The Theory of Few Sellers
Monopoly is a theory of a
market with one seller and many buyers. Supply and demand is
the theory of a market with many sellers and many buyers.
What changes in these theories would be needed to tell us
what happens if there is oligopoly, that is, more
than one seller, but fewer than many? What, for example,
happens if there are two sellers, or duopoly? Though
many economists suspect that the results of two sellers are
more similar to those of one seller than to those of many
sellers, economics lacks a clear theory that can prove this
The problem of interdependence has thwarted
economists' attempts to develop a good theory of oligopoly.
When there are only a few sellers, each recognizes that his
decisions affect others who may react to what he does.
This problem of interdependence can be shown in terms of
game theory in a situation that is identical to the
prisoners' dilemma. The table below shows the pricing
options of the only two gas stations in an isolated town.
The payoffs in the center are profits. If both stations
charge high prices, the joint profits are maximized. But
then each has a temptation to cut prices to get to a more
favorable corner. If one of them gives in to this
temptation, it may start a gas price war as the other firm
must retaliate. They then end in the least favorable
position of lowest joint profits. We could expand the table
to show what would happen if they cut prices even further,
to $.80, and we would see that this cut would make them both
still worse off. Gas price wars do break out occasionally,
but they usually do not last long. Rather quickly, the firms
realize the futility of the fight and will try to return to
the original position.
There may be no equilibrium solution in a situation of
this sort. Rather, there may be a period of collusion
in which firms agree (though it may be an unspoken
agreement) to keep prices high. Then, the collusion may
disintegrate as firms begin cheating and finally a new
period of collusion may begin. Whether sellers collude or
compete will depend on many factors that can be difficult to
measure and put into a theory, such as the number of
sellers, their personalities, whether they have equal or
unequal shares of the market, whether their costs are the
same, the ease of cheating and of detecting cheating, and
whether the sellers can compete on nonprice bases such as
service and quality.
A thorough examination of the possibilities of
oligopolistic strategies and how well they fit observed
behavior of real-world oligopolies is a large and
controversial subject that is beyond the scope of these
readings. The important point concerning economic efficiency
is that if oligopolists perceive their demand curves as
downward-sloping (that is, if they take into account that
the amount they produce will have a significant effect on
the price they can charge), their marginal revenue curves
will lie below their demand curves and they will restrict
output relative to what an industry of price takers would.
Thus, there will be an efficiency loss involved. Most
economists use the term "market power" to describe the
ability of any price maker to set price.1
When the possession of market power is profitable, it
should attract new entrants into the industry. If
entry is easy, then the existence of very few or even
only one firm may not result in economic inefficiency. The
threat of potential entry may be enough competition to keep
the industry operating at or close to the competitive
solution. In this case, the market is a contestable
market. However, if entry is not easy but there are
significant barriers to entry, the threat of
competition is less. Barriers to entry exist when there are
sunk costs--expenses that cannot be recovered once a
firm has entered the industry. Where these costs are high,
the industry probably operates as the theory of monopoly
suggests it will.
Barriers to entry can take several forms. They will exist
if large amounts of specialized machinery are required to
enter an industry and resale of that machinery is difficult.
They will exist if a firm must establish a reputation for
the quality or reliability of a product. They will also
exist if a firm must expend resources in order to get
governmental approval to enter. In all of these cases, the
barriers to entry can be viewed as sunk
The theory of contestable markets suggests that even if
there is only one seller, the seller may be forced to act as
if there were many more. In contrast, there are times when
great numbers of sellers are able to organize and act as a
unified seller. Sellers have the incentive to act in this
way because it will increase profits. The key to their
success is their ability to restrict sales.
One place that restrictions on the market are important
is in the labor market.
1 Although the word "power"
usually implies the ability to use force, the possessor of
market power usually does not possess this ability. A
monopolist cannot usually fine, imprison, or physically harm
someone who does not do what the monopolist wants. However,
the term "market power" is widely used and there seems to be
no good alternative. Hence, we will use it.
economists also treat situations in which there is economic
rent or producers' surplus as barriers to entry. Rent exists
when some resource is especially good for a particular use.
Land of special fertility, with rare ores, or with unusually
good location is difficult to compete against, as are people
with special talents.