Assume a duopoly in the soft drinks market with Coca-Cola and Pepsi the only two firms. Should Coca-Cola and Pepsi spend $100 million on a TV advertisement or not?
If both Coca-Cola and Pepsi do not advertise then they make $100 million more profit because they save $100 million if they do not pay for TV adverts. If Coca-Cola believes that Pepsi will not advertise then Coca-Cola will advertise, make its brand stronger, steal some of Pepsi’s consumers and make $1 billion more profit, Pepsi’s profits fall by $500 million because Pepsi lose some consumers and vice versa. If both Coca-Cola and Pepsi advertise then they make their brands equally as strong and receive $100 million less profit because they receive no extra sales and yet must spend $100 million on advertising.
If Coca-Cola believes Pepsi will not advertise then Coca-Cola will want to advertise to steal some of Pepsi’s consumers and receive $1 billion extra profit rather than make $100 million less profit. Pepsi will reason the same way. So both Coca-Cola and Pepsi will play their dominant strategy and advertise.
Both Coca-Cola and Pepsi advertising means they will each make $100 million less profit because they advertise but attract no extra consumers from each other. So the Nash equilibrium (Advertise, Advertise) makes Coca-Cola and Pepsi worse off than if they both do not advertise. As long as CocaCola and Pepsi do not trust each other to not advertise, they will both advertise. If Coca-Cola and Pepsi could collude and make an agreement or if they trust each other then they could both not advertise and save $100 million.
An Example of Oligopoly: The Car Industry An example of an oligopoly is the car industry.