Hi. Welcome to Economics. This is Kate. This tutorial is called "Oligopoly." As always, my key terms are in red, and my examples are in green. In this tutorial, we'll identify oligopoly as one of the market structures studied in Economics. And by the end of the tutorial, you'll be able to define this market structure and understand its main characteristics.
So we know that firms are the ones who take the factors of production and supply us with goods and services. We know also that firms do not all behave the same way. You might have businesses you like, businesses you don't like. Why do firms behave the way that they do? Well, based on a lot of different factors. But some of the ones we'll be talking about in this tutorial is how big the company is, what kind of product they sell, how much competition they face, and how easy or how difficult it is to get into the business.
So if we look at where oligopoly falls on the spectrum of competition, it's right here. So perfect competition was a market structure where there are so, so many firms that are selling a homogeneous or identical product. Whereas monopoly was only one firm dominating the entire market, selling something that was one of a kind. As you can see, oligopoly is actually closer on the spectrum to monopoly than to perfect competition. So it's defined as an industry market structure characterized by a few firms selling similar products. So here, certainly they're not a monopoly. But there are many fewer than in monopolistic imperfect competition.
Why is it that more firms don't enter? 'Cause in monopolistic competition and imperfect competition, if the industry is doing really, really well, there are these low barriers to entry, so almost anyone can get into the business and start producing. Well, in oligopoly, there are going to be barriers to entry. So that's what characterizes this market structure. And some examples of barriers to entry that could exist are exclusive access to resources or something like a patent. I put down here for our pharmaceutical companies. There are not that many major pharmaceutical companies in our country, and a big reason to that is because of these barriers to entry.
Any industry that has significant high startup costs will encourage large scale production, and it will encourage a few large firms to develop because they can spread out those initial upfront costs. The two examples I was thinking about are maybe our cell phone network providers or cable or digital television providers in a certain area. I'm sure it is very expensive to get into that industry and start setting up that kind of network. So it becomes very difficult for anyone else to enter to compete with them.
So like all firms, oligopolies are going to set output and price wherever they maximize profit. They're going to tend to produce more than a monopoly, definitely, but less than more competitive market structures, like perfect or a monopolistic competition.
Let's talk about price for a couple of minutes. Prices are definitely going to be lower than in a monopoly because they do face some competition. But they'll certainly be higher than in more competitive market industries. Have you ever thought to yourself, gee. You know, I just feel like I'm getting ripped off by this company. I think that there really should be more competition here. These companies are charging very similar prices, and I can't seem to get a deal. I know I've thought that way. Generally it's in this market structure-- oligopolies.
So if you ever thought, huh, these prices seem pretty similar, sometimes that goes along with this idea here of collusion. It's an attempt by firms to agree on prices and also to agree on the number of units produced. So in oligopolies, this becomes possible sometimes because of the small number of firms. In monopolistic or perfect competition, it's certainly not possible because there's just too many, and they could never all sit down and agree on anything. But if they could, wouldn't that be in their best interests to do it? Because it would allow them to act as one company and earn monopoly profits.
Thankfully for us, this does not always work out. And that's due to a phenomenon we call the prisoner's dilemma which is a model used to illustrate why collusion breaks down. So I want to give you the classic example of the prisoner's dilemma, and it's this prisoner situation. OK? So two prisoners have an option to confess or not confess. Are you already thinking this sounds like a television show? Yeah. Any crime television show kind of has a scene like this on it. All right.
So the prosecutor really is relying on a confession because he doesn't have enough information to convict them of what they actually did. The minor offense will only give them one year in jail. So if they both shut up and don't say anything, they're only spending one year in jail.
They're going to be questioned in different cells. They have no ability to communicate. They are told if one prisoner confesses and the other remains silent, the prisoner confessing gets to go free. The one remaining silent serves 20 years in jail. They both confess, kind of as a thank you for being honest they only serve three years in jail. OK
So what would you do? Would you rat out your buddy? Here's what we call a payoff matrix, and here's how it works. You read it so if prisoner one confesses and prisoner two confesses, this negative three, negative three represents them both spending three years in jail or losing three years of their life or freedom. They both don't confess-- negative one, negative one. They both only get one year in jail. But these show if one confesses and one does not.
So what's the best outcome? Well, if you look at what's the best outcome for them both combined, it would be this. It would be if they could both agree to not confess. But is that going to be the result, especially without the ability to communicate?
Think about prisoner's one situation. He's saying to himself, hmm. Let me think about this. If my friend confesses, oh gee. I'd better confess otherwise I'm spending 20 years in jail. Right? That would be his situation right here. If my friend doesn't confess, well certainly, I could not confess. And I'd only get one year in jail. But isn't it still in my best interests to confess if he doesn't? 'Cause now I go free. Either way, it's in both of their best interests to confess. So both have an incentive to cheat.
You may be sitting here thinking, OK. What in the world does this have to do with oligopolies? Well, let me tell you. So let's say that there are two grocery stores, and they're an oligopoly. And if they could agree to both keep prices high, this would be in each of their profits, 50 million and 50 million. But if they compete with one another and can't agree on it, they both slash prices. They only make 25 million each. If grocery store one keeps prices high while grocery store two slashes prices, grocery store one loses out. And grocery store two gains all the business.
So the best strategy for both stores combined is this. But just like on the previous slide with the prisoners, they both have an incentive to cheat on one another and slash prices-- at least in the short run. But this prisoner's dilemma shows us why there is an incentive here to cheat on one another and for collusion to break down. Sometimes the collusion works. Sometimes it breaks down because of this phenomenon here.
A cartel is a group of colluding firms. It's more official. Cartels happen to be illegal in the United States through our antitrust laws. But the most common example in the world is OPEC, the group of countries that export oil. They meet annually to try to coordinate prices and production levels. And I'm sure sometimes those meetings are very successful, and they all leave there thinking that each other is going to do exactly what they said they were going to do.
But generally we find that the world price of oil is much lower than the agreed upon price. Why would that be? Well think about it. As soon as they leave the meeting, any one of them could start producing just a little bit more. And as they start producing a little bit more, that's going to increase the supply of oil on the world market, driving down price. So this prisoner's dilemma really comes into play in a lot of situations.
So in this tutorial, we talked about oligopoly as a market structure with few firms. They're selling similar products, but they're certainly not identical. There are significant barriers to entry, and that's why there are more competitors. They're setting out output and price is going to be somewhere between more competitive markets in a monopoly. And there's this interesting collusive behavior that either works or breaks down according to the prisoner's dilemma scenario we just went through.
Thank you so much for listening. Have a great day.
A group of colluding firms.
An attempt by firms to agree on prices and the number of units produced.
An industry market structure characterized by a few firms selling similar products.
A model used to illustrate why collusion tends to break down.