Four Market Model Summary: Oligopoly: Videos & Practice Problems

An oligopoly is a market structure characterized by a few firms dominating the industry, which creates high barriers to entry for new competitors. These firms are interdependent, meaning each firm's decisions affect the others, leading to strategic behavior often analyzed through game theory. Unlike perfect competition, oligopolies face a downward-sloping demand curve, so the price is greater than marginal cost, and marginal revenue is less than price. This market power allows oligopolies to maintain long-run profitability. Examples include companies like Coke and Pepsi in the soft drink industry and aluminum suppliers. Understanding these features helps explain pricing strategies and market outcomes in oligopolistic markets.

Game theory is crucial in understanding oligopolies because firms are interdependent and must consider competitors' potential reactions when making decisions. Unlike perfect competition, where firms maximize profit by setting marginal revenue equal to marginal cost ($\mathrm{MR}=\mathrm{MC}$), oligopolistic firms engage in strategic pricing and output decisions. They anticipate rivals' moves and may cooperate tacitly or compete aggressively. This strategic interaction can lead to outcomes like price rigidity, collusion, or price wars. Game theory models, such as the Prisoner's Dilemma, help explain why firms might not always compete aggressively despite incentives to do so, highlighting the complexity of oligopoly behavior.

Oligopolies have high barriers to entry due to factors like significant capital requirements, control over essential resources, economies of scale, and strong brand loyalty. These barriers prevent new firms from easily entering the market, limiting competition. As a result, existing firms maintain market power, allowing them to set prices above marginal cost and earn long-run economic profits. This contrasts with perfect competition, where free entry drives profits to zero in the long run. The high barriers ensure that oligopolistic firms can sustain profitability over time, making the market less competitive and more stable.

In an oligopoly, the demand curve faced by each firm is downward sloping, meaning that to sell more output, the firm must lower its price. This contrasts with perfect competition, where firms face a perfectly elastic (horizontal) demand curve at the market price. Because oligopolies have few firms and some market power, they can influence prices. Consequently, the price ($P$) is greater than marginal revenue ($\mathrm{MR}$), and marginal revenue is less than price, unlike in perfect competition where $P=\mathrm{MR}=\mathrm{MC}$. This difference affects how oligopolies set output and prices strategically.

Yes, oligopolies can sustain long-run profits primarily because of their market power and high barriers to entry. With only a few firms controlling the market, they can influence prices and output levels to maintain profitability. The high barriers prevent new competitors from entering and eroding these profits. Unlike perfect competition, where free entry drives profits to zero in the long run, oligopolies can keep prices above marginal cost, ensuring positive economic profits persist. This long-run profitability is a key feature distinguishing oligopolies from more competitive market structures.