms have some power in the market and therefore have significant control of what prices they can charge. As such, they can charge higher prices than businesses in more competitive markets.  Some oligopoly industries have product differentiation and advertising and some do not.

Finally, game theory shows us that collusion is difficult, even among a few businesses; it can also help oligopoly businesses make pricing and output decisions when other businesses’ decisions affect its own.