Question

Firms in oligopoly must constantly think in terms of how other firms in the industry will react to whatever they do. Why do they have to do this? Why is it that firms in perfect competition and in monopoly don’t have to worry about how other firms will react?

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Answer 1

An oligopoly market is characterized by a limited state of competition. The industry is dominated by a small number of large firms, they could be selling either identical or differentiated products, and there are significant barriers to entry in the industry. Because the number of firms are less, oligopolies usually focus on gaining the maximum market share. When the firms are competing for market share, what other firms do becomes very important. If the product is identical and substitutable, if one firm reduces the price, the other firms will also have to follow suit, otherwise their market share would reduce.

For instance, take airline industry. In most countries, airline industry is characterized by oligopoly form of market. If one airline were to reduce its price of tickets, we can expect consumers to flock towards it because the service of transportation being sold is identical. If say, the services were differentiated, like better in-flight services, the consumers may or may not substitute.   

This is when the firms are not colluding. But we must remember that oligopolies can also result from various forms of collusion that reduces market competition and typically leads to higher prices for consumers.

Firms in perfect competition and monopoly do not have to worry about how the other firms will react. This is so because, in perfect competition, the products being sold are perfect substitutes and the number of buyers and sellers are very large. If one firm were to reduce its price, the other firms will have to follow suit or the consumers most definitely will substitute. This doesn't leave them with any choice. Also since there are no barriers to entry or exit, firms that are not able to sustain low prices typically exit the market.

In monopoly there is only one seller - it literally has no one to worry about. Being the sole seller, the firm can set its prices according to what makes sense to it without having to worry about competition repercussions. Also, the fact that barriers to entry are high provides it with extra cushion.