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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). 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. We will assume in our 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 just analyzed in the previous chapter. 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 firm’s decision on how much to produce will have an impact on the price the other firms can charge, or my decision on 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. 25A An Intuitive Development of a Models of Oligopoly While we could think of oligopolies with more than two firms, we will focus here primarily on the case where two firms operate within the oligopoly market structure (that is then sometimes called a ”duopoly”). The basic insights extend to cases where there are more than two firms in the oligopoly – but as the number of firms gets large, the oligopoly becomes more and more like 738 Chapter 25. Oligopoly a perfectly competitive market structure. We will also simplify our analysis by assuming that the two firms are identical (in the sense of facing identical cost structures) and that the marginal cost of production is constant....
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