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Unformatted text preview: Chapter 25 Oligopoly We have thus far covered two extreme market structures perfect competition where a large number of small firms produce identical products, and monopoly where a single firm is isolated from competition through some form of barrier to entry (and through a lack of close substitutes that could be produced by someone else). 1 The models that represent these polar opposites are incredibly useful because they allow us to develop intuition about important economic forces in the real world. At the same time, few markets in the real world really fall on either of these extreme poles, and so we now turn to some market structures that fall in between. The first of these is the case of oligopoly . An oligopoly is a market structure in which a small number of firms is collectively isolated from outside competition by some form of barrier to entry. Just as in the case of monopolies, this barrier to entry may be technological (as, for instance, when there are high fixed costs) or legal (as when the government regulates competition). We will assume in this chapters analysis of oligopoly that the firms produce the same identical product and will leave the case where firms can differentiate their products to Chapter 26. Were the firms in the oligopoly to combine into a single firm, they would therefore become a monopoly just like the one we analyzed in Chapter 23. Were the barriers to entry to disappear, on the other hand, the oligopoly would turn to a competitive market as new firms would join so long as positive profits could be made. Since there are only a few firms in an oligopoly, my firms decision about how much to produce will have an impact on the price the other firms can charge, or my decision about what price to set may determine what price others will set. Firms within an oligopoly therefore find themselves in a strategic setting a setting in which their decisions have a direct impact on the economic environment in which they operate. You can see this in how airlines behave as they watch each other to determine what fares to set or how many planes to devote to particular routes, or in how the small number of large car manufacturers set their financing packages for new car sales. Below, we will develop a few different ways of looking at the limited and strategic competition that such oligopolistic firms face. 1 This chapter builds primarily on Chapter 23 and Section A of Chapter 24. Only Section 25B.3 of this chapter requires knowledge of Section B from Chapter 24 and this section can be skipped if you only read Section A of Chapter 24. The chapter also presumes an understanding of the different types of costs covered in the earlier chapters on producer theory (as summarized in the first section of Chapter 13) as well as a basic understanding of demand and elasticity as covered in the first section of Chapter 18. 966 Chapter 25. Oligopoly 25A Competition and Collusion in Oligopolies While we could think of oligopolies with more than two firms, we will focus here primarily on...
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