How do Firms behave in Oligopoly?

If a commodity is sold by more than one firm but the number of sellers is few, the structure is an oligopoly. The special case of exactly two sellers is a duopoly. In analysing oligopoly here, we assume the product is homogeneous and has no substitute produced by any other firm.

With only a few firms, each is large relative to the market and can affect total supply and hence the market price. If, say, one of two equal-sized duopolists doubles its output, market supply rises sharply and price falls, cutting the profits of every firm. Rivals then respond to protect their own profits by re-deciding how much to produce. So the industry's output, its price and its profits are all outcomes of how the firms interact — this mutual interdependence is the defining feature of oligopoly. Firms may behave in three broad ways:

1. Collude (form a cartel). At one extreme, firms agree to collude to maximise collective profit. The cartel then behaves like a single monopoly: the industry's total output and its price are the same as a monopolist would choose.
2. Compete by undercutting. At the other extreme, firms compete, each cutting its price a little below the others to attract their customers. Rivals retaliate in kind, so the price keeps falling as long as firms undercut one another — in the limit it falls to marginal cost (no firm supplies below $MC$), which is the perfectly competitive price. …