Oligopoly

Definition

An oligopoly is a market dominated by a small number of large sellers — typically three to ten firms — whose pricing and output decisions are mutually interdependent. Each firm must account for how rivals will respond when setting its own strategy. This strategic interdependence — the defining feature that distinguishes oligopoly from both perfect competition and monopoly — means no firm has an optimal strategy in isolation. What is best for firm A depends on what firm B does, and vice versa.

Oligopoly is the most common market structure in advanced economies. Airlines, automobiles, telecommunications, pharmaceuticals, and banking are all oligopolistic industries. The behavior of these markets — whether firms compete aggressively or coordinate quietly — has major implications for prices, innovation, and consumer welfare.

Why it matters

Key takeaways

The defining feature is strategic interdependence — optimal strategy depends on rivals' choices. This is why game theory was developed: to model these interactions formally.
Collusion produces monopoly-like outcomes: firms acting as a cartel restrict output and raise prices to maximize joint profit. But the Prisoner's Dilemma explains why cartels are inherently unstable.
Competitive oligopoly (like Bertrand competition on price) can produce outcomes close to the competitive benchmark — in some models, two firms are enough to produce competitive pricing.
The kinked demand curve model explains oligopoly price rigidity: rivals match price cuts but not price increases, so the payoff to raising price is low and the payoff to cutting is limited.
High barriers to entry (capital requirements, economies of scale, brand loyalty, network effects) create and sustain oligopoly by preventing new competition from entering.
Antitrust law prohibits explicit collusion (price-fixing cartels) but tacit coordination — firms independently arriving at similar prices without communication — is harder to prosecute.

Collusion versus competition

Read it as: Oligopolists face a structural dilemma. Collusion raises joint profits but creates a temptation for each firm to defect — undercut rivals to capture share while they hold prices high. If everyone defects (red path), the cartel collapses. If everyone holds (green path), the cartel survives — but requires ongoing trust, retaliation threats, and is illegal under antitrust law in most jurisdictions.

The game-theoretic structure

The Prisoner’s Dilemma in oligopoly

The classic representation of cartel instability is the Prisoner’s Dilemma: both firms do better cooperating (high prices) than competing (price war), but each firm has a dominant strategy to defect regardless of what the other does. If your rival holds prices and you cut, you capture their customers; if your rival defects and you hold, you lose share. The dominant strategy is to defect — and so the Nash equilibrium is mutual defection, even though both firms would prefer mutual cooperation.

This explains why cartels rely on mechanisms that change the payoff structure: price-matching commitments that eliminate the gain from defection; transparent pricing that enables rapid detection of defectors; strong retaliation threats that make defection unprofitable in repeated interactions.

Price rigidity

The kinked demand curve model offers an intuitive explanation for why oligopoly prices tend to be sticky. If a firm raises its price above the current level, rivals will not follow — they gain share by staying put. If a firm cuts its price, rivals will follow — they cannot afford to lose share. This asymmetry produces a kink in the firm’s perceived demand curve and a corresponding range of marginal costs over which the optimal price is unchanged, making price rigidity rational.