The Basic Dilemma of Oligopoly
The basic dilemma faced by oligopolistic firms is very similar to the
dilemma faced by the members of a cartel, which we studied in Chapter
10. There we saw that the cartel as a whole had an incentive to form an
agreement to restrict total output (and raise price), but each individual
member of the cartel had the incentive to cheat on the agreement and
increase its own level of output.
For the small number of firms in an oligopoly, the incentives are the
same. Firms can either cooperate (or collude) in an attempt to maximize
joint profits, or they can compete in an effort to maximize their individual
profits. Not surprisingly, the decision by one firm to cooperate or to
compete will depend on how it thinks its rivals will respond to its
decision.
How do these decisions by firms affect price and output in the markets in
which they operate? To answer this question, we first make a distinction
between cooperative and non-cooperative behaviour. If the firms cooperate
to behave like a single profit-maximizing monopolist, they will reach
what is called a cooperative (or collusive) outcome. If the firms are at
such a cooperative outcome, it will usually be worthwhile for any one of
them to cut its price or to raise its output, so long as the others do not do
so. However, if every firm does the same thing, they will be worse off as a
group and may all be worse off individually. An industry outcome that is